A known unknown: preference risks for commercial landlords on rental arrears

Commercial landlords are exposed to a range of risks from the economic and social consequences of the COVID-19 pandemic. One new risk to be confronted will come from the increased prevalence of rental deferrals and interaction with the Australian insolvency regime over ‘unfair preferences’. 

Why is rent ‘protected’ in normal trading conditions?

Under the Australian insolvency regime, an unsecured creditor of a company in liquidation may be forced to return payments received from that company in the preceding six months. 

In normal trading conditions, rent paid to a landlord of commercial tenancies is not considered to be subject to this risk. There are two primary reasons for this:

• Rent is generally paid in advance of the period for which it is due, meaning that the payment is not characterised as a payment under a ‘debtor/creditor’ relationship; and
  
  
• Rent paid to occupy commercial tenancies is seen as securing an asset that has greater ultimate value to the company than the price of the rent itself – known as the ‘doctrine of ultimate effect’. Described in another way, the ‘doctrine of ultimate effect’ applies “if a company gives up $1,000 in cash, but gains goods which are unquestionably worth $1,000 or more …”^[1]

Is payment of rental arrears at risk in a COVID-19 economy?

The current trading conditions are far from normal. 

There is an increased likelihood of landlords receiving payment for rent in arrears – whether under a formal standstill arrangement or, simply, late payment. Payment of rent in arrears would very likely be a payment under a ‘debtor/creditor’ relationship, meaning that the protection for payment in advance would not be available. 

There may also be a very real question as to what the value is to the tenant of securing the ongoing operation of the lease. This would need to be assessed on a lease specific basis, but the impact of physical distancing requirements and the current stage 4 restrictions in Victoria could mean that the true value of securing a lease is reduced – potentially to an amount below the rental arrears required to be paid. 

For example, a large retail chain could still be deriving a profit from its head office building and any distribution centres which are processing online orders, but may be deriving limited benefit from stores which are shut or have drastically reduced customers. 

If the rental arrears on those stores went back to the time that restrictions were first imposed in March 2020, consideration would need to be given to the value of the leases for those stores to the tenant into the future. That consideration would be informed by factors such as the duration of the lease and the time that the restrictions are ultimately relaxed – the latter of which is far from certain. 

Could a landlord rely on ‘good faith’ defence for rental arrears?

Another ‘defence’ that would normally be available to a landlord (or any other creditor) to resist an unfair preference claim would be showing that the landlord received payments in good faith and had no reasonable grounds for suspecting that the company was insolvent or at risk of being insolvent at the time the payments were made. 

This is an objective process and does not require the creditor to have actual knowledge that the company was insolvent at the time of making the payment, simply that they had knowledge of indicators of insolvency. However, it may be increasingly difficult for landlords to rely on that defence given:

• In the current economic climate, indicators of insolvency will be more obvious to creditors, particularly where the tenant is affected by government restrictions; and
  
  
• As part of the good faith negotiations between landlords and tenants under the Mandatory Code of Conduct for SME Commercial Leasing, the tenant had to disclose financial information to the landlord to establish the financial hardship that triggered any rent deferral or waiver, which are likely to have put the landlord on notice of potential indicators of insolvency.

The known unknown

The interaction of the payment of rental arrears in response to the pandemic and the insolvency regime remains unknown. But, landlords receiving payment for rental arrears should be aware of their potential exposure to unfair preferences. Depending on the circumstances, it may be that landlords are incentivised to actively assist the recovery or restructuring of the tenant’s business to avoid the risk of insolvency altogether.