Update 3 (The Mandatory Code) - effects of Covid-19 on commercial tenancies

The Commercial Leasing Mandatory Code of Conduct (current as at 11pm, 7 April 2020)

This is update 3 of 9 - for our latest article on this topic see here.

In our Update 2 we gave a summary of the Prime Minister’s 7 April 2020 press release confirming that an industry code had been agreed and would soon be legislated as mandatory by the states and territories. You can read our Update 2 here: https://www.easternbridge.com.au/post/update-2-effects-of-covid-19-on-commercial-tenancies-current-at-2pm-7-april-2020

That agreed industry code has now been published. You can access and read the code in full here: https://www.pm.gov.au/sites/default/files/files/national-cabinet-mandatory-code-ofconduct-sme-commercial-leasing-principles.pdf

A number of the comments in our Update 2 are not borne out by the wording of the Code. We have not amended Update 2 – it accurately reflected the Prime Minister’s press conference – but we have clarified each such issue here.

Who will the code apply to?

In Update 2 we indicated that the code would be mandatory where the tenant or the landlord qualified for the JobKeeper program. That is not contemplated by the code. The code will only be mandatory where the tenant qualifies for the JobKeeper program (the tenant must also have an annual turnover of less than $50,000,000).

The Code clarifies that the turnover of franchise groups will be determined having regard to the individual franchisee’s turnover and turnover of retail corporate groups will be determined at the group level (rather than by reference to the turnover of any particular outlet).

Some definitions to be aware of

The Code defines the “pandemic period” as the period commencing 3 April and lasting for as long as the JobKeeper program is operational. At present that program is scheduled to run for “a maximum of” six months commencing 30 March 2020.

The concept of a “reasonable recovery period” after the end of the pandemic period is used throughout the Code (we have referred to it in some, but not all, relevant places above). No recovery period is defined and in our view there is real scope for dispute as to what constitutes a reasonable recovery period. Some businesses may take years to recover from this pandemic. Some, of course, will never recover Prohibitions on actions by a landlord for the duration of the recovery period are likely to become unreasonable at some point.

The Code includes a note that it will be made mandatory by state and territory legislation but that it is “not intended to supersede such legislation”. That begs the question – to what extent, if any, will the legislation seek to impose additional constraints? That remains to be seen but, the Code having been agreed by lengthy negotiation, we would not expect significant state government intervention to shift that agreed position.

The overarching principles

The Code includes a preamble of sorts being a set of overarching principles intended to ‘guide’ the negotiations and agreements between landlords and tenants.

The overarching principles note that the intention of the Code is to share the “financial risk and cashflow impact” of COVID-19.

The overarching principles contemplate parties being open in their communications, including in relation to disclosure of “sufficient and accurate information” – a term defined in the Code to include “information generated from an accounting system, and information provided to and/or received from a financial institution, that impacts the timeliness of the Parties making decisions”.

The overarching principles are best summarised by paraphrasing two of the bulleted principles - requiring the parties to negotiate in good faith and in an open, honest and transparent manner.

The leasing principles

The leasing principles set out the specific expectations of landlords and tenants in reaching agreement in accordance with the Code. A brief summary, and commentary as appropriate, of each leasing principle is set out here.

Leasing Principle 1 prohibits landlords from terminating the lease “due to non-payment of rent during the … pandemic period”. Leasing Principle 14 prevents a landlord from relying on any clause that would make it a breach for a tenant to reduce trading hours or cease operation of the business. The “moratorium on evictions” touted by the Prime Minister over the last two weeks will, then, be a moratorium only on eviction for failure to pay rent during the pandemic period or for failure to keep a business open.

The moratorium would not seem to apply for unpaid rent pre-dating 3 April 2020.

The moratorium would not seem to apply for any other defaults brought about as a consequence of coronavirus (for instance if a tenant has sought to ‘pivot’ their business in a manner not allowed by the terms of lease).

