Restructuring rent: insolvency law innovations impacting commercial landlords

Economic downturns create opportunities for the restructuring or acquisition of challenged assets, and we anticipate increased activity in this space in 2023. The indicators pointing in that direction are:

• inflation remains elevated, with the Reserve Bank of Australia successively hiking interest rates in response;
• ASIC’s insolvency statistics for Q3 and Q4 2022 showing an escalating number of external administration appointments;
• the Australian Taxation Office ramping up debt collection activity – reportedly seeking the repayment of approximately $45 billion in uncollected, undisputed tax debt (an increase of nearly 70% from mid-2019 when the figure was sitting at $26.5 billion); and
• given that confluence of factors, industry organisations (such as the Australian Restructuring, Insolvency & Turnaround Association), and commercial credit reporting bureaux (such as CreditorWatch), foreshadowing an increase in the number of formal appointments this year.

One relatively stable sector of the economy in which the ripples are likely to be felt is commercial property leasing, not least because rent review provisions typically adjust rent by reference to the consumer price index (CPI) – and CPI rose 7.3% over the 12 months to the September 2022 quarter. Underlying all of the above is the post-pandemic struggle for many retail tenants. For example, the City of Sydney’s December 2022 annual business needs survey revealed that more than 75% of the city’s retailers were operating at reduced capacity since the pandemic, with 50% still operating at below pre-pandemic capacity.

Inevitably, against such an economic backdrop (and the cessation of pandemic-era business supports), an increasing number of commercial tenants will struggle to service their lease obligations and will require some form of restructuring (including attempting to negotiate rent relief with the landlord), or will enter formal insolvency.

Having acted both for landlords and administrators of tenant companies in many high-profile administrations in the Australian market, we’ve seen the (occasionally avant garde) methods of restructuring being utilised – and landlords responding in kind. This article explores some of the key issues which arise when a tenant is insolvent.

Restructuring an insolvent business with leasing obligations

In Australia, the most common formal insolvency process used to attempt to restructure a distressed business is voluntary administration via the Corporations Act 2001 (Cth). In a voluntary administration, an insolvency practitioner is appointed to the debtor company and takes control of the company and its business, to the exclusion of its incumbent directors and management.

The administrator has a statutory remit to explore available options to maximise the chances of the business continuing in existence; but is ultimately an independent professional who must also investigate the reasons for the company’s financial distress. At the same time, the administrator will very closely manage any ongoing trading to limit their (statutorily imposed) personal liability for the company’s debts incurred during the administration period.

Where a business operates from leased premises, the way in which the administrator manages the company’s leasing obligations will be a critical focus. Landlords are invariably key stakeholders in any administration and obtaining their buy-in to any trading, sale or restructuring plan pursued by the administrator is generally a prerequisite to value preservation.

Rent-free periods, liquidators’ liability for rent, and the Lundy Granite principle

Under the Corporations Act, administration triggers a “stay” which prevents landlords from enforcing against leased property while the administration is on foot. The flipside is that administrators are personally liable for rent or other amounts attributable to the administration period (apart from a 5 business-day (“rent-free”) period at the start of the administration – to allow the administrator time to decide what leased property to retain before incurring personal liability). While administrators can satisfy such liabilities from the assets of the company to which they are appointed, they remain personally liable for any shortfall.

In other words, the administrator can cause the company to continue in possession of the property, if they have sufficient funds to pay rent and other outgoings (and it is in the interests of creditors to do so). Alternatively, they can formally notify the landlord that the tenant does not propose to exercise rights in relation to the property, however, that notice must be given within the “rent-free” period. Such a notice terminates the administrator’s personal liability (but the liabilities of the tenant under the lease remain, albeit subject to the proof of debt regime). Additionally, for most leases entered into after 1 July 2018, in addition to the stay on enforcement actions, the landlord cannot terminate, or enforce any other right under the lease, if the trigger for doing so is merely the appointment of an administrator to the tenant.

This is the conventional position. However, in recent years, largely driven by extended pandemic lockdowns, administrators in larger and more complex administrations have increasingly sought to (further) limit their personal liability by obtaining Court extensions in the Federal and State Supreme Courts of the “rent-free” period before they incur personal liability or must relinquish the leased property. In fact, the number of reported extension applications in the two years since 2020 exceeds the number of reported applications in the decade between 2010 and 2019.

