08 April 2020

Mandatory Code of Conduct for commercial leases: what does it mean for you?

This article was written by Stuart Dixon-Smith, Simone Menz, Carl Black, Chris Wheeler, Mark Bayliss, Francesca Giorlando, Chris Mitchell, Julia Nikolic and Tristan Howes.

On 7 April, the National Cabinet announced a Mandatory Code of Conduct (Code) for COVID-19 impacted small and medium sized commercial tenants. The good faith leasing principles imposed by the Code stand to radically alter the rights of affected landlords and tenants, and we would anticipate that their implementation will require careful legislation from States and Territories and complex bilateral negotiations between landlord and tenant parties. The Code seeks to share the burden of the challenging conditions faced by the property sector (including through a sharing of benefits provided to landlords by their banks) and to ensure commensurate protections are in place to support Australian businesses. Whilst the Code was prepared after consultation with stakeholders in the commercial property sector, many aspects will require further development by both State and Territory government and industry participants to ensure clear and successful outcomes.

This alert sets out the changes to existing commercial leasing arrangements required by the Code, and considers the implications and opportunities for landlords and tenants.

Applicable Leases

Whilst the Code has been developed to enable a consistent national approach and application, the States and Territories will each separately introduce legislation to give effect to the Code. Commencement will be determined by each State and Territory and the Code is intended to apply for as long as the Commonwealth JobKeeper program is operational (COVID Period).  Regardless of the dates on which individual States achieve legislative adoption of the Code, the Code proposes commencement of the measures from a date after 3 April, within individual State legislation to define the date.

The Code applies to commercial tenancies where the tenant is both:

  • a small or medium sized enterprise with an annual turnover of less than $50 million per year (measured at the franchisee level for franchises and at the group level for retail corporate groups). It is thought the intent is for the grouping to apply to all corporate tenants, not just retail groups; and
  • suffering financial distress and hardship – defined so that tenants eligible for the JobKeeper program automatically qualify.  Businesses with an annual turnover less than $1 billion are eligible for the JobKeeper program if they have experienced a 30% fall in revenue since 1 March 2020, and are not subject to the major bank levy.

The principles espoused in the Code are also intended to apply “in spirit” to the leasing arrangements of all businesses affected by the COVID-19 pandemic, regardless of whether they meet the specific eligibility criteria. The below rules will not strictly apply to ineligible tenancies, but nonetheless may provide guidance for negotiations which might occur as a result of the COVID-19 pandemic.

Key Requirements

The Code is based on good faith leasing principles and is designed to encourage parties to reach mutually agreeable outcomes. However, its “principles” include the following guidance, to be applied on “a case by case basis”:

  • the Code includes several express positive obligations required of negotiated outcomes:
    • Rent reductions: landlords must reduce rent proportionately to the decline in the tenant’s business, measured by the reduction in turnover during COVID Period and a reasonable recovery period. The reduction is to be a combination of waivers and deferrals of rent. Alternate outcomes such as deferral, pausing or hibernating may also be used to reach commercially agreed outcomes; and
    • Lease obligations remain on foot: tenants must remain committed to the terms of the lease and continue to pay rent where possible;
  • the Code also imposes a number of restrictions that apply during the COVID Period and a reasonable recovery period:
    • Rent increases: landlords must not impose rent increases (except in the case of retail turnover rent);
    • Terminations: landlords must not terminate leases for the non-payment of rent;
    • Securities: landlords must not draw on tenant securities (including personal guarantees) for the non-payment of rent;
    • Penalties: landlords are prohibited from imposing penalties for tenants who stop trading or reduce opening hours; and
    • Interest: landlords must not charge interest on any unpaid rent;
  • despite the level of prescription, the Code seeks to promote flexibility for landlords and tenants in several respects:
    • the Code includes a number of broad overarching principles encouraging tenants and landlords to work together to share the financial burden during the COVID Period;
    • landlords and tenants are encouraged to negotiate in good faith amendments to their existing arrangements that are bespoke and appropriate to their particular circumstances; and
    • an expectation that landlords will work with their banks to share the burden, and share any benefits provided to them with tenants;
  • the arrangements will be overseen by a binding mediation process coordinated by each State and Territory.  It will be interesting to see how this will be resourced.

The changes in detail

Lease obligations

Tenants must continue to observe the terms of the lease, subject to any agreed amendments. This is expressed as a prerequisite to the applicability of the Code, with any material disregard of the lease by the tenant to result in forfeiture of the specific protections set out in the Code.

