Once a retail lease, always a retail lease? Yes, says the Victorian Supreme Court

Can a lease which is subject to the Retail Leases Act 2003 (Vic) ("Act") at the time it is entered into cease to be subject to the Act as a result of a change in circumstances?

This possibility was raised by the decision of the Victorian Civil & Administrative Tribunal ("VCAT") in William Buck (Vic) Pty Ltd v Motta Holdings Pty Ltd (Building and Property) [2018] VCAT 15 in early 2018.

At the time, we wrote that, if it can, the consequences for both landlords and tenants in Victoria could be significant, affecting important matters including recovery of costs, the landlord's maintenance obligations and rent review processes.

In July 2019, in Verraty Pty Ltd v Richmond Football Club Ltd [2019] VCAT 1073, this trend continued when VCAT decided that a lease subject to the Act at the time it is entered into could cease to be subject to the Act. However, this decision was appealed to the Victorian Supreme Court.

Rising occupancy costs trigger lease dispute: Richmond Football Club Ltd v Verraty Pty Ltd

Under the Act, "retail premises" do not include "premises in respect of which the occupancy costs … under the lease concerned (are) more than the amount prescribed by the regulations". Broadly speaking, "occupancy costs" are rent and outgoings.

Under the lease in this case, after the lease was entered into, the occupancy costs increased to over $1 million per year.

Landlord position

The landlord argued that, as a result of the increase in occupancy costs above $1 million per year, the lease ceased to be a lease of "retail premises" and that so long as a lease was subject to the Act at its inception, it could "jump out" of the Act, and could, if circumstances changed again, "jump back in".

In support of this position, it argued that the Act made it clear that if the Act did not apply when the lease was entered into, it could not apply subsequently during the term of the lease. However, whilst Parliament could have chosen to remove entirely the possibility of leases "jumping in" and "jumping out" of the Act, it did not do so.

Tenant position

The tenant argued that the increase in occupancy costs above $1 million per year did not result in the Act not applying, and that the application of the Act is to be determined when the lease is entered into (or renewed) and, once that determination is made, that position does not change during the term of the lease (or the renewed term).

The tenant was focused on the purpose and context of the Act. 

Decision

The court decided in favour of the tenant and held that the application of the Act was to be determined at the time the lease was entered into and, if the Act applied, that position could not change for the term of the lease. 

The judgment referred to the importance of the words in the Act, but also to the purpose and context of the Act which, based on section 1 of the Act and on the Second Reading Speech on the introduction of the Retail Leases Bill which preceded the Act, were to "enhance the certainty and fairness of retail leasing arrangements between landlords and tenants".

The judgment referred to the "significant uncertainty" of a lease "jumping in" and "jumping out" of the Act including;

• this producing "an impossible situation" and the "most unsatisfactory state of affairs for parties not to know whether any agreed rent review provisions… are subject to (the ratchet) restriction" under the Act; and
• the "fluctuating uncertainty" of the application of the Act in relation to land tax recovery.

The judgment referred to "other difficult issues" that would arise including in relation to refurbishment, relocation and demolition, damage and refurbishing, and liability for repairs more generally."

The court considered that if "jumping in" and "jumping out" of the Act were conceivable, this would produce a situation that was "completely at odds with a main purpose of certainty and fairness of retail leasing arrangements", a purpose which was "to enable parties… to know and understand their obligations under a proposed leasing arrangement for the term of that lease so they could make the commercial decision whether to enter into the lease in the first place".

How the Richmond Football Club Ltd v Verraty Pty Ltd decision increases certainty…

Section 4(1) of the Act describes when the Act applies, subject to the disqualifying characteristics in section 4(2).

This case involved occupancy costs increasing above $1 million per year.

Of all of the disqualifying characteristics for application of the Act, the amount of occupancy costs is probably the one with the greatest scope for generating uncertainty, if a lease could fall in and out of the application of the Act.

Where occupancy costs are close to the prescribed amount, the fluctuation of outgoings amounts might have had far greater significance in terms of the fluctuating application of the Act than the actual amounts involved.  In some circumstances, landlords might have been discouraged from seeking competitive tendering of some outgoings amounts, for fear that it might result in the onerous consequence (to the landlord) of the Act applying.

However many other changes in circumstances, besides fluctuating occupancy costs, could have had the effect of a lease "jumping in" and "jumping out" of the Act. Any of the disqualifying characteristics in section 4(2) of the Act might not have applied when the lease was entered into, but might have applied subsequently.

For example, the tenant might become a listed corporation (eg. though an initial public offering in Australia) or a subsidiary of a listed corporation (eg. by being acquired by a listed corporation), or a listed corporation on a relevant overseas stock exchange or a subsidiary of such a corporation. That event might be reasonably easy to identify and determine.

Other disqualifying characteristics in section 4(2) might not be as easy to identify and determine, such as changes in use.

