A recent Outer House case, Burgerking Ltd v Rachel Charitable Trust considered whether it was reasonable for a landlord to refuse consent to a sublease where the tenant proposed to pay the subtenant an excessive reverse premium. Lord Drummond Young held that where it is proposed that a reverse premium will be paid to a subtenant and the premium is "greatly beyond" what could be said to be compensation for the difference between the passing rent and the market rent, it is not unreasonable for a landlord to refuse consent to the sublease.
Background
Burgerking Ltd was the tenant of premises in Paisley High Street on a 25-year lease that was due to expire in 2009. The original rent was £88,500 pa, and this was reviewed in 1989 and increased to £150,000 pa, with the rent payable for the part of the premises occupied by Burgerking being £112,000 pa. The rent was well in excess of the market rent, and was not increased at rent reviews in 1994 and 1999. It was agreed by the parties during the proceedings that the market rent in 2004 was approximately £75,000 pa.
The restaurant had been performing poorly and Burgerking sought to dispose of the lease by renunciation, assignation, or sublet. Subletting was the only viable option because of the poor market, as no one would be willing to take over the tenant's lease at its current rent and terms. All the agencies Burgerking approached for this purpose advised that because there was a lack of tenant demand, and the market rent was well below the passing rent, a significant premium would be required to sublet the premises.
The proposed transaction and grounds for refusing consent
It was proposed that Burgerking would grant a sublease of the premises to Quids In Ltd for a rent equal to the passing rent of £112,000 pa until the end of the lease in 2009. Burgerking would pay Quids In a reverse premium, payable by instalments of £25,000 per quarter. The dispute arose after the landlord, Rachel Charitable Trust, refused consent to the sublease, consent being required under the terms of the lease. Such consent was not to be unreasonably withheld. Rachel Charitable Trust gave two reasons for refusing:-
1. The first related to Quids In's ability to pay the rent due under the lease: "…consent is not to be unreasonably withheld or delayed in the case of 'a substantial and respectable…subtenant…who is of sound financial standing and is in the reasonable opinion of the landlords demonstrably capable of performing…the tenants' obligations under the proposed sublease…' Given that the rent liability in terms of the proposed sublease for the five-year term is £560,000 and that Quids In would also be liable for other outgoings…(the landlords) are not of the view that Quids In fulfil this test on the basis of the information exhibited."
2. The second reason related to the proposed payments from Burgerking to Quids In: "Quids In are receiving a payment of £25,000 a quarter from Burgerking and so while the rent under the sublease is £112,000 pa, the £100,000 yearly subsidy from Burgerking effectively means that Quids In would be paying £12,000 by way of rent. A rent of £12,000 pa is well below full market rent and so the proposed sublease does not comply with…the Lease."
The first reason for refusal - The standing of Quids In
The landlord's first reason for refusing consent to a sublease to Quids In related to the requirements of the lease regarding financial standing outlined above. The reason given for refusal was that the rent liability under the proposed sublease was £560,000 over five years and with rates and other outgoings in addition, Quids In would not be able to pay. The issue was therefore the financial capacity of Quids In to meet the outgoings under the sublease. Evidence was led of the accounts of Quids In which were indicative of a successful business. The landlords had used a "market test" based on the proposed subtenant's net profit as a multiple of the rent payable to decide whether Quids In was capable of meeting its obligations. The test involved considering three consecutive financial years of the proposed tenant and determining whether the net profits in each of those years amounted to three times the rent payable. Quids In failed this test. However, the judge held that while it was not unreasonable to make use of the test, it was not reasonable to do so to the exclusion of all other considerations. Using the test on its own was not the act of a reasonable landlord, and therefore the first ground for refusal of consent was defective, in that it gave dominant weight to a test that should only be applied as one of a range of considerations.
