Navigating Tenant External Administration: A Guide for Landlords

The principle of equity protecting landlords’ claims for rent in an insolvency

The Corporations Act provisions for voluntary administration interact with the equitable principle that derives from a long line of English and Australian cases, originating from the 19th century case Re Lundy Granite Co; Ex p Heaven (1871) LR 6 Ch App 462 (the Lundy Granite principle).

According to the Lundy Granite principle, where leased property is used for the benefit of the administration or liquidation, rent and other amounts payable under the lease for that property are treated as a deemed expense of the administrators or liquidators. This has the result that the rent and other amounts payable under the lease enjoy the same priority of distribution as would an administrators’ or liquidators’ expense in any subsequent winding up.

The imposition of personal liability on administrators for rent during the administration (and the associated statutory priority and indemnity provided to administrators for that liability) under the Corporations Act has generally left the Lundy Granite principle with little practical work to do. However, the Lundy Granite principle has come back into focus, with the emerging practice of Court extension of the administrator’s Rent Free Period. For a landlord, this has the potential result that, at least as far as the statutory scheme in the Corporations Act is concerned, the landlord’s entitlement to rent is subordinated to a general unsecured claim ranking alongside the claims of other creditors.

The issue arose in Ford v Scentre Management Ltd (2020) 145 ACSR 654; [2020] FCA 1023 where the Federal Court held that the Lundy Granite principle applied to rent accrued during the administration period, despite the administrators obtaining extensions of the Rent Free Period.

More recently, it arose in the context of the administration of the airline business of the Virgin Australia group of companies (Virgin) where the administrators obtained a nearly seven week extension of the Rent Free Period. In Melbourne Aircraft Leasing (UK) Ltd v Algeri 161 ACSR 569; [2022] NSWSC 443 (Melbourne Aircraft Leasing) Justice Black of the Supreme Court of New South Wales held that the Lundy Granite principle did not apply to distributions from a creditors’ trust arising out of a deed of company arrangement (DOCA), with the effect that the lessors’ claims to rent during the administration period ranked as ordinary unsecured claims in the creditors’ fund.

Below we explore this decision and what it means for landlords wishing to protect claims to priority for administration period rent. While the decision relates to equipment leases, the implications for landlords are identical.

The Virgin Administration

In April 2020, following the onset of the COVID pandemic and closure of Australia’s borders, Virgin, Australia’s second major airline, appointed administrators to most of the entities within the broader Virgin group.

From the outset of the administration, the administrators determined a strategy to sell or recapitalise the Virgin business as a going concern. Critical to that strategy was the oversight of the airline’s fleet of aircraft, of which 52% was leased.

The administrators publicly expressed the need to retain as much of the fleet as possible to facilitate the sale or recapitalisation and began almost immediately negotiating with the aircraft lessors to retain possession of the leased aircraft for that purpose, circulating a draft standstill agreement styled an “Aircraft Protocol Agreement”.

The purpose of the Aircraft Protocol Agreement was to progress the sale or recapitalisation of the business by facilitating a partial standstill of rights between the administrators and the lessors. The terms included a deferral of lease or finance payments during the administration period and a requirement that the deferred payments not be a liability of the administrators during the administration. The administrators were not required to make any payments to the lessors unless the aircraft assets were used during the administration and that use was profitable, and those payments were to operate as a reduction of Virgin’s liabilities under the relevant leases. However, the administrators were obliged to continue maintenance and insurance in respect of the aircraft assets.

Shortly after their appointment, the administrators of Virgin successfully applied to the Court to extend the Rent Free Period by over a month to 26 May 2020. As negotiations on the terms of the Aircraft Protocol Agreement were still ongoing on 22 May 2020, the administrators applied for a second extension order to extend the Rent Free Period from 26 May 2020 to 16 June 2020 (extending it to nearly 7 weeks in total).

During the second extension, the majority of the aircraft lessors entered into Aircraft Protocol Agreements.