The graphic below identifies the incidence of reported “rent-free” extension applications in Australia’s Federal Court and State Supreme Courts over the 2010-2022 period.

The length of the extensions granted by the Courts have varied, depending on the circumstances of the relevant administration. The applications decided during the pandemic reveal that the Courts were far more willing to grant extensions of the “rent-free” period to administrators at that time, than pre-pandemic. They also reveal the Courts’ readiness to grant longer extensions (of weeks or even months, rather than days) to allow administrators to assess a company’s position in respect of leased assets. The table below sets out some key data in respect of a selection of pre- and post-pandemic extensions.

While many of the applications in 2020-2021 cited pandemic-related factors to justify the extension sought (such as the uncertainty for retail businesses created by Government imposed lockdowns), the Courts have shown a willingness to grant such relief in any circumstances where “the administrator has had insufficient time to conduct the necessary investigations to decide whether he or she thinks it best to retain or give up possession of leased property”. The grants of relief in 2022 – at a remove from pandemic-related difficulties – suggest that applications of this nature will become more common where administrators are faced with a large number of leases and wish to preserve the business and associated options for potential purchasers, but cannot assume the significant financial exposure associated with the leases while lease diligence or sale options are explored.

A related development has been the emergence of claims made by landlords and lessors that, even where the administrator has been relieved of statutory personal liability, rent during the administration period should be paid in priority to ordinary unsecured creditor claims, pursuant to the so-called “Lundy Granite” principle (arising from a 19th Century English liquidation case of the same name). This principle had previously only been recognised in liquidations, applying where the liquidator “elects to cause the company to continue in occupation of leased premises”. In the PAS Group administration, the companies leased a total of 166 premises, including 161 retail stores. The administrators obtained an order extending the “rent-free” period while they continued to trade from most of the stores through the administration period. They generated gross revenue of $7.32 million from trading from leased premises. The total rent for all 166 properties for the extension period was $1.385 million. In giving directions as to what priority should apply to the unpaid rent in a (hypothetical) winding up, the Court found that, according to the principle in Lundy Granite, the unpaid rent should be accorded priority above the companies’ other unsecured creditors.

There remain, however, a number of uncertainties as to how the Lundy Granite principle will be applied to Australian administrations. In proceedings brought by 11 aircraft lessors against the former administrators of Virgin Australia Airlines, the administrators (for whom the authors acted) successfully argued that the principle did not apply where the companies were not in liquidation, but rather had executed deeds of company arrangement (DOCAs) with creditors’ claims (including those of landlords and owners of leased aircraft) being dealt with pursuant to the terms of a creditors’ trust. While there have been some English cases which extended the principle in English administrations, the English administration regime has at least one critical difference to Australia’s voluntary administration regime: the former provides for the distribution of assets within the administration (under rule 4.218 of the Insolvency Rules 1986 (UK)), the latter does not. Where it applies, the Lundy Granite principle affects the order of priority on distribution. Where there is no statutorily prescribed order of priorities on distribution (as in an Australian administration), until an Australian court finds otherwise, the correct position is that the Lundy Granite principle has no work to do.

Where the administrator elects to retain property during the administration period, the best outcome is usually for the administrator and the landlord to negotiate a mutually acceptable arrangement in respect of rent to avoid any later uncertainty or dispute as to their respective entitlements and obligations. There is nothing in Australian law which prevents the parties from entering into such an arrangement and, as found by the NSW Supreme Court in the Virgin Australia Airlines proceedings, no Corporations Act preclusion on the administrators negotiating a compromise or standstill of their statutory personal liability for rent.

Discriminating between creditors in insolvent reorganisations

A restructuring may seek to discriminate in favour of creditors whose support is necessary for the ongoing operation of the business, or to discriminate against creditors who are no longer integral to the business’ future operations. For example, a restructuring of an insolvent retailer may treat landlords who lease premises in profitable locations more favourably than those who lease unprofitable shops. Even landlords who vote against the restructuring are bound by it as regards the terms of their leases.