Rent reductions

Landlords must provide reductions in the rent payable by the tenant, proportionate to the reduction in the tenant’s turnover, during the course of the pandemic and a reasonable recovery period thereafter.  Rent reductions may provide up to a 100% reduction of the rental amounts normally payable by the tenant. 

Rent waivers must account for at least 50% of any rent reduction (unless waived by the tenant), and should make up a higher proportion where the tenant would otherwise be unable to fulfil their lease obligations and having regard to the financial ability of the landlord. Any such rent waivers may not be recovered by landlords during the remaining term of the lease.  This will lead to the requirement for tenants to be very transparent to landlords about their financial position, both their cashflow position and their financial reserves (cash, loan facilities and equity positions).

The balance of the rent reduction should be made up of rent deferrals, repayable over the greater of the balance of the term and 24 months after the COVID Period and a reasonable recovery period (except as otherwise agreed).  It is not immediately clear how a 24 month repayment period would be implemented where the balance of the term is less than 24 months. The expectation is that the relief agreement would be an enforceable enduring arrangement potentially well past the term of the lease in some cases.

The rent reductions are likely to apply only to net rent. Outgoings can still be recovered, although landlords are asked to seek to waive recovery whilst tenants are unable to trade.

Landlords must not impose any fees, interest or charges in relation to any agreed rent waivers and deferrals. This contrasts to the position of many loan deferral arrangements with the banks.

For example:

  • a tenant experiencing a 40% decrease in turnover as a result of measures taken to deal with the COVID-19 pandemic would be entitled (in principle) to a reduction in the corresponding rent by 40%, with at least half of this reduction being a permanent waiver;
  • if the monthly rent was $10,000, the tenant would pay $6,000 each month; and
  • $2,000 each month is deferred (and payable over a period of at least 24 months after the reasonable recovery period), whilst $2,000 each month is permanently waived by the landlord.

Extended terms

Tenants should be provided with the opportunity to extend lease terms for an equivalent period of the rent waiver and deferral period. This would provide them with an opportunity to trade during the eventual period of recovery, whilst providing time to repay any deferred rent.

Rent increases

Landlords must not increase the rental amounts payable by commercial tenants during the COVID Period and a subsequent reasonable recovery period.  The duration of the recovery period has not been defined, and it is likely that further detail will be provided by States and Territories.  If this detail is not forthcoming, allowances for a reasonable recovery period will need to be negotiated between landlords and tenants.

The prohibition on rental increases applies regardless of any arrangements between tenants and landlords in their existing commercial leases, but excludes increases due to turnover rent provisions of retail leases.

Terminations

Landlords may not terminate leases due to the non-payment of rent during the COVID-19 pandemic and a subsequent reasonable recovery period, regardless of the terms of the existing lease. This does not prevent the lease being terminated for reasons other than the non-payment of rent, taking into account the overarching principles of the Code.

There was an initial indication that tenants would be provided with an arbitrary right to terminate their lease, unless landlords signed up to the Code. However, this has not materialised.

Securities

In addition to the termination restrictions, landlords are precluded from drawing down tenant securities such as bank guarantees, security deposits, bonds or personal guarantees, due to the non-payment of rent by tenants.  Again, this does not prevent landlords drawing on these securities in other circumstances permitted under the lease, taking into account the overarching principles of the Code.

Nor is there a restriction on landlords when entering into relief agreements from requiring those securities extending to cover the deferred rent.

Penalties

Landlords may not penalise tenants who reduce operating hours or cease trading by reason of the COVID-19 pandemic. It is not clear, however, whether a tenant which elects to close (rather than being forced by the law) would then generate an automatic 100% decrease in turnover as a result and would then be entitled to a comparable rent reduction.

Land tax and other outgoings

If statutory changes result in a reduction of the land tax, council or Territory government rates or other charges payable by a landlord, or insurance costs, the landlord must pass a proportion of these savings to the tenant as required by the terms of the lease. This will include the pass through of separate State and Territory Government commitments to provide direct waivers or deferrals of land tax. This appears to reflect the standard provisions of most net lease arrangements, although further reductions may be required for gross lease arrangements.

The expectation is that States and Territories will be passing complementary laws to provide this tax relief.  Indeed the ACT has already made those announcements.