The Virgin business was bought by Bain Capital on 26 June 2020. Nearly all of the creditors agreed to the terms of the DOCAs proposed by Bain. The administrators then issued DOCAs for Virgin which were approved at the Virgin creditors’ meeting on 4 September 2020. The principal DOCA styled as “Primary DOCA” referred to the establishment of a trust fund for the creditors classed as “Pool A” (Creditors’ Trust). The Creditors’ Trust was established, settled and governed by a trust deed dated 17 November 2022 (Trust Deed). On that date, the Primary DOCA settled and the administrators became the trustees of the Creditors’ Trust whose aim, as per the Trust Deed, was to adjudicate claims and pay distributions to creditors.

The aircraft lessors submitted proofs of debt to the trustees pursuant to the Trust Deed. The trustees of the Creditors’ Trust adjudicated the lessors’ claims for administration period rent (and other amounts payable during the administration period). Although the trustees generally accepted the amount of the aircraft lessors’ claims, they did not accept those claims on a priority basis and they were ranked as ordinary unsecured claims, thereby rejecting the lessors’ claims to enjoy priority consistent with the Lundy Granite principle.

The decision in Melbourne Aircraft Leasing

Nine of the aircraft lessors then brought proceedings in the Supreme Court of New South Wales, challenging the trustees’ decisions regarding the admission of their proofs of debt. The lessors sought declarations and orders enabling them to enjoy a distribution from the Creditors’ Trust on par with administrators’ expenses, in accordance with the Lundy Granite principle.

While the elements of the Lundy Granite principle were largely undisputed, the issue was whether Lundy Granite could apply in the context of a the Primary DOCA and resulting Creditors’ Trust and if so, whether the lessors received a benefit which deprived the Lundy Granite principle of operation. There were a number of alternate causes of action advanced by the parties, but the focus of this article is on those pertaining to the Lundy Granite principle.

The Court held it was unnecessary to determine the general question of the application of the Lundy Granite principle to non-liquidation forms of external administration. The Court stated that it would not be a principled development of Australian law to extend the scope of the Lundy Granite principle “beyond the distribution of assets in a winding up regime in which it has well-established application or a distribution of assets analogous to a winding up, to the very different context of a distribution of assets in a deed administration or creditors’ trust”. (Melbourne Aircraft Leasing (UK) Ltd v Algeri (2022) 161 ACSR 569, [85])

Black J considered the key question to be whether the Lundy Granite principle could apply, in the case of a distribution from the Creditors’ Trust, made in accordance with the terms of the Trust Deed.

His Honour held that the Trust Deed was to be interpreted having regard to its text, context and purpose, and in a manner which avoided (if the terms permitted) a construction productive of commercial nonsense or commercial inconvenience. As the Trust Deed did not explicitly mention the Lundy Granite principle, it did not retain the lessors’ priority. The “waterfall provision” in the Trust Deed departed from the statutory order of priorities applicable in a winding up, and made no provision for distribution to “Pool A Creditors” other than on a pro rata basis. It also did not provide for priority payment of pre-appointment date lease liabilities as “deemed expenses”.

In the alternative, assuming the Lundy Granite principle was applicable, Black J considered whether it could apply to the facts in this case. His Honour found that retaining the lessors’ aircraft objects was beneficial to both the lessors and the administration, and on that basis the Lundy Granite principle did not apply. His Honour found:

• The administrators retained the aircraft objects, “obtaining the advantage of their retention and the associated ‘optionality’ for the sale process.”
• However, the lessors also received the substantial benefit of “ongoing maintenance, storage and insurance costs being met by the Administrators” and maintaining access to potential lease opportunities with the new owner of the business. Along similar lines, Black J also noted that the alternative would have resulted in the lessors bearing those maintenance, storage and insurance costs, where there was no likely alternative profitable use for those assets given the pandemic; and
• There existed an arrangement which not only benefited the administration but also benefited the lessors. This arrangement was held to exist informally as negotiations for the Aircraft Protocol Agreements took place, and then formally after the entry into those Agreements.
• His Honour observed that none of the lessors led any evidence that the course adopted by the administrators “was not to their [the lessors] commercial advantage, or that they did not participate in it for their commercial advantage, or that they could have adopted any realistic alternative course”. In that circumstance, his Honour found that the lessors did not establish that the administrators’ retention of their Aircraft Objects was not for their benefit, stating:

“… the alternative was a disclaimer of the Aircraft Objects in the midst of a pandemic, and the Plaintiffs led no evidence they could have put them to any alternative profitable use…. I am satisfied that the Plaintiffs in fact obtained a significant benefit in avoiding continuing costs and in access to the lease opportunities with a new owner of the business.”

