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This article examines some of the ways a landlord can seek to protect its rental stream.
One of the most important considerations for landlords is to protect the income stream when letting properties.
Careful due diligence should be undertaken on potential tenants, however, as leases tend to be for several years in length, circumstances can change and tenants may find themselves unable to comply with their lease covenants.
Leases in general, if drafted correctly will contain various provisions protecting a landlord against tenant default.
A rent deposit is a sum of money provided by a tenant to a landlord as security for payment of rent and performance of its lease covenants. The rent deposit monies are usually held in a bank account established and operated by the landlord.
The rent deposit agreement details the circumstances in which a landlord can drawdown against this sum and the conditions that must be satisfied for the deposit to be repaid to a tenant. The rent deposit will usually be held for the entire duration of a lease.
A rent deposit is attractive to landlords as it is an immediately accessible source of funds that can be utilised as soon as a tenant is in breach of relevant covenants within a lease. There is also no need to terminate the lease to take legal proceedings to recover the debt or secure performance of the obligation.
The major disadvantage is that a rent deposit does not usually exceed a sum equating to 12 months rent. However, the amount of the rent deposit is a commercial decision between the parties.
A landlord can request a tenant to provide post-dated cheques for the entirety of the term of a lease. Post-dated cheques are commonly used as security instruments in Bahrain to guarantee future payments.
The post-dated cheques will act as security allowing landlords to cash the cheques on the dates set out. In addition, under Bahrain law, a post-dated cheque which is subsequently not honoured is a criminal offence.
Article 393 of Legislative Decree No. 15 of 1976 provides that the penalty for an unhonoured cheque will be a prison sentence of a maximum of 3 years and / or a fine.
However, this is subject to proving that the issuer of the cheque was acting in ‘bad faith’. Such a requirement may be difficult for landlords to prove. Whilst the above penalty and consequently reputational damage is likely to encourage non - default by tenants, this option on its own may not provide sufficient protection for landlords.
A guarantee is a promise to ensure that a third party fulfils its obligations and/or a promise to fulfil those obligations if that third party fails to do so. There are a number of forms in which a guarantee can take and we have set out those which may best assist landlords in protecting its rental stream.
Guarantees can be provided by a parent company (ParentCo) of a tenant whereby the ParentCo agrees to indemnify a landlord against losses resulting from a tenant’s failure to observe the covenants in the lease. The ParentCo would also be required to perform the covenants in the lease if a tenant fails to do so.
The guarantee can be given in the lease itself or it can be given by way of a separate agreement.
A landlord will need to undertake financial due diligence against the ParentCo to ensure that the guarantee from ParentCo is of value and, subject to undertaking financial due diligence, a landlord will be receiving a guarantee from an entity which should have significantly more financial strength than the tenant.
In addition, if a ParentCo is a foreign company potential enforceability issues need to be considered. However, this risk can be mitigated by comprehensive legal documentation setting out a landlord’s rights and recourses against a ParentCo (including but not limited to dispute resolution provisions).
With such a guarantee, a specific individual (eg owner or major shareholder) or director can agree to indemnify a landlord against losses where a tenant defaults under a lease. Similar to the ParentCo guarantee, the personal or director’s guarantee would require the individual or director to perform the tenant's covenants under the lease upon default by the tenant.
Again, the individual or director can give this guarantee in the lease itself or in a separate agreement.
As with the ParentCo guarantee, the main advantage to a landlord would be that it is receiving a guarantee from an individual or director that will have significant covenant strength and will therefore enhance the level of protection being offered.
Landlords will need to satisfy themselves that the relevant individual or director has sufficient financial standing / assets to make the guarantee attractive. Landlords can take a charge over the individual’s or directors assets by way of additional security.
The guarantee will impose personal liability on the individual or director and, as such, is unlikely to be willingly offered.
With a bank guarantee or performance bond, a bank or insurance company (Issuer) will agree to pay a sum of money to a landlord, or allow for a performance bond to be drawn upon, if a tenant is in breach of the terms of the lease.