Discriminating between creditors in a restructuring is permissible, but there are limits. For a restructuring implemented through a creditors’ scheme of arrangement, if a creditor or class of creditors is treated so differently that it cannot consult together with the other creditors with a view to their common interest, then it votes in a separate class. If creditors vote in separate classes, it gives an opportunity for a disadvantaged class of creditors to block the scheme.

For a restructuring implemented through a DOCA, creditors vote as one class. A creditor or group of creditors against whom the DOCA would discriminate may therefore be outvoted by the majority. Their remedy is to apply to Court and, if they can demonstrate that the DOCA is unfairly prejudicial or unfairly discriminatory, to seek orders varying, or setting the DOCA aside.

In the United Kingdom, while the 19th century Lundy Granite principle has received recent judicial consideration, so too has the issue of discrimination of landlords in corporate insolvencies. In the UK, in recent years a number of high-profile retailers successively implemented Company Voluntary Arrangements (CVAs) or restructuring plans restructuring landlord liabilities without, in some cases, impairing other creditors, prompting judicial challenges to those CVAs and restructuring plans and even a review of the use of CVAs by the Insolvency Service of the UK Government.

A prominent example of a UK restructuring that discriminated between landlords was the 2021 restructuring of Virgin Active. The gym’s landlords were divided into 5 classes: A, B, C, D and E. The restructuring plan proposed that all landlords retained a right to forfeit the leases. Each class of landlord was treated differently. Class A landlords were paid all their arrears of rent whereas class E received only a dividend under the restructuring plan; classes B, C and D were treated in intermediate ways. Landlords in classes B to E did not approve the plan by the required majorities at the creditors’ meetings. The Court nevertheless approved the plan, against the opposition of a group of landlords, in circumstances where the plans did not discriminate arbitrarily or capriciously between different classes of creditors and all of the landlords were better off than if the plan was not approved and Virgin Active entered administration.

How can a DOCA compromise a landlord’s rights?

In Australia, there is (at present), no cross-class cram down provisions of the kind which enabled the Virgin Active restructuring to succeed. There are also limits to what a DOCA can do to compromise a landlord’s rights. A DOCA cannot compromise a landlord’s proprietary rights (for example, its right to recover possession of the premises upon termination of the lease or to enforce a registered security interest), without the landlord’s consent. A DOCA also cannot compromise third-party rights, for example, the landlord’s ability to call on a bank guarantee or a third party contractual guarantee.

A DOCA can discriminate between creditors, provided that it is not oppressive or unfairly prejudicial to, or unfairly discriminatory against, one or more creditors. In ascertaining whether a DOCA is unfairly prejudicial or unfairly discriminatory, the Court will have regard to the following principles:

• a DOCA may discriminate against or prejudice a creditor or a class of creditors, so long as there is no additional element of unfairness;
• discrimination between different creditors is less likely to be unfair if it is:
  • commercially sensible;
  • rationally explained; and/or
  • necessary to secure the continuation of the company’s business which underlies the arrangement;
• there will be cases where the financial disadvantage to creditors voting against the proposal is so substantial, and certain, that it amounts to unreasonable or unfair prejudice;
• prejudice is likely to be unfair to a creditor or class of creditors if it is very likely to result in a worse outcome for them (having regard to returns, risks and delays) than a winding up – a similar test to that considered by the English Court in the Virgin Active restructuring.

What is the impact of these developments?

Apart from the introduction of the “ipso facto” stay regime (preventing termination of contracts (including leases) solely on the basis of an insolvency event) in 2018, there has not been any significant legislative change which alters the position of landlords in corporate insolvencies in Australia since the commencement of the voluntary administration regime in 1997. However, there has been greater ingenuity by restructuring and insolvency professionals in the deployment and development of the existing legal framework, including to seek extensions of the “rent-free” period to relieve an administrator of rent liabilities while restructuring options are explored.

For insolvency practitioners, these developments are positive – they can make the difference between salvaging a distressed business or shutting up shop. For landlords, they mean closer attention needs to be paid to tenant insolvencies, including being ready to negotiate, intervene, or even make applications to Court, to ensure their rights are adequately protected.

The authors acknowledge the assistance of Leigh Gordon, rotating solicitor, with this article.