If the Act applied to a lease at the outset based on an assessment of the use of the premises at the outset, and no disqualifying characteristics in section 4(2) applied at that time, but that use changed (even without any change to the disqualifying characteristics in section 4(2)) before this decision it would appear that the Act might have been able to cease to apply.

There is no doubt that the decision significantly removes scope for uncertainty in relevant leasing arrangements.

…and how it has left some issues uncertain

Renewal of lease

What happens if a lease to which the Act applies is renewed, but circumstances have changed and a disqualifying characteristic in section 4(2) of the Act has come into existence at the time the renewed lease is entered into, which did not exist at the time the original lease was entered into? This could happen if, for example, occupancy costs were less than $1 million per year at the time a lease was entered into, but are greater than $1 million at the time the renewed lease is entered into?

In these circumstances, based on comments from Justice Croft in this case, it should not be assumed that none of the provisions of the Act will apply to the renewed lease.

The terms of a new lease will depend on the terms for renewal contained in the lease which is being renewed. Often, the terms for renewal in a lease will specify that the terms of the renewed lease are to be the same as those of the lease being renewed, but with specified updating and amendment (for example that the number of renewal terms is reduced by one).

Justice Croft indicated that terms for renewal must also be read with section 27(1) of the Act which provides, among other things, that if a retail premises lease contains an option to renew, the lease must state the terms and conditions on which the lease is renewable. He indicated that the result would be that a lease is "effectively revised by the implication of the various provisions of the Act which apply the formula… "a retail premises lease is taken to provide as set out in this section"".

Justice Croft indicated that if, when the lease was first entered into, the parties contemplated the possibility of the Act not applying at the time of renewal they could include in the original lease "express terms to the effect that the provisions contained in the renewed term are to be those contained in the original lease unaffected by the operation of the (Act)" (emphasis added).

While this part of the judgment was not required to decide the matters before the court, and therefore does not have binding force, the comments are likely to be accorded significant weight.

The take-away for landlords is that if a tenant under a lease covered by the Act is granted a right of renewal, the terms of renewal should make it clear that if the Act does not apply to the renewed lease, then the new lease should not include any terms from the original lease incorporated as a result of the operation of the Act.

Commercial manipulation

The decision raises the question of whether the disqualifying characteristics in section 4(2) of the Act could be commercially manipulated, particularly in relation to occupancy costs, to achieve a desired outcome in relation to the application of the Act.

To use a simple example, parties to a prospective lease might agree that for a lease with a term of 5 years, the rent is to be:

• Year 1: $950,000
• Year 2: $975,000
• Year 3: $1 million
• Year 4: $1.25 million
• Year 5: $1.5 million,

and that no contribution to outgoings is required. On its face, based on the occupancy costs at the outset, the Act would apply.

However, if the rent structure was reversed so that rent was $1.5 million in the first year and then gradually decreasing to $950,000 in the fifth year, on its face, the Act would not apply.

Such a change would appear to achieve the outcome of the Act not applying to the lease, without being in breach of the Act, including section 94 of the Act, the section intended to "preserve the untrammelled operation of the Act".

A manipulation of the structure of payment of occupancy costs of this kind might only be available in limited circumstances (eg. where occupancy costs are somewhere near the $1 million per year level).

However, the treatment of incentives creates great potential uncertainty and might provide significant scope for manipulation. For example if a lease had an annual rent payable on the commencement date of $1.98 million, but a 6 month rent free period, would the lease fall outside the Act (on the basis that the face rent payable on the commencement date is over $1 million) or within the Act (on the basis that the effective rent payable on the commencement date is $990,000 and under $1 million). 

Other disqualifying characteristics in section 4(2) of the Act might be more difficult to manipulate, but still possible, such as deferring changing the ownership structure of the tenant or even the permitted use of the premises under the relevant lease.

What should Victorian landlords do now to manage retail leases?

Entering the lease

The Act is intended to provide protection to tenants and has a cost impact for landlords. If it aligns with its commercial drivers, a landlord should do what it can to preclude the Act from applying to the relevant lease at the outset, so that it never applies.

Renewals

If the Act applies at the outset, any renewal terms should explicitly state that if the Act does not apply to the renewed lease, then the new lease does not include any terms from the original lease incorporated as a result of the operation of the Act.

Permitted use

Where possible, a lease should include a provision prohibiting the tenant from using the premises in a manner which would result in the premises being "retail premises" under the Act.

Negotiation of leases

In negotiating leases, where commercially possible, landlords should always include a treatment of relevant issues which assumes the Act will not apply (eg. tenant required to pay land tax, ratchets in rent review clauses etc.). To the extent the Act applies, any such clauses could not be enforced.

However, if the Act applies at the outset, and the tenant renews the lease in circumstances where the Act no longer applies, then clauses which could not be enforced in the original lease will become enforceable under the renewed lease.

In addition, if this decision is overturned on appeal, it is possible that leases which are subject to the Act when the lease is entered into might subsequently cease to be subject to the Act.