03 Mar 2014

Willmott Forests - disclaimer by liquidators of an insolvent landlord

by Orla McCoy

The Willmott decision leaves open a number of significant related issues.

The High Court has confirmed that liquidators of an insolvent landlord may disclaim leases, thus extinguishing the tenant’s leasehold estate or interest in the subject land: Willmott Growers Group Inc. v Willmott Forests Limited (Receivers and Managers Appointed) (In Liquidation) (Willmott Forests).[i]

This decision has prompted a flurry of legal commentary, expressions of concern within property and property finance sectors, and calls for legislative reform.[ii]

From a policy perspective, the High Court judgment accords with the longstanding purpose of the disclaimer provisions, allowing a liquidator to rid the company of financial obligations which might be to the detriment of the creditors as a whole.

Those provisions allow an official receiver, bankruptcy trustee or liquidator to ‘advance the prompt, orderly and beneficial administration of the bankrupt estate or, in the case of a company, the winding up of its affairs.’[iii] Notably, the disclaimer power is not available in voluntary administration or receivership.

However, disquiet arises because the High Court judgment ostensibly undermines tenants’ security of tenure. This has ramifications for the commercial property sector and its financiers. It has also been suggested that the decision enlarges an insolvent estate (at the tenant’s expense) since it upholds the right of a liquidator to disclaim a lease and to sell the entirety of the leased property, not just the reversion.[iv]

The High Court judgment also leaves open a number of significant related issues, which are discussed below.

Background to the case

The landlord (Willmott) was the responsible entity and manager of managed investment schemes involving forestry plantations. Investors in those schemes leased land from Willmott on which trees were grown. When Willmott went into liquidation, the liquidators found that potential purchasers of the land and trees were only prepared to acquire them unencumbered by the schemes.

Accordingly, the sale contracts were conditional upon the liquidators’ giving unencumbered title to the land and trees. The liquidators sought directions and orders pursuant to section 511 of the Corporations Act that they were justified in disclaiming the scheme contracts (including the leases) as onerous and unprofitable under section 568(1). A number of investors opposed the liquidators’ application.

At first instance, it was held that the liquidator of a landlord can disclaim a lease, but that does not extinguish the tenant’s proprietary interest in the land. This decision was reversed on appeal. The Court of Appeal held that a tenant’s interest in leased land cannot survive the termination of the lease which creates the tenant’s interest. The investors appealed to the High Court.

The High Court majority identified two issues:

"First, does s 568(1) give a liquidator power to disclaim a lease which the company granted to a tenant; and, second, if a liquidator has power to disclaim such a lease, what does s 568D(1) provide to be the effect of that disclaimer?"

The Court’s reasons

The High Court majority held that a liquidator of a landlord could disclaim a lease and that disclaimer terminates the tenant’s interests in the land.

The majority held that the power to disclaim is coloured by the fact that the opening words of section 568 refer to disclaimer of the "property of the company". In their view, "property" in this context refers to "the company's possession of any of a wide variety of legal rights against others in respect of some tangible or intangible property of the company." From this they concluded:

"Once it is understood, as it must be, that ‘property’ in the chapeau to s 568(1) is a compendious description of legal relationships amounting to ‘ownership’ of objects of property (both tangible and intangible), the reference in [s. 568(1)(f)] to ‘a contract’ must be understood as identifying, as the disclaimer property, the rights and duties which arise under the contract. The contract is the source of those rights and duties."

It is firmly established[v] that a lease is a species of contract, to which "the ordinary principles of contract law, including that of termination for repudiation or fundamental breach"[vi] apply. It followed, according to the majority, that the power to disclaim a lease includes the power to disclaim the landlord’s "rights and duties" which "consist of" (in the sense that they derive from) the contract of lease. This conclusion was "put beyond any doubt by the reference in s 568(1A) to ‘a contract … other than a lease of land.’"

Critically, the majority held that "The reference in [s 568(1A)] to ‘a lease of land’ cannot be read as referring only to leases in which the company is a tenant"[vii] (emphasis added).

