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Covid-19: The SME Commercial Leasing Principles

The long-awaited government response to the effect of COVID-19 on commercial tenancies has  been released. Unlike the cash flow boost for businesses and the JobKeeper programme, the government is not bailing out commercial and retail tenants whose business has been affected by the pandemic. The government has instead announced a set of principles (a Code of Conduct) which are to guide good faith negotiations between landlords and tenants, with the aim being for the parties to reach temporary, bespoke and appropriate arrangements for each tenancy, taking into account their particular circumstances.

This new regime has only just been announced, and no doubt there will be many questions arising from its application. This guide answers the most immediate questions that our clients have asked us about the Code based on the information released to date.

What is the National Cabinet Mandatory Code of Conduct?

The Code of Conduct is a set of guidelines for use by parties in negotiating rent concessions. It has been implemented as a response to the difficulties faced by small to medium businesses during the COVID-19 pandemic. It is intended that each State and Territory will give effect to the code through legislation or regulations as required.

Who does the Code of Conduct apply to?

The Code applies to all commercial tenancies where the tenant is a small to medium enterprise and suffering financial stress or hardship as a result of the COVID-19 pandemic. If a commercial tenant has annual turnover of less than $50 million and is eligible for the JobKeeper programme, they automatically meet the definition of ‘SME tenant’ that is experiencing financial hardship and the Code of Conduct will apply to their tenancy.

While it is not immediately obvious when reading the code, a business with turnover of less than $50 million that doesn’t qualify for the JobKeeper programme might still attract the application of the Code of Conduct if it is suffering financial stress or hardship. The definition of ‘financial stress or hardship’ leaves open this possibility. The test to be applied in this instance is whether or not the tenant is able to meet its financial or contractual commitments where it has been unable to generate sufficient revenue as a direct result of the COVID-19 pandemic.

For franchises, the $50 million annual turnover threshold is applied at the franchisee level. Presumably this will still be the case where the franchisor (or a related party of the franchisor) holds the lease, however there isn’t sufficient clarity in the Code itself to answer that question definitively. Where the tenant is part of a retail corporate group, the turnover threshold is applied at the group level.

Even where a tenancy does not meet the criteria for the application of these principles, the Code of Conduct requires that landlords and tenants take steps to adhere to the ‘spirit’ of these principles in their dealings with each other.

What is the purpose of the Code of Conduct?

The objective of the Code of Conduct is to balance the interests of landlords and commercial tenants operating small to medium businesses during the COVID-19 pandemic. This is done by encouraging the parties to negotiate their own temporary arrangements to give tenants a time to recover from hardship suffered during the pandemic. These temporary arrangements include a combination of rent waivers and deferrals.

Importantly, the Code of Conduct is designed to be applied on a case by case basis. This means that the parties must consider the financial hardship suffered by the tenant, the terms of the lease (e.g. will the lease finish soon? Are there further lease terms? etc.) and whether the tenant is in administration or receivership.

Some of the overarching principles that landlords and tenants must adhere to when negotiating these arrangements include:

  • Their common interest to ensure business continuity and the resumption of normal trade after the pandemic period.
  • The need to be open, honest and transparent, and provide each other sufficient and accurate information. Tenants should expect to produce trading data and financial statements to their landlords. While such disclosure might be necessary to secure temporary rent relief during the pandemic, handing that information to a landlord might tip the negotiating power in the landlord’s favour next time a market rent review is conducted after the pandemic.
  • Interestingly, the Code requires landlords and tenants to assist each other in dealing with external parties including government authorities, utilities and financial institutions. Expect landlords to ask their tenants to supply corroborating information if the landlord itself is seeking mortgage relief from its bank.

How is the Code of Conduct applied?

The following leasing principles must be adhered to by the parties in their negotiations:

  1. A landlord cannot terminate a lease during the COVID-19 pandemic period (and a reasonable subsequent recovery period) for non-payment of rent.
  2. The Code does not absolve a tenant from its obligations under its lease. If a tenant does not abide by a material term of the lease, it forfeits the protection provided to it under the Code.
  3. Landlord’s must offer proportionate reductions in rent payable, in the form of waivers and deferrals.  These must be in proportion to the reduction in trade due to the COVID-19 pandemic, consistent with the tests applied for the Commonwealth’s JobKeeper Program. Any waiver of rental can’t be recouped by the landlord after the COVID-19 pandemic period .
  4. Any rental waiver or rent free period must be no less than 50% of the total reduction in rent (unless otherwise agreed by the tenant in writing). This may need to be increased if the tenant cannot fulfill its obligations under the lease, but thought must also be given to the financial ability of the landlord to provide any additional waivers above the 50% guideline. For example, if a tenant’s revenue has fallen by 100%, it will likely be entitled to relief of 100% of the rent. This will mean that 50% of the rent will be waived, and the remaining 50% deferred. If the tenant’s revenue fell 30%, then at least 15% of the rent will be waved while the other 15% could be given as rent deferral.
  5. The tenant must be afforded at least 24 months from the end of the COVID-19 period to pay any deferred rental. However, if more than 24 months remain on the term of the lease, then the tenant must be allowed to repay the deferred rent over that greater period.
  6. Any reduction in statutory charges (i.e. outgoings such as land tax or council rates) received by the landlord during the COVID-19 pandemic period must be passed onto the tenant.
  7. A landlord should try to share any benefit it receives as a result of the deferral of loan repayments from their financial institution with the tenant. Interestingly there is no corresponding provision that gives a landlord relief under the Code if its financial institution does not provide it any relief.
  8. A landlord should waive recovery of outgoings from its tenant where possible while the tenant is not trading and can reduce the availability of the relevant service during this time.
  9. Any arrangements made between parties should not require a tenant to make repayment of rent until the earlier of the COVID-19 pandemic ending or the existing lease expiring. The Code also requires that parties take into account a reasonable subsequent recovery period after the pandemic ends.  Ideally this period should be protracted to allow the tenant to recover financially.
  10. No fees, interest or other charges are recoverable by the landlord with respect of rent waived and no fees, charges or interest can be charged on deferred rental. 
  11. A landlord cannot draw on any security provided under the lease by the tenant such as a bank guarantee during the COVID-19 period and/or a reasonable subsequent recovery period.
  12. A tenant should be given an opportunity to extend its lease for the period of any rent deferral or waiver to be able to trade after the COVID-19 period to recoup some of its losses.
  13. A landlord must freeze any rent increases  for the duration of the COVID-19 pandemic and a reasonable subsequent recovery period following the pandemic. The freeze on rent increases does not apply to rent based on the tenant’s turnover.
  14. A landlord cannot punish the tenant for reducing its opening hours or ceasing to trade due to the COVID-19 pandemic.

What if the parties can’t reach agreement?

If the parties cannot reach an agreement with respect of temporary arrangements, the parties will be referred to a binding mediation. These mediations will be carried out by the existing State and Territory bodies tasked with mediating retail and commercial tenancy disputes, such as the Office of the Small Business Commissioner in Victoria. The consequences of not complying with the Code will also be clarified in the legislation and regulations passed and may vary nationally.

We expect that as the Code of Conduct is legislated there will be more light shed on how it will operate. This article will be updated to reflect those additional details as they come to hand, so check back in regularly. If you have any question that you would like us to answer, please get in touch.