Individual arrangements

Parties are expected to formally document their arrangements to ensure the agreed variations to their existing commercial leasing arrangements are recorded, and may be referenced and amended as required during, and after, the COVID Period. The additional prescribed factors which should be taken into account by parties in arriving at their individual arrangements include:

  • the revenue, expenses and profitability of the tenant;
  • the specific impact of the COVID-19 pandemic on the tenant;
  • the commercial arrangements applicable to the specific premises;
  • whether the tenant’s lease has expired, is due to expire or is in “hold-over”;
  • whether the tenant is in receivership or administration;
  • the structure, period of tenure, and mechanism for determining rent in the existing lease; and
  • whether the tenant was in arrears prior to the COVID-19 pandemic.

Comments and Implications

Given the detailed nature of the Code, a number of implications are clear at this stage:

  • landlords and tenants must negotiate bespoke agreements appropriate for their particular circumstances.  This means there is no automatic arrangement that can be easily applied by landlords to all, or large groups of, their tenants. However landlords can craft generic offers to make to tenants which tenants can choose to accept or reject, in the hope that large clusters of tenants can be addressed without individual negotiations. The offer would need to be carefully drafted to ensure that for each tenant accepting it complies with the Code;
  • tenants should be prepared to substantiate any trading decline, both to establish eligibility for the protection of the Code and in the course of seeking rent waivers in excess of 50% of any rent reduction, by sharing financial statements and accounting and other financial information with landlords;
  • it will be necessary for landlords and tenants to balance the requirement to provide sufficient information (defined in the Code to include accounting information and information provided to or received from financial institutions) during negotiations with usual commercial sensitivities, keeping in mind the resumption of normal activities at the conclusion of the COVID-19 pandemic;
  • the Code expressly cautions against landlords seeking to redistribute the risk of default from themselves to tenants.  The principles espoused in the Code strongly discourage opportunistic behaviour of any kind, in particular by landlords;
  • the existence of a binding mediation procedure will provide an avenue for the resolution of any instances of disagreement or bad faith negotiations;
  • as the Code states that rent waivers should make up a higher proportion where the tenant would otherwise be unable to fulfil their lease obligations and having regard to the financial ability of the landlord, and given the mediation procedures, it is likely that many tenants who receive only a 50% rent waiver might seek more; and
  • a key issue will be the status of any agreements reached before the relevant commencement date (including where there is any element of retrospective commencement). Given the likely mandatory nature of the State legislative response and the existence of a binding mediation system, it is safe to assume that any arrangements entered before the commencement of the Code will be capable of being revisited to the extent of any inconsistency.

However, many details within the Code will require further clarification, including:

  • the extent to which a number of provisions of the Code which are expressed as requirements can be negotiated, varied or waived in good faith, given the emphasis on flexibility and commercial agreements;
  • how rent waivers and reductions ought to be calculated, revised and implemented given the indeterminate length of the pandemic and recovery period (i.e. rent reductions must be negotiated at a point in time before the overall decline in tenant turnover resulting from the COVID-19 pandemic is known) and the monthly fluctuations in the tenant’s turnover;
  • whether a number of restrictions on certain landlord conduct set out in the Code will be mandated by State or Territory legislation, or whether it is expected that such restrictions will be documented in each agreement with tenants;
  • the inherent logistical challenges and costs for landlords in conducting bespoke and good faith negotiations (and possible mediations) and concluding detailed documentation with dozens (and in some cases, hundreds) of tenants across their portfolios, in an appropriate time frame;
  • how the mediation processes and enforcement mechanisms will operate in each State and Territory, including the powers mediators will have to resolve commercial impasses; and
  • whether landlords and tenants who have already reached agreement on rent relief and other arrangements prior to the introduction of the Code will need to revisit those arrangements.

The Code presents landlords and tenants with the flexibility to agree the terms of any variations to their existing commercial leasing arrangements, in line with the stated principles, rather than seeking to provide a one size fits all solution. This creates both opportunities and challenges to reach mutually beneficial commercial arrangements.

We are on hand to assist landlords and tenants to work through these complex requirements and negotiate outcomes to protect their businesses through the COVID-19 pandemic and best position them for recovery.

Key contacts

COVID-19: Implications for Business

The spread of Coronavirus (COVID-19) has forced us to think and act differently. Beyond the human response, now is the time to think about what the consequences may be on your business, and how best you can prepare for those.

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