Commercial rent deposits: what happens on insolvency of landlord or tenant?

Landlords often require their tenants to provide a rent deposit as security for payment of the rent and performance of the tenant’s covenants in the lease. The rent deposit deed will set out the circumstances in which the landlord can draw against this money and the conditions that must be satisfied for the deposit to be repaid to the tenant. Both landlords and tenants need to be aware of the implications of the other becoming insolvent in relation to the rent deposit funds.

Rent deposits as financial collateral arrangements

Up to 6 April 2013 rent deposit charges needed to be registered at Companies House within 21 days of creation in order to be valid. Since that date charges over rent deposits are no longer registerable security and cannot be registered at Companies House. Instead landlords and tenants need to pay attention to the charge structure itself to make clear that the deposit money should be safe from either the landlord’s or the tenant’s insolvency official.

Under the Financial Collateral Arrangements (No. 2) Regulations 2003, there are reduced formalities for the creation and registration of a rent deposit and improved enforcement rights. Since 6 April 2013, a rent deposit in a charging form will be construed as “a Financial Collateral Arrangement” if the rent deposit is entered into between two non-natural persons (not individuals).

The effect of the Financial Collateral Regulations 2003 on rent deposits since 6 April 2013 is as follows:

• There is now no need to register the deed at Companies House.
• Any moratorium on the administration or liquidation of the tenant will not apply and the landlord will be able to withdraw monies from the rent deposit without first seeking the agreement of the administrator, liquidator or the Court.
• As a liquidator has the right to disclaim a lease, if a rent deposit is included within the lease itself, this may automatically result in a disclaimer of the rent deposit. A liquidator will have no right to disclaim the rent deposit if this is in a separate deed.
• There will be no need for the landlord to get a Court Order to draw down the rent deposit.

Rent deposit structures

There are five main ways in which the rent deposit can be structured. Care needs to be taken in deciding which one depending on all the circumstances, including potential insolvency, the ease of operation, cost and tax considerations and the ability to transfer the rent deposit to successors in title. The five main ways of holding a rent deposit are as follows:

1. The landlord holds the money, but it continues to belong to the tenant, who charges it in favour of the landlord. This is the most common arrangement for holding a rent deposit.
2. The tenant holds and owns the money, but charges it in favour of the landlord.
3. The landlord holds the money on trust for the tenant.
4. An independent third party, usually the landlord’s solicitor or managing agent, holds the money as a stakeholder.
5. The money is paid to the landlord, belongs to the landlord and is either held as part of the landlord’s general funds or in a separate account.
   Protection from landlord insolvency

Applying the different arrangements set out above for holding rent deposits:

1. Here the tenant should ensure that its name appears on the rent deposit account, in order to put the bank on notice that the funds do not belong to the landlord and to prevent a set off or combining of accounts. Also this will put the landlord’s insolvency official on notice that some other party is interested in the money and there should be further investigation. As the owner of the deposit money, the tenant creates a fixed equitable charge in favour of the landlord as security for performance by the tenant of its obligations under the lease. The deposit money should be safe from the landlord’s insolvency official, who would be bound to use it only in accordance of the terms of the rent deposit deed.
2. The deposit money belongs to and is retained by the tenant who deposits it in a separate bank account. The tenant creates a fixed equitable charge over the deposit money in favour of the landlord as security for performance by the tenant of its obligations under the lease. Keeping the deposit money in the tenant’s own bank may help its relationship with its bank. The deposit money will be safe from the landlord’s insolvency official. Interest on the account can be paid direct from the bank to the tenant.
3. As the deposit money is held by the landlord on express trust for the tenant, the landlord is the legal owner of the money, but is bound by the terms of the trust as to how it may use the money. The tenant retains the beneficial interest in the deposit money unless and until the landlord applies it in accordance with the term of the rent deposit deed. The deposit money will be safe from the landlord’s insolvency official, because it does not become the landlord’s own property as the landlord merely holds it as trustee. Care must be taken to ensure the landlord does not hold the deposit in one of its general accounts. As long as the money is held in a separate account, the landlord’s bank will not be able to set off the funds in that account against any other debts or liabilities. The landlord is subject to fiduciary duties as a trustee and will be in breach of trust if it mixes the deposit money with its own monies.
4. The stakeholder, as an independent third party, acts as agent for both the landlord and tenant. This prevents the tenant’s money from being mingled with the landlord’s own funds and potentially lost to the tenant if the landlord becomes insolvent. Solicitors and managing agents are usually reluctant however to accept this type of continuing responsibility and may charge a fee for doing so.
5. This is an unattractive arrangement for a tenant, because the rent deposit is owned by the landlord with the monies being mingled with the landlord’s own general funds. If the landlord becomes insolvent, the deposit money is indistinguishable from the landlord’s other assets and can therefore be used by the insolvency official to meet claims from the landlord’s general creditors. Also if the landlord owes money to the bank, that money can be set off in respect of the landlord’s debts.