Therefore, even if the Lundy Granite principle could apply to claims against a creditors’ trust, Black J held that the principle did not apply in this case, because the retention of the aircraft objects was for the joint benefit of the administration and the aircraft lessors.

Impact of the decision in Melbourne Aircraft Leasing considerations for landlords

Traditionally, landlords are not involved in the cut and thrust of company restructures in the way a bank or other financier typically will be. But given the way Melbourne Aircraft Leasing played out, landlords may need to reconsider a passive approach to administrations if they want to retain their entitlement to priority distribution for the use of their property during an administration. Landlords wishing to protect any potential claims for priority rent will need to be well considered and strategic from the outset of an administration, as discussed below.

1. Opposing extensions of the Rent Free Period

It may be appropriate to oppose any application for extension of the Rent Free Period. This may not necessarily take the form of blanket opposition but instead, a middle-ground position which accommodates an administrator’s understandable desire to limit personal liability without adversely impacting upon the landlords’ priority claims by preserving the operation of the statutory indemnity (s 443D) and priority (s 443E).

Under this approach, landlords would not oppose limitation of an administrator’s personal liability, provided it avoids “a diminution of any rights or protections that would otherwise extend to creditors in the ordinary course of an administration”. This is potentially achievable by using the power in s 447A of the Corporations Act, to vary the operation of Pt 5.3A in a manner which, rather than extending the Rent Free Period, would limit the administrators’ personal liability to the assets of the company in administration. The ability to limit administrators’ personal liability to the assets of the company using s 447A is commonly used in administrations. Under this approach, the administrator’s personal liability under s 443B(2) is engaged and in turn, the statutory indemnity and priority provisions is also engaged, but personal liability is limited to the company’s assets.

2. Negotiating strategy

Lessors should consider the following when negotiating with administrators to permit their continued occupation or use of leased goods or property:

• evincing an intention (in open correspondence) to seek the return of their goods or to re-enter their property at their earliest opportunity, to minimise any dispute about the commencement date of the operation of the Lundy Granite principle;
• identifying potential alternative tenants / lessees and communicating the existence of any legitimate alternatives to the administrators – this may assist in establishing the lessors had a prospect of “alternative profitable use”; and
• ensuring that any negotiations for the administrators’ continued use or occupation of the goods or property are without prejudice to the lessor’ priority claims – this will reduce the risk that the negotiations constitute an “arrangement” of the kind which has the effect of dis-applying or limiting the Lundy Granite principle.

3. Drafting suggestions for any standstill agreement with administrators

In Melbourne Aircraft Leasing, Black J held that the terms of the Aircraft Protocol Agreements resulted in a “standstill” of the Virgin companies’ obligation to pay rent during the administration period. His Honour therefore concluded that administration period rent was not payable by Virgin under the aircraft lease agreements, thereby disengaging s 443B. To avoid a similar outcome, and ensure that s 443B remains engaged, landlords should seek to include in any standstill agreement with an administrator, drafting which preserves as payable, the company’s lease obligation to pay rent during the administration period (while agreeing, for example, a covenant to not sue during that same period).

4. Ensuring that any DOCA protects the landlords’ rights, among other matters, to administration period rent

To the extent that a deed of company arrangement is approved by creditors where:

• the landlord’s priority for rent is not protected as a priority distribution under the DOCA (or if there is one, creditor’s trust); or
• the landlord’s estimated return under a proposed DOCA is less than its return in a winding up (under which a landlord would be able to enjoy the benefit of the Lundy Granite principle),

there may be grounds to set aside the DOCA. This prospect, in turn, may give rise to the ability to negotiate, at the DOCA proposal stage during an administration, a DOCA which better protects the landlord’s claims to priority rent.

The extent to which any of these steps will be necessary or appropriate will depend on the particular facts and circumstances of an administration. The likelihood of an administration resulting in a successful restructure will often require the co-operation of all key stakeholders including, importantly, the landlords.