It may be that the legislation that will make the code mandatory will itself impose a broader moratorium on evictions.

We see a risk that tenants may use LP14 as leverage in negotiations for a greater rent reduction than the Code may otherwise contemplate. A threat to cease trading altogether poses risks to a landlord being both a loss of trade to adjoining tenancies as well as a further decline in the tenant’s revenue (resulting in an increased rent reduction requirement on the part of the landlord).

Leasing Principle 2 notes that “[m]aterial failure to abide by substantive terms of their lease will forfeit any protections provided to the tenant under this Code.”

Further to the limited moratorium noted in respect of LP1 above, any material breach by the tenant will immediately forfeit any rights the tenant might have under the Code. It remains to be seen what would be considered a ‘material’ breach but we note that LP2 does not contemplate providing a tenant with an opportunity to remedy its breach before removing the protections of the Code.

We would anticipate landlords requiring any variation agreed between the parties in reliance on the Code to contemplate an unwinding of the agreement if the tenant were to breach the lease in some material fashion.

Leasing Principles 3, 4 and 5 set out the proportionate reduction principles, requiring a landlord to offer tenants reductions in rent in the form of “waivers and deferrals” of rent proportionate to the reduction in the tenant’s trade during the pandemic period and during the “subsequent reasonable recovery period”.

Rental waivers must account for at least 50% of the reduction, with the balance of the reduction to amount to a deferred payment obligation only. LP4 notes that the waiver should reflect a greater proportion where “failure to do so would compromise the tenant’s capacity to fulfil their obligations under the lease” – that principle would seem to allow tenants scope to negotiate for waiver significantly in excess of 50%.

Repayment of the deferral element of reduction must be over the greater of a period of 24 months (not 12 months as stated by the Prime Minister) and the balance of the term of the lease unless the parties agree otherwise. Leasing Principle 9 notes that any repayment requirement should only commence after the end of the lease or the end of the pandemic period, allowing a reasonable subsequent recovery period while Leasing Principle 10 notes that no fees, charges or interest should be charged in respect of any waived or deferred rent.

The Code includes at Appendix 1 an example of how LP3, LP4 and LP5 are intended to operate in practice.

Leasing principle 6 requires any reduction in statutory charges (relevantly land tax and council rates) to be passed on proportionally to the tenant. Our view is that in a gross lease those benefits are to be passed on in addition to benefits otherwise contemplated by the preceding principles.

Leasing Principle 7 requires any benefit obtained by a landlord due to deferral of loan payments to be passed on proportionally to the tenant. We note that landlords might reasonably be reluctant to pass on details of their lending arrangements, however in circumstances in which a bank is simply capitalising interest on loan payments missed (and at the moment that is the extent of the relief being offered by the Australian Banking Association) there would be a good argument that the landlord does not obtain any real or material benefit that must be passed on pursuant to this principle.

Leasing Principle 8 notes that a landlord should “where appropriate” seek to waive any other expense or outgoing payable by a tenant. The principle notes that landlords may reduce services in those circumstances. In our view this principle is likely only to apply in circumstances where building administration, management and similar costs are passed on to tenants – the principle would contemplate a landlord reducing the services provided to the building (for instance reducing the level of cleaning or security presence) and passing the cost savings on to a tenant.

We do not consider this principle to require a landlord to forego recovery of other fixed outgoings such as building insurance. We note the preceding principles contemplate only reduction in rent and not reduction in outgoings where those are charged separately.

Leasing Principle 11 prohibits a landlord from drawing down on a tenant’s security (including calling on any personal guarantee) during the pandemic period or subsequent recovery period. It is our understanding that some tenants may prefer the landlord drawing down on their security (and presumably not calling on the tenant to top-up that security until the end of the pandemic/recovery period).

At this stage our view is that it will not be open to agree to something prohibited by the Code unless the Code allows such agreement (and we note that agreement contrary to principles is specifically contemplated in respect of Principle 5). It may be that when the code is legislated some more clarification or direction will be provided in that regard.