Rent deposits are therefore usually held in a charge rent deposit structure. A tenant will want to be named on the account so that the landlord’s insolvency official will be on notice of the tenant’s interest in the money.

Protection from tenant insolvency

If the tenant becomes insolvent it is important that the landlord can deduct unpaid rent and other overdue payments from the rent deposit with minimum delay and cost. In this situation the rent deposit is intended to provide protection for the landlord.

1. As the owner of the deposit money, the tenant creates a fixed equitable charge over it in favour of the landlord as security for performance by the tenant of its obligations under the lease, ensuring that if the tenant becomes insolvent the landlord is a secured creditor. Up until 6 April 2013, the rent deposit deed was unenforceable against a tenant’s insolvency official if it was not registered at Companies House. Since that time, charges over rent deposit are no longer registerable security and cannot be registered at Companies House. If the tenant becomes insolvent, the landlord has the benefit of the charge and is a secured creditor, although if there is any money left over after the tenant’s obligations have been satisfied through the rent deposit, then the balance of the deposit monies have to be returned to the tenant’s insolvency official. Care must be taken on the transfer of the reversion to a new landlord when it may be necessary to take a new charge.
2. There is no need for any charge by the tenant in favour of the landlord and the landlord can make any necessary deductions from the deposit as trustee. This can save time and administrative trouble and cost in having to register the charge. The landlord has control over the account. There can be other reasons, for example tax considerations, for ensuring that it is made clear that beneficial ownership of the deposit money remains with the tenant. There is a possibility however that such a trust could be said to create an equitable charge, which would then require registration under Section 860 (7) (g) of the Companies Act 2006, or risk being void against the tenant’s insolvency official. The landlord can be under implied fiduciary duties, including for example to earn a reasonable rate of interest on the deposit money and to account to the tenant for that interest.
3. As mentioned above this type of arrangement places a significant administrative burden on the solicitor or managing agent who are likely to want to charge a fee.
4. It can be advantageous for the landlord to hold the deposit monies in an account with its own general funds, particularly for an institutional landlord with many properties, as it lessens the burden of administering numerous separate rent deposit accounts.
   For protection from a situation where a tenant may become insolvent, the landlord should ensure that it has the benefit of a charge over the deposit money and is therefore a secure creditor. Provided that the rent deposit is in the possession or control of the landlord, in the event that the tenant goes into administration or liquidation the landlord will be able to take money from the rent deposit in accordance with the terms of the rent deposit deed. The type of rent deposit arrangement used will therefore depend on the circumstances of each case.

Consider the terms carefully

Even if there is no immediate risk of insolvency, both landlords and tenants should consider the terms of a proposed rent deposit arrangement carefully, to ensure their position is protected.

If you have any questions in relation to the above please do not hesitate to contact Joanna Osborne – Head of Property Litigation.

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