As to the second question (the effect of disclaimer of a lease), the majority held that the landlord’s "rights, interests and liabilities in respect of the leases cannot be brought to an end without bringing to an end the correlative liabilities, interests and rights of the tenants."[viii] In other words, the company can only be released from its liabilities by terminating the tenants’ correlative "rights" under the leases. Those rights would include both the tenant’s right to quiet enjoyment and any interest or estate in the land.

Tenants would, pursuant to section 568D(2), retain the right to prove in the winding up to the extent they suffer loss as a consequence of disclaimers of leases.

In a strong dissenting judgment, Justice Keane said:

  • a liquidator of a lessor cannot disclaim a lease of land without the leave of the Court under section 568(1A), and
  • the power to disclaim property of the company consisting of a "lease of land" is concerned with the property of the lessee. [ix]

Ramifications for the commercial property market

Commentators have remarked upon the consequences of the Willmott Forests High Court judgment for tenants,[x] particularly tenants with long-term leases who have injected a great deal of capital into their tenancies.[xi] Others have observed that the High Court judgment has "profound ramifications to the concept of [a] tenant’s ‘security of tenure’ [which] may result in tenants and their financiers seeking further covenants from landlords or strategies to deal with the risk of loss of tenure."[xii]

Typically, commercial enterprises raise finance by giving security over their assets. Where those assets include a lease, disclaimer of the lease by the lessor’s liquidator may trigger a default under the tenant’s security documents, and extinguish the financier’s security. Termination of a lease may also result in the loss of the tenant’s local customer base and goodwill, or the inability to continue operations from a unique location.

The High Court’s decision will, therefore, change commercial lending and security practices. Tenants and their financiers will need to give greater consideration to the lessor’s security profile, including conducting pre-finance due diligence on the lessor. Additional reporting and disclosure obligations in finance documents in relation to lessor distress or default may be expected.

Events of default may expand to include breaches of covenant or insolvency events on the part of the borrower’s landlord(s). Security packages are also likely to be supplemented or diversified to require personal guarantees, tripartite arrangements between tenants, their landlords and the tenant’s financiers, or the grant of options to purchase the leased property.

Apart from the additional costs, inconvenience and risk arising from these changes, some quarters of the market suggest that one outcome of the decision is that liquidators may use the disclaimer power to enlarge the pool of assets available to the general body of creditors. In dissent, Keane J argued that the purpose of disclaimer was "distinctly not to expand the pool of assets available to creditors by clawing back property previously disposed of by the company."[xiii]

Of course in practice it is, and will remain, uncommon for liquidators of lessors to disclaim a lease because the continuation of the lease, or the sale of the property with the benefit of the lease will often be of commercial benefit. The disclaimer power is only likely to be used where the lease imposes very onerous obligations on the insolvent company (eg. a peppercorn rent, a very lengthy lease term or the lease rendering the land unsaleable).

Also militating against a deluge of disclaimers by liquidators of insolvent lessors is the still unresolved question whether leave of the Court is required to disclaim a lease.

Do liquidators require leave of the Court to disclaim leases of land?

The majority ruling did not answer two very important practical questions. Under section 568(1A), a liquidator cannot disclaim "a contract (other than an unprofitable contract or a lease of land)" except with the leave of the Court. The dissentient Justice Keane held that a liquidator of a lessor cannot disclaim a lease of land without leave under section 568(1A).

The majority held that section 568(1A) was not an issue in this case:

"[There has not been] any occasion to consider in this case whether the liquidators require the leave of the ‘Court’ before disclaiming the investors’ leases or, if they do require leave, what considerations would inform the decision to grant or refuse leave."[xiv]

That means that two potentially important questions remain unanswered:

  • Do liquidators of landlords require leave before disclaiming a lease?
  • If they do, what factors will the Court look at when considering whether to allow disclaimer?