Leasing Principle 12 notes that a tenant “should be provided with an opportunity to extend its lease for an equivalent period of the rent waiver or deferral period”. Particularly in circumstances in which the operative word is “should” and not “must”, it is unclear whether this would be interpreted as a strict requirement (potentially significantly extending the length of leases which may be detrimental to any landlord seeking to develop or otherwise re-deploy the premises at the end of the term of the lease).

It is important to note that, contrary to the Prime Minister’s comments 3 April 2020, the Code includes a note that “[a]ny amount of reduction provided by a waiver may not be recouped by the Landlord over the term of the lease” – that would seem to remove the concept of allowing a landlord to require a tenant to commit to a longer lease term in return for the rental reduction allowed by the landlord pursuant to the Code.

Leasing Principle 13 freezes any rental increases that would otherwise apply during the pandemic period or reasonable recovery period (except in respect of rent calculated on the basis of a tenant’s turnover). In our view that principle would not prevent a landlord ‘catching up’ on rental increases after that period is over (subject to the terms of the lease as may be amended by agreement in that regard).

Dispute resolution

The Code requires the parties to submit to mediation in circumstances in which landlords and tenants cannot reach agreement on leasing arrangements. In Victoria the Office of the Small Business Commissioner would presumably be given the task of arranging those mediations and one wonders at the capacity of the SBC to arrange mediations sufficiently promptly having regard to what will likely be a significant and sudden increase in demand for those services.

Concluding notes

The Code introduces concepts that are reasonably ambiguous and there will be no judicial guidance to assist in interpretation for some time. The Code introduces a broad range of considerations for landlords and tenants. We recommend you contact our office for specific advice on your circumstances and assistance in negotiating and documenting any amendment to lease having regard to the Code.

If you have already reached agreement with your landlord or tenant in relation to relief in the present circumstances we recommend you review the agreement now to ensure that it is consistent with the Code.

Key Takeaway Points A list of key obligations under the Code is as follows: MUST - Tenants must be eligible for the JobKeeper programme - Tenants must comply with their lease (as negotiated under the Code), or lose the Code’s protection - Landlords must not terminate leases for non-payment of rent - Security deposits, bank guarantees and personal guarantees must not be drawn or called upon - Tenants must be permitted to reduce opening hours or cease to trade due to the pandemic without penalty - Rent waivers and deferrals must be offered by landlords based proportionately on the tenant’s reduced turnover during the pandemic period, including the landlord waiving at least 50% of that total reduction (unless the tenant waives this requirement by agreement); - In negotiating any waivers exceeding 50%, regard must be had to the landlord’s financial ability to provide such additional waivers; - Rental deferral repayment must be spread over the balance of the lease term, and for no less than 24 months, whichever is greater, unless the parties otherwise agree - Fees, interest or other charges must not be applied to rent waived or deferred - Rent increases must be frozen until further notice, despite any agreement to the contrary (except for turnover rent) - Outgoings reductions received by the landlord must be passed on to the tenant in full (to the extent the tenant is required to pay them) - Parties must not use the Code’s mediation processes to prolong or frustrate reaching resolution SHOULD - Outgoings recovery should where appropriate be waived by landlords during the period the tenant is unable to trade - Landlords should share any benefit of loan deferral provided by its bank with the tenant on a proportionate basis - Landlords should provide the tenant the opportunity to extend the lease as required to pay deferred rent over the 24-month minimum amortisation requirement - Repayments by agreement should generally occur over an extended period to avoid undue financial burden on tenants, commencing no earlier than the end of the COVID-19 pandemic plus a reasonable subsequent recovery period - Where agreement cannot be reached, the matter should be referred to mediation (by either party)

A template deed of variation of lease is available for free on the Eastern Bridge homepage.

Paul Nunan

Director

Accredited Specialist | Commercial Leasing

Yen Ong

Lawyer