Tenants' Rights of First Refusal…Not as straightforward as you may think

Whilst property lawyers will be familiar with the requirements of the Act and the circumstances in which it applies, freeholders, landlords and tenants alike may not be so familiar with their obligations or rights. In fact, many are under the misconception that the Act only applies where a landlord is proposing to sell its freehold interest in a building (and must therefore offer to sell the freehold to the residential tenants first before disposing of that interest to a third party, i.e. a right of first refusal). However, the Act may also apply to a lease of a non-residential part of the building being granted (for example, of a commercial unit or perhaps common parts), where a lease of airspace is granted to a developer to construct a penthouse or where a lease of a non-residential part is being surrendered back to the landlord.

Not all buildings are caught by the Act and it applies only to mixed use and purely residential buildings. It does not apply to commercial space only.

Where the Act applies, the requirements that must be complied with are by no means straightforward, and freeholders, landlords and prospective purchasers alike should carefully consider the impact the Act has on any transaction they propose concerning the building.

What's the purpose of the Act?

The Act's primarily objective is to give residential tenants the "right of first refusal" of the interest being disposed of. Tenants cannot compel a landlord to sell their interest; they simply have a right to acquire that interest before the landlord sells it to any other party ("Proposed Purchaser").

Who does it apply to? Who does it benefit?

The Act applies to the landlord, which does not necessarily have to be the freeholder - it could be an intermediate landlord who is disposing of its interest in a head lease for example. The Act is for the benefit of "Qualifying Tenants", in short, a tenant with a long leasehold interest in a flat, rather than say, a tenant occupying under the terms of an AST (assured shorthold tenancy).

Do all proposed disposals have to be offered to the qualifying tenants?

A 'disposal' by a landlord is not limited to the sale of the freehold; it extends to a number of dispositions and before any disposals are made, the parties should carefully consider whether the terms of the Act apply to the proposed disposition.

What should the landlord do?

Before the landlord disposes of, or enters into a contract to dispose of, its interest in a building which is caught by the Act to a Proposed Purchaser, it must first serve notices, pursuant to section 5 of the Act ("Notice"), on all Qualifying Tenants in the Building. Proper and careful consideration must be given to ensure service is effective both in terms of the method of service and the prescribed timescale under the Act.

The Notice must state the consideration being paid and the terms on which the interest is being disposed of by the landlord to the Proposed Purchaser. Should the Qualifying Tenants refuse/fail to exercise their rights of first refusal within a period of 2 months from the date the Notice is served, the landlord is free to dispose of that interest to the Proposed Purchaser on the same terms (and on no more favourable terms, e.g. at a reduced price) as that referred to in the Notice.

Consequences of non-compliance?

The consequences for a landlord failing to comply with the Act are considered quite harsh by many. Failure to comply may result in a criminal conviction (although to date, there are no such reported cases of landlords being convicted) and a fine. Further, regardless of when the disposal took place, if the procedure under the Act was not originally followed, the Qualifying Tenants can, at any time in the future, serve a 'purchase notice' on the current landlord, requiring it to transfer the relevant interest to a company nominated by the Qualifying Tenants for the same price paid by the purchaser at the time. This could have huge consequences for parties who have acquired an interest in a building from a landlord many years ago, as it could be required to transfer that interest to the Qualifying Tenants (wise enough to spot the fact that a Notice was not served at the relevant time) for a price significantly lower than the current market value of that interest. It is also important to bear in mind that if a Notice is withdrawn, there are implications for re-serving of a subsequent Notice, and again, timescales apply.

Therefore, purchasers of an interest where the original disposition would have been caught by the Act should carry out full due diligence on that original disposition, to ascertain whether the procedure under the Act was complied with and if not, the potential risk of a purchase notice being served by the Qualifying Tenants in the future.

So, how can you avoid the pitfalls of the Act?

Whether or not the Act applies requires careful consideration when acting for a landlord. Whilst the Act will no doubt apply in many circumstances, there are a number of exemptions that landlords and Proposed Purchasers may wish to consider at the outset of negotiations.

For example:

• a disposition made to a company associated with the landlord (for at least 2 years) will not fall foul of the Act – in that regard, it is worth the landlord having a number of connected shell companies on its books, should it ever need to make a disposal that would otherwise be caught by the Act; or
• a disposition made before there are enough Qualifying Tenants (for example, in a newly constructed building, the landlord could grant a lease of the airspace before more than 50% of the residential flat leases are under contract) will not be caught by the Act.

Equally, prudent or savvy tenants will want to look at the history of a property to determine whether there are means of acquiring the interest based on historic failures to comply with the Act in relation to a disposal by a previous landlord. This could mean that tenants acquire an interest at historic values and not what is now being proposed.

So whether you are proposing to acquire a lease of airspace of a building for development potential, or you are a freeholder/landlord looking to dispose of an interest in your building for value, it is essential to obtain advice from a property lawyer early on, as to how best to structure the transaction in order to avoid the pitfalls of the Act, particularly as the penalties can be harsh.