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Insolvency and Deposits: Get your priorities right

Landlords often ask for a rent deposit when they grant a new lease, or consent to an assignment, especially if the incoming tenant is of shaky covenant strength.  This provides security against possible future default.

If a tenant becomes insolvent then this is exactly the sort of situation where a landlord would want to make use of a deposit.  Where it is in the “commingling” form (i.e. paid to the landlord so that it becomes a debt in favour of the tenant) then that is unproblematic: no restrictions are imposed by the moratorium which arises on the tenant’s insolvency.

However, if it is in the “charging” form (i.e. kept in a separate account charged to the landlord) then the moratorium prevents the landlord from enforcing the charge without the consent of the administrator or permission of the court.  The landlord may argue that the deposit is a “financial collateral arrangement”, in which case the moratorium would be disapplied under EU regulations.  But that requires the deposit to be in the “possession or control” of the landlord.  What if it isn’t?

A welcome answer could be inferred from Re A/Wear UK Ltd (in administration), a Court of Appeal case from December last year.

In the case, two landlords entered into agreements with the company on terms that (a) the landlord could require the lease to be surrendered on six weeks’ notice, (b) the tenant would pay a “reverse premium” for the surrender (£340,000 for one lease, £210,000 for the other), (c) the premium would be held in an escrow account by the landlord’s solicitors, and (d) the solicitors would release the monies to the landlord on completion. The tenant had a contingent right to a return of the premium if the surrenders never happened.

The landlords served notice to complete the surrenders but before completion the tenant went into administration.  The administrators refused to complete the surrenders as that would trigger the release of the premiums to the landlords.  As a result of the moratorium, the court’s permission was needed by the landlords to seek an order for specific performance requiring the tenant to comply with the agreements.

The High Court refused permission: the landlords could forfeit the leases if they really wanted the properties back.  Their true agenda was to trigger the payment of the monies held in escrow. Generally, a court will not permit enforcement of an obligation to pay where the company is insolvent as that would mean one creditor gets paid in priority to others.

The Court of Appeal overturned the decision.  Once the money was placed in escrow, it was no longer part of the tenant’s assets available to be distributed to its creditors.  Therefore, granting the landlord permission to seek an order would not disadvantage other creditors.  Whilst it was true that if the landlords did not get permission then it was possible that the tenant’s contingent interest in the deposits might be realised, this did not justify a refusal.  That would be to promote the interests of the other creditors over those of the landlords.  The same rationale could be applied where a landlord needs the court’s permission to enforce a rent deposit.

The decision also confirms that landlords are right to give short shrift to administrators who demand an immediate return of a rent deposit.  The tenant’s interest remains contingent and always subject to the landlord’s contractual rights.

Re A/Wear UK Ltd (in administration) [2013] EWCA Civ1626