Interestingly, the majority found that:

  • the relevant "property" disclaimed was a "contract", meaning that the disclaimer power invoked was that contained in section 568(1)(f), and
  • a contract which is a "lease of land" is the property of the company in liquidation, irrespective of whether that lease is by or to the company in liquidation.

It is therefore arguable that, when disclaiming a "contract" which is a "lease of land", the express exception set out in section 568(1A) applies. In the same way that leave is not required for the disclaimer of an unprofitable contract, leave will not be required for the disclaimer of a lease of land. In Re Real Investments Pty Ltd,[xv] Chesterman J said:

"Ordinarily one might think that a 'lease of land’ would constitute land which can only be disclaimed if burdened with onerous covenants (see section 568(1)(a)) but the draftsman seems to have regarded leases as a species of contract, not an interest in land, and permitted that species and one other to be disclaimed without leave."

Neither this statement nor the judgment of Master McLauchlan of the Supreme Court of Queensland in Re Jandowae Estates Pty. Ltd,[xvi] in which an application for leave to disclaim a lease was dismissed "because the liquidators do not require the leave of the Court to disclaim the contract of lease",[xvii] was considered at any length by the superior courts in Willmott.

Given this uncertainty, a prudent liquidator may consider seeking directions or leave of a Court before disclaiming a lease of land.

The second open question concerns the factors the Court might take into consideration when considering an application for leave to disclaim. On this point, it may be noted that the majority said:

"The Act does provide expressly, in s 568B(3), that the ‘Court’, on application, may set aside a disclaimer ‘only if satisfied that the disclaimer would cause, to persons who have, or claim to have, interests in the property, prejudice that is grossly out of proportion to the prejudice that setting aside the disclaimer would cause to the company’s creditors’ [emphasis added]."

One possible inference is that the same "grossly out of proportion" test might apply to a liquidator’s application under section 568(1A) for leave to disclaim a lease. How would one then assess "grossly out of proportion" in relation to the disclaimer of a lease?

In one sense, the monetary loss to a tenant caused by disclaimer is not likely to be "grossly out of proportion" to the loss suffered by other creditors; the pari passu principle ensures that all unsecured creditors suffer rateably. Of course, a lease over land confers rights over unique property, so damages may not be an adequate remedy.

A tenant who leased a factory unit or shop in a capital city suburb might not experience too much difficulty finding suitable replacement premises. The same would not necessarily be true of the lessor of a shop or restaurant at a prime tourist destination, or of one who had invested significant capital outlay on a custom-designed fit-out.

The mere fact that such a tenant could mount a strong argument in favour of keeping the lease alive would not be definitive, as the statutory test is whether that tenant would suffer prejudice which is grossly out of proportion to that suffered by other creditors.

Accordingly, other factors are likely to be relevant. For example, if the leased land is the company’s only significant asset and the company has many creditors whose claims are larger than the tenant’s putative damages, it is arguable that allowing the lease to remain on foot (potentially denying them any payment until the end of the lease term) will be a disadvantage to ordinary creditors which is grossly disproportionate.

Conversely, if the land is only a small part of the insolvent company’s available assets, the liquidator’s inability to sell the land unencumbered by a lease might have only a negligible impact on the total cash that could be made available to creditors through liquidation of the company’s assets. The remaining term of the lease could also be relevant. The disclaimer of a short-term lease or a lease which is shortly due to expire (without any option to renew) is not likely to be as prejudicial to a tenant as the disclaimer of a lease which has years to run.

It also remains to be seen what types of conditions might be imposed by the Court upon the grant of leave to disclaim a contract, or what other orders the Court might consider to be just and equitable in connection with the application.[xviii]

Final thoughts

In the present climate, liquidators, tenants and their financiers will be watching this space closely. Faced with a landlord in liquidation, to forestall uncertainty, a tenant (or its financiers) may on written application require a liquidator to decide whether or not they will disclaim the leased property.[xix] If such an application is issued, a liquidator will have 28 days[xx] after receipt of the application to disclaim the property, failing which the power to disclaim will be lost (and, in the case of a contract, the liquidator taken to have adopted it).