However, it should be stressed that the Issuer does not undertake to perform the covenants in the lease upon tenant default unlike a ParentCo and personal/director guarantee.
The level of the bank guarantee or performance bond will reflect the level of protection required by a landlord (or such level as agreed between the parties). The form of guarantee/performance bond will need to be very carefully drafted to ensure it is favourable to a landlord and sufficiently protects its rights.
For example, it is critical from a landlord’s perspective that the relevant amount is payable on demand and that there are no conditions which restrict access to the funds.
It is unlikely that a tenant will agree to provide the bank guarantee/performance bond indefinitely and will probably require the level to be reduced each year.
The main advantage is that if drafted carefully, the bank guarantee will be akin to a rent deposit and would provide a landlord with immediate access to funds as it would permit a landlord to draw upon the guarantee and obtain the monies on demand by a tenant default.
From a tenant’s perspective it will seek to limit the length of time that the guarantee/performance bond will be provided for as well as the level of the guarantee/performance bond (as tenants are likely to incur a significant cost for providing the required guarantee/performance bond by the Issuer).
A landlord and tenant may enter into a formal agreement to charge other properties or assets of the tenant to the level of protection required. Should a tenant default in performing its covenants within a lease, a landlord would be able to enforce its rights under the charge(s) (eg right of foreclosure/enforced sale).
A landlord will need to assess the financial strength of a tenant and what, if any, other assets a tenant may have (and where those assets are located if not in Bahrain). In the event that a tenant does not have any other assets of sufficient value, a landlord may consider taking a charge(s) over the ParentCo’s assets.
The main disadvantage of this option is that if the charge relates to a property within Bahrain and a landlord seeks to exercise its right of sale upon default by a tenant, a landlord will be required to adhere to the procedures prescribed by Legislative Decree No.12 of 1971 in relation to the Bahrain Civil and Procedures Law.
This will require a landlord to make an application for an execution order from the Court of Execution (Court) in Bahrain to enforce its rights under the charge.
Once an execution order has been made, a landlord will not be permitted to carry out any transactions in relation to the said property without the consent of the Court. In addition, the Court will likely require that the property is sold by public auction.
If the charge relates to other assets (ie non-property assets) within Bahrain, there may still be issues relating to enforceability and time and cost issues relating to such enforcement.
When the tenant is a company a landlord may seek to take a charge over a tenant’s shares by way of additional security.
The main advantage to taking a charge over shares in the tenant to provide greater protection to a landlord in relation to any potential disposal of a lease or change in shareholding by a tenant (and therefore enhances the degree of control that a landlord has over and above the covenants contained in a lease).
Such an option is unlikely to provide any significant protection or recourse against a tenant in the event of default under a lease due to circumstances where it is unable to pay rent (eg insolvency). For example, if a tenant is in financial difficulty, the value of its shares is likely to be greatly reduced (and will be worthless in an insolvency situation).
There may be other issues to consider such as practical issues in relation to enforcing any charge over the shares as well as the need to check whether a tenant’s Articles of Association contain any restrictions which may affect the taking such security in the first place.
A landlord and tenant may agree that any rents obtained from undertenants of a property are placed into an escrow account and be used by a landlord in the event that a tenant is in default under the lease.
Alternatively, a landlord may consider taking a charge over the bank account established by a tenant into which it receives rents from undertenants.
The payment of the rents obtained from undertenants into an escrow account will provide a landlord with comfort that these amounts are safe and secure.
A charge over a tenant’s account (whilst not as beneficial to a landlord as an escrow account) will mean that a landlord will take priority over other creditors in the event of a tenant’s insolvency and will allow a landlord to then use any monies in that account against the default by a tenant.
We have significant experience in advising landlord clients across a range of matters including the above as well as other possible alternatives in protecting their investment value in property assets.
The article was written by Unkar Chanian.
For more information please contact Unkar on +973 17 133202 or email@example.com.