The judge was satisfied on the facts that Quids In was able to meet its obligations under the Lease. The Lease required that a prospective subtenant be of sound financial standing, substantial and respectable, and demonstrably capable of performing the obligations under the proposed sublease. The judge said that the whole of the transaction must be taken into account in determining whether Quids In meets this standard. A substantial reverse premium was payable to Quids In, and the proposal was that Quids In would be a subtenant and not a tenant. This was important as Burgerking would remain fully liable to the landlord for the whole of the rent and other obligations under the Lease. Therefore, the standards that apply to a subtenant were not as strict as those that would apply to an assignee. These factors were taken into account by the judge.
The judge concluded that Quids In was able to meet its obligations as subtenant, and the first reason for refusal of consent was not one that a reasonable landlord could make.
The second reason for refusal - The effect of the payments to be made to the subtenant
There was debate in the case regarding the payments from Burgerking to Quids In. Burgerking argued that the payment was a reverse premium, normal in a commercial transaction where there was oversupply and the market rent was well below the passing rent. The landlords viewed the payments as a rent subsidy because of their recurring nature on a quarterly basis, and argued that the existence of the payments would be influential evidence in relation to the market value of the rent if the transaction proceeded. It was asserted in court that the transaction would adversely affect the investment value of the landlords' property, as a valuer would treat the rent payable as only £12,000 pa (the passing rent minus the quarterly payments).
Lord Drummond Young held that the £25,000 per quarter was a genuine reverse premium justified by commercial conditions. It did not follow from the transaction that the property was only worth a rent of £12,000 pa. The reverse premium was a factor, however, that could affect the rent obtained for the property, as the transaction would be relevant when determining its market value.
The commercial impact of the transaction - Scale of the reverse premium
Lord Drummond Young said that the justification for a reverse premium was because the market rent had fallen significantly below the passing rent – the reverse premium was required to compensate for the difference. In the circumstances of the case, however, the reverse premium was greatly in excess of that required to compensate for the difference between market rent and passing rent. The passing rent was £112,000 pa, and it was agreed by the parties that the market rent was approximately £75,000 pa. The compensation requirement for a reverse premium would therefore be approximately £37,000 pa. The proposed reverse premium was £100,000 pa.
Lord Drummond Young stated that provided the premium could be seen as bearing some relationship to prevailing market rents, i.e. be compensatory in nature, its effect on any future assessment of market rent was unlikely to be very great. In such a case, the reasonable landlord would normally have no objective justification for objecting to the reverse premium, because the premium would effectively recognise the state of prevailing market rents. However, where the reverse premium goes greatly beyond what might reasonably be taken as compensation for the difference between market rent and passing rent, a reasonable landlord might be justified in refusing consent. "The transaction in such a case points to a situation that is markedly worse than that indicated by prevailing market rents, and that seems likely to have an effect on future transactions in the market."
The judge concluded that the £100,000 reverse premium was so large that the proposed transaction would have an impact on the rent that could be obtained in the future, and affect the capital value of the asset. A reasonable landlord was therefore justified in refusing consent.
Comment
The result differs from the decision in the English case of NCR Ltd v Riverland Portfolio Ltd No. 1, which is referred to in the judgment. Consent to a proposed sublease was refused in that case, one of the grounds being that the reverse premium took the rent under the sublease below market value, in contravention of the provision in the Lease that governed subletting. It was held that the reverse premium was a genuine premium, and should not be considered as a component in the rent. The decision on this part of the case was upheld in the Court of Appeal, where it was held that the judge at first instance had been entitled to hold that the existence of the reverse premium was not a reasonable ground for refusal of consent.
Lord Drummond Young said that the scale of the reverse premium in the present case was the crucial issue, and it was sufficiently large to determine the rent that was likely to be obtained in the future. No such finding was made in NCR. The net sum payable by the subtenant was 16 per cent of the current market rent, compared to 40 per cent in NCR, and the judge considered this difference to be material.
The Opinion of Lord Drummond Young is available from the Scottish Courts Website at: http://www.scotcourts.gov.uk/opinions/2006CSOH13.html