A Scamper Through Some Key Issues
Given the difficult economic circumstances, incentives for tenants are being offered and there has been a resurgence in interest in turnover leases.
The use of turnover rents is said to be a model which encourages greater risk sharing and a stronger partnership between landlord and retailer. There are problems with turnover leases:
- Reliance on data sharing and trust between landlords and tenants
- The availability of CVAs for tenants to escape liability where a traditional lease means the tenants trading position becomes untenable apply to turnover leases as well enabling tenants to escape onerous provisions
- Recently the temporary legislative changes which have resulted in limitations in the landlords’ rights to enforce
Turnover leases are not uncommon for example in mining leases and more recently, they have been applied to other commercial lettings, notably to lettings of shops, hotels and restaurants and they have become increasingly popular.
In times of recession, turnover rents are more favourable to tenants because the tenant’s liability to pay rent is related to its ability to pay promoting division of risk and fairness.
Apart from the potential for the incorporation of turnover rent clauses in new leases, it continues to be surprising that it remains undecided whether the court has any jurisdiction to set a turnover rent on a lease renewal under the Landlord and Tenant Act 1954 Part II. It is simply stated in “Woodfall on Landlord and Tenant” (looseleaf), para. 22.149.6, that:
“In appropriate circumstances, the court may fix the rent by reference to a percentage of the tenant’s turnover or commission.
The courts have fixed rents in this manner in the case of lifestock markets, but it may be that the court would have such power in relation to retail units where there are no comparables … or where the current tenancy provides for rent to be assessed on that basis. There is a problem as to how the problem of disregarding the tenant’s goodwill can be overcome in these circumstances.”
In Reynolds and Clark “Renewal of Business Tenancies” (5th ed.), the authors set out a valuable analysis of sections 34 and 35 of the LTA 1954, and discuss the arguments for and against the court having jurisdiction to set a turnover rent, including such case law as exists.
If a turnover lease is being contemplated consider:
1. The definition of profit and the interrelationship with taxes
Theoretically in Debenhams Retail Plc v Sun Alliance & London Insurance Co Ltd  3 E.G.L.R. 34, the tenant held department store premises under a lease granted in 1971 for a term of 99 years from 1965. The lease reserved a basic rent together with an additional rent calculated by reference to the store’s turnover, defined as “the gross amount of the total sales”. The Court of Appeal held the words “gross amount of total sales” meant everything that was taken at the till, including VAT, without deduction.
2. The possibility of changing profit rates
If the price of a commodity rises at a faster rate than the cost of living, pressure is likely to develop on dealers in that commodity to reduce their margin of profit or rate of commission: Naylor v Uttoxeter UDC (1974) 231 E.G. 619, per Brightman J. Accordingly, the tenant may find that the proportion of rent to profit increases.
Similar problems arise where profit margins are reduced.
3. The definition of turnover
If acting for tenants the definition of turnover needs to be carefully considered upon which the rent is to be calculated. It should as far as possible be related to the actual profit made by the tenant.
From the landlord’s point of view too close a relationship between rent and profit means that their income will depend to a large extent on the efficiency with which the tenant carries on business rather than on the value of the demised property.
4. A basic rent should be reserved
This provides a base figure for the landlord set in the past at between 70 per cent and 90 per cent of the open market rental. An alternative is to use a guaranteed minimum which is reviewed at periodic intervals.
5. Minimum and maximum turnover figure
A tenant’s adviser should ensure that there is a minimum turnover figure, which is not to be taken into account in assessing the rent, and possibly a maximum figure above which turnover is ignored.
Where the tenant is likely to have sales or special offers, their advisers should attempt to ensure that it is the amount they receive rather than the full retail price which is to be included in the calculation of turnover.
Where the tenant’s business includes a substantial number of transactions in which they give credit to their customers, the draftsman will have to consider whether the amount of the transaction should be brought into account at the time of the transaction or at the time of payment, whether interest payments are to be included in the calculation of turnover and whether the tenant is to have an allowance for bad debts.
8. Vouchers, gift cards, the internet and click and collect
The landlord’s adviser should consider the impact of sales of store vouchers and gift cards. They should consider the way in which the retailer accounts for profits resulting from shoppers’ and tenant’s use of the internet.
Orders placed remotely on the internet but collected from the store should also be attributed to the store where the collection is made.
9. Rent Review
If the lease is to include rent review provisions, it has been common to see clauses where the parties have provided for the base rent to be reviewed to the open market rental level disregarding the turnover provisions.
Equally, in the hospitality and leisure sectors, and for unique properties, a profits method of valuation is commonplace (and requires careful thought).
The parties should also consider whether the provisions as to payment of a turnover rent are to continue if the lease is assigned or a sub-letting takes place, or are to be made personal to the original tenant.
If the provisions are to terminate, the full market rent should become payable.
Licence fees or sub-rents is taken into account in the calculation of the tenant’s turnover.
11. Keep Open Covenants
Consider impact of the Health Protection (Coronavirus Restrictions) (England) Regulations 2020 and the Health Protection (Coronavirus Restrictions) (Wales) Regulations 2020 enforcing the lockdown which has forced thousands of businesses to close.
Subject to the need for parties to consider the incorporation of pandemic specific drafting, a landlord’s adviser will generally wish to couple a turnover rent clause with a tenant’s covenant to keep open to attempt to ensure that the demised property is kept open and trading. Clearly, if the demised property ceases to be used for trading, the landlord’s income will drop or possibly cease.
In addition to the impact of government regulation, the tenant should ensure that the clause excludes circumstances where the store is, for example, closed for repairs, refitting or as a result of damage caused by insured risks.
The landlord may wish to include a term for the rent to revert to the open market rental level if the closure is in excess of a certain period.
12. Accounting Machinery
If a Base Rent is payable, then the lease will provide that the Base Rent is to be paid in conventional instalments in advance. Because the turnover for each year can only be established following the end of the relevant year, most landlords will also normally wish to provide for a provisional sum to be paid in advance on account of the turnover rent on the same dates as the basic rent is payable.
The lease should provide for the landlord to have sufficient power of inspection of the tenant’s books to satisfy himself that any information supplied by the tenant is correct. There should probably be a provision for independent determination (by an accountant rather than a surveyor) in case of dispute. Reliance on the tenant’s audited accounts for the purpose of calculating turnover may be unwise for the landlord, not because those accounts may be inaccurate but because they may not be settled until well after the end of the rental period in question.
The tenant’s adviser will wish to ensure that confidentiality provisions are included to ensure that the landlord does not disclose the tenant’s private business information, and that it uses that information solely to calculate the turnover rent.
14. Dispute Resolution
Linked to the need for confidentiality, a private arbitration mechanism will be the best way forward in the event of dispute.
- If acting for a landlord where a tenant is seeking assistance and guidance consider whether in consideration for providing assistance to the tenant some form of benefit can be gained for the tenant. The lease can be regeared to assist the landlord’s management.
- When acting for tenants in connection with turnover leases ensure that the tenant appreciates rent is not calculated on the basis of profit. If trading conditions lead to a reduction in profit sharing turnover could eradicate profit altogether