Rent deposits: a good deed indeed

TEN-MINUTE TOPICS: In a new monthly series giving readers the basics on core subjects, Sue Highmore explores how rent deposits operate and the pitfalls to be avoided when dealing with them On any new letting, the landlord needs reassurance that the tenant can pay the rent reliably and will observe the lease terms. The landlord will check the tenant’s financial position and references and, if it doubts the tenant’s covenant strength, will seek additional protection, such as a guarantee or a rent deposit. Unlike residential property, where there are standard deposit schemes established under the Housing Act 2004, for commercial property the parties can negotiate the rent deposit arrangement. There are several options (see box). This article concentrates on the first, most popular, method – the charge. Relevance A rent deposit serves two purposes for a landlord. Its existence (even if no call is made on it) underpins the income stream and thus the value of the property to any purchaser. If the tenant is in default, the rent deposit also provides the landlord with funds to remedy that default. The rent deposit deed should give the landlord control over when and how to withdraw the money and require the deposit to be topped back up. It should be structured to prevent the tenant’s insolvency practitioner from accessing the deposit to satisfy the tenant’s other creditors. The tenant’s prime concern is to reduce the amount of “dead” capital tied up in the rent deposit. It is equally keen to ensure that, if the landlord becomes insolvent, the deposit monies will be returned to the tenant in full and not applied by the insolvency practitioner or bank to settling other debts. Component parts of the document The rent deposit deed should set the amount to be deposited and the tenant’s obligation to top that up following drawdown. The deed must include the grant, by the tenant to the landlord, of a first fixed charge over the deposit as security for performance of the tenant’s obligations in the lease and deed. The landlord should acknowledge the deposit is owned by the tenant subject to that charge. The deed usually specifies that any interest earned on the deposit accrues to the tenant (net of tax) either when the deposit is repaid or more often. The deed should specify when the deposit is to be repaid to the tenant. Certainly this should happen when the lease expires (if the tenant vacates). Often the tenant will want earlier release. Typical triggers are demonstrating that it has improved financial strength (a profits test), or expiry of a fixed period, even if the lease has longer to run. Whatever the triggers, the amount returned to the tenant should be reduced by any outstanding liabilities owed to the landlord. Some rent deposit deeds contain detailed covenants on when and where to open the bank account, for the tenant to cooperate in this process (often necessary to satisfy money laundering rules) and for bank costs to be paid by the tenant (often by deduction from the deposit). This type of rent deposit deed is not registrable at the Land Registry or (since April 2013) at Companies House. This makes it difficult for any prospective assignee of the lease, or purchaser of the reversion, to know that the rent deposit exists. Yet they may end up being bound by its provisions. The deed can do little to alleviate this. Potential pitfalls Forgetting the VAT: If VAT is payable, the deposit amount should equal the relevant number of months’ VAT-inclusive rent. Failing to check whether the tenant can charge the deposit: Due diligence is important here. For example, if the deposit fund is caught by an existing floating charge given by the tenant company a letter of non-crystallisation will be needed before the rent deposit deed is completed. Some rent deposit deeds contain a tenant’s warranty that there is no pre-existing charge over the money. Forgetting to qualify the landlord’s obligation to release the deposit where the lease terminates early due to disclaimer or forfeiture:In these circumstances, the landlord will want to keep the deposit and draw down lost rent until reletting. Not checking that a pre-2013 deed from a corporate tenant was registered at Companies House: If not, it will be invalid and must be replaced by a new one. Late registration is impossible. Inadequate drafting for transmission to successors: For leases granted on or after 1 January 1996, section 28 of the Landlord and Tenant (Covenants) Act 1995 (the 1995 Act) treats the rent deposit deed as a “collateral agreement”: This complicates transmission. On sale of the reversion, the outgoing landlord only escapes liability under the deed (such as returning the money) if the tenant gives an express release. Yet performance may be impossible if that landlord has handed on the deposit monies to its successor. Some rent deposit deeds address this by limiting each landlord’s obligations to the period it holds the reversion. This works for the original landlord (based on Avonridge Property Co Ltd v Mashru [2005] UKHL 70; [2006] 1 EGLR 15) but there is no authority yet that it works for successor landlords. Another approach is to include in the deed a tenant’s obligation to release the outgoing landlord on request, possibly conditional on the incoming landlord giving a (theoretically unnecessary) direct covenant to observe the rent deposit deed. This approach may prove unenforceable under section 25 of the 1995 Act. The outgoing landlord may ultimately have to depend on the indemnity covenant by its successor to observe the lease and rent deposit deed. The incoming landlord is bound by the 1995 Act to observe the rent deposit obligations, even if it did not know about the deed or inherit the fund. This makes due diligence crucial. If the purchaser discovers there is a rent deposit, it must arrange to take over the deposit fund and check that interest has been paid out or accrued properly. On lease assignment the assignor is automatically released from the rent deposit deed obligations (eg to top up) but the 1995 Act does not require the deposit to be returned to the assignor. Either the rent deposit deed must set this up, or the assignor should require the assignee to pay it a matching sum. The assignee automatically inherits, under the 1995 Act, liability to perform the rent deposit deed but the declaration that the funds belong to the “tenant” may not be drafted to refer to the tenant for the time being. Often the best solution to this confusion is to set up a completely fresh rent deposit for each assignee, and require this as a condition of consent to assignment. This is also the way to deal with a pre-1996 rent deposit, where there is no automatic transmission of liabilities. Legislative context Section 859A(6)(a) of the Companies Act 2006 excuses from registration at Companies House any rent deposit created by a corporate tenant in favour of its landlord by way of a charge over a cash deposit. The Landlord and Tenant (Covenants) Act 1995 governs when and how original parties to the rent deposit deed cease to be liable under it. Money laundering rules influence the way the bank holding the deposit will deal with the landlord, tenant and any insolvency officials. Types of rent deposit Charge The landlord holds the money in a separate account at its bank, but the deed declares it belongs to the tenant and is charged to the landlord. An example is available at http://bit.ly/2y6O21i. The advantage of this method is that the deposit is safe from the insolvency official of both tenant and landlord, and the bank cannot use it for offsetting. Trust The landlord holds the money in a separate account at its bank, on express trust for the tenant and with rights to draw on it. Trusts are less popular due to fiduciary duties, tax issues and registration uncertainty. Co-mingling The landlord holds the money either combined with the landlord’s other funds or in a separate account. There is no declaration that the tenant has any interest in it. The method is easy but unpopular with tenants because the deposit can be lost on the landlord’s insolvency. Tenant-held charge The tenant holds the money in a separate account at its bank, charges it to the landlord and gives the landlord rights to operate the account. Emotionally unpopular with landlords. Stakeholder A third party (often a solicitor) holds the money and deals with it according to the deed. Now rarely used. Sue Highmore is a writer and trainer Pic credit: Image source/Rex/Shutterstock