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COVID-19 misunderstanding (about rent and insolvent trading)

by Stephen on August 17th, 2020

There is little doubt that New Zealand’s failure to follow Australia, by implementing a mandatory code of conduct for commercial lease negotiations as a result of the impact of COVID-19, has been a cause of pain for many SMEs.  However, the purpose of this note is not to re-litigate the arguments for and against such a measure.  Instead, I want to focus on what appears to be a piece of misinformation doing the rounds about the correlation between rent obligations and the insolvent trading regime.

At a glance, suggestions that broad swathes of commercial landlords will refuse to negotiate further rent concessions during Auckland’s Level 3 lockdown just don’t make sense.  It is self-evident that, even in the most desirable locations, it is in landlord’s own interests to have a tenant in situ and paying something towards rent and outgoings rather than adding to the “broken teeth” that was a feature of many main street locations during the GFC. 

The Australian code noted that landlords and tenants share a common interest in working together, to ensure business continuity, and to facilitate the resumption of normal trading activities at the end of the COVID-19 pandemic during a reasonable recovery period.  For the landlord, this means that the cost of having the premises lie dormant while they find a new tenant is significant.  And for the tenant, typically the faster that they can get back to work the more likely they start down the road to recovery.

Sensibly, the Australian code explicitly recognised that, while each tenancy must be considered on a case-by-case basis, rent negotiations must be based on the reduction in the tenant’s trade during the COVID-19 pandemic period and a subsequent reasonable recovery period.  In short, this is a reminder of the fundamental economic proposition that an asset’s value is simply a factor of the income stream it is capable of generating. 

There is little doubt that the latest setback, with Auckland returning to Level 3 until midnight on 26 August (and the rest of the country on Level 2) is going to hit parts of the retail sector in Auckland and elsewhere particularly hard.  However, the suggestion that some retailers won’t resume trading without a lasting agreement with the landlord about rent concessions because of fears about insolvent trading seems to be based on a rather fundamental misconception.

Insolvent trading regime

To recap, the insolvent trading regime under the Companies Act 1993 has two limbs, each of which may expose a director to personal liability:

  • section 135: which specifies a director must not agree, or cause the business being carried on in a manner likely to create a substantial risk of serious loss to the company’s creditors; and
  • Section 136:  which states that a director must not agree to the company incurring an obligation unless the director believes at that time, on reasonable grounds, that the company will be able to perform the obligation.

The Companies Act does not make it clear when an obligation is “incurred”.  However, there is some useful guidance provided by the Australian Courts, in the context of their insolvent trading regime, about when a lease debt is incurred. 

When is a debt incurred?

Two cases at the end of last century point to a simple list:

  • In relation to a property lease – the debt is incurred when the lease is first entered into.  To incur a debt there must be “a positive, voluntary act” by the company.  The rental payments may well become payable on a monthly basis, but once the lease is signed, that is an involuntary step.
  • The insolvent trading regime is concerned with when the debt was incurred rather than when it becomes payable – which should lead to the conclusion that, if some time after entering into the lease, the tenant becomes insolvent – the rental payments will not form part of an insolvent trading claim.  (However, the monthly rent obligation will form part of the assessment of whether a company is insolvent (i.e. able to meet its debts when they fall due)).
  • Of course, if other obligations were entered into when the company was insolvent (and the director knew or should have known of the insolvency) – then personal liability could follow.
  • If the lease comes to an end and the tenant remains in possession (holding over) on a monthly basis – then a new obligation will be incurred each month.

Temporary safe harbours

For those who are still yet to reach an accommodation with the landlord, directors should seek to rely on the temporary safe harbour from the insolvent trading regime for the effects of COVID-19 (section 138B of the Companies Act).  Specifically, where the business was viable (and solvent) on 31 December 2019 and the liquidity problems are, or will be, a result of the effects of COVID-19 – then directors should be considering if it is more likely than not that the company will be able to pay its due debts on and after 30 September 2021. 

A number of commentators have made it clear that the safe harbours do not provide company directors with some sort of carte blanche until September next year.  Instead, they provide breathing room for the directors of what were fundamentally sound businesses to get back on track with some confidence that their personal liability is not at stake.  But there is a balancing act required, which includes observing the ‘general duty’ of a director to act in good faith and in what the director believes to be the best interests of the company.

The safe harbour regime specifically notes that a director may have regard to:

  • the likelihood of trading conditions improving;
  • the likelihood of the company reaching a compromise or other arrangement with its creditors (which will necessarily include the landlord); and
  • any other matters the director considers to be relevant.

Any recovery plan will necessarily require directors to keep a clear eye on business cashflows, and having a plan – rather than a wing and a prayer approach to recovery.

Sale of business

Finally, one dilemma that recent publicity has highlighted as being a particular risk in the hospitality sector is the view that (to have a viable business worth selling) the seller must have a long lease.  This may be seen to put pressure on sellers to seek renewals or extensions of the lease term.  If the business is marginal, I would suggest that any director seeking to secure a longer term lease would want definitive advice about the solvency situation before committing to a longer lease term with the aim of improve their outcome by a sale.

Further information

Please contact me should you have any queries concerning the information to be provided.

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