Further developments can also be expected in the context of applications to have a disclaimer set aside either before it has taken effect,[xxi] or, with the leave of the Court, after it has taken effect,[xxii] particularly in relation to the disclaimer of contracts.

 This article was first published in the Australian Insolvency Journal Volume 26, No 1, March 2014

 


[i] [2013] HCA 51. I considered the judgments of the Court of Appeal and the Supreme Court of Victoria in an earlier article published in this journal: Disclaimer by Liquidators: Divesting a Company of Continuing Obligations, (2013) 25(1) A Insol J. [back]

[ii] See, for example, the editorial comment in Lang’s Commercial Leasing in Australia at [¶85-403] ‘Now that the High Court has made this ruling on the scope and effect of the disclaimer power, it falls to the legislature to amend the disclaimer provisions in the Corporations Act 2001 (Cth) if it wants to restore the traditional meaning of disclaimer’ [emphasis added].[back]

[iii] Ex parte East and West India Dock Co.; Re Clarke (1881) 17 Ch. D 759, at p. 764. [back]

[iv] See editorial comment in Lang’s Commercial Leasing in Australia at [¶85-403], viz: ‘The effect of the majority’s decision is that any contract to which the insolvent company is a party can be disclaimed by the company’s liquidator … this conceivably means that a liquidator could use the disclaimer power to defeat creditors’ claims – to effectively dissolve the company’s undischarged liabilities, including obligations under a loan contract, mortgage or charge.’ [back]

[v] Citing Deane J in Progressive Mailing House Pty Ltd v Tabali Pty Ltd [1985] HCA 14; (1958) 157 CLR 17 at 51 [a] lease for a term of years ordinarily possesses a duality of character which can give rise to conceptual difficulties. It is both an executory contract and an executed demise’ [emphasis added by the High Court in Willmott Forests at [39]].[back]

[vi] Citing Mason J in Tabali, supra, at [29] (Willmott Forests at [39]). [back]

[vii] Willmott Forests at [41]. [back]

[viii] Willmott Forests at [54].[back]

[ix] Willmott Forests at [108]. Keane J proceeded to outline each of the considerations of text, context, policy, legislative history and authority in support of his views at [109]-[133].[back]

[x] ‘Tenants beware: HCA confirms broad scope of liquidators’ powers to disclaim leases under s.568 Corporations Act 2001 (Cth)’: Herbert Smith Freehills LLP, K de Kerloy, 5 December 2013. [back]

[xi] ‘High Court decides: liquidators of insolvent landlords can disclaim leases with the effect of extinguishing the tenant’s leasehold interest’: King & Wood Mallesons, T Troiani, J Cameron, P Pan and L Johnson, 4 December 2013. [back]

[xii] ‘A get out of gaol free card for landlords?’: Baker & McKenzie, S Busa and D Walter, 9 December 2013. [back]

[xiii] Willmott Forests at [125]. [back]

[xiv] This, presumably, was because the application before the Court originated as an application by the liquidators of Willmott for directions and orders (pursuant to section 511 of the Act) as to whether they were justified in disclaiming the leases. It was not an application for leave to disclaim or a challenge to a putative disclaimer per se. In fact, it was noted in the Court of Appeal judgment that the sale contracts which prompted the initial application for directions were no longer on foot (but the question remained open and would self-evidently affect any future sale): Re Willmott Forests Limited [2012] VSCA 202, at [13]. [back]

[xv] [1999] QSC 89; [2000] 2 Qd R 555, at 559 [13]. [back]

[xvi] (1989) 7 ACLC 179. [back]

[xvii] Jandowae, supra, at [181]. [back]

[xviii] See section 568(1B) of the Act. [back]

[xix] See section 568(8) of the Act. [back]

[xx] Unless that period is extended by the Court – see section 568(8) of the Act. [back]

[xxi] Pursuant to section 568B of the Act. [back]

[xxii] Pursuant to section 568E of the Act. [back]

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