Cross border property transactions - preparing a client report

Imagine the scene: you are seated at your desk, deep in negotiations for a standard UK institutional lease, when a brand new instruction arrives from a US client who wants to purchase as an investment, a portfolio of let properties throughout Europe. The subject matter of this portfolio is a chain of cinemas each of which is let to different international cinema operators. Apart from being an exciting and high profile transaction, this type of work will raise issues in your mind about the extent to which the property legal systems and market practices operate differently in the rest of Europe. The value of each property is underpinned by the lease to which it is subject. The client will therefore need an understanding of the principal differences in the treatment of leases between jurisdictions so a consideration may be made of the potential effect in value.

So, where do you start? This will depend largely upon the nature of the transaction : is it a share acquisition or an asset purchase? What UK specialist lawyers will you need to involve? Once you have your home team together you will need to line up overseas lawyers to assist in the due diligence process and any local formalities for your client in its acquisition of these properties. As part of this you will need to ascertain the following:

• are there any time constraints or deadlines which need to be communicated to the overseas lawyers to ensure that they can meet these?
• are there any budgetary constraints and can these be met?
• what is the relevant client relationship history for the purposes of conflicts of interest - remembering that you need to check that your overseas lawyer does not have any conflict as well?

Once the full legal team has been brought on board the real work of ascertaining what you are buying and beginning the reporting procedure to your client will start. There are likely to be many legal specialisations whose input will be required and a comprehensive form of report will therefore need to be drawn up to deal not only with these aspects but also to cover the differences in law in each jurisdiction: your client will require a comprehensive form of report which can accommodate and report sensibly on these differences. It is therefore necessary to have some understanding of the different legal approach adopted by a common law jurisdiction such as the UK and civil law jurisdictions such as the continental countries have adopted. The general principle adopted by the codified systems in continental European countries was that a tenant had only a personal right to use the property let and no real right in the property and therefore very little security. This is reflected in the shorter term of the lease, the landlord's obligation to repair the structure of the property and the restrictions on transferability of the lease which are all normal in continental transactions. Fortunately however, some of the more impractical aspects of Roman law were dropped early on so that a real right is in effect granted giving an almost unrestricted power to use the property.

The common law situation in England, differs greatly. The common law system is based on case law and the common law approach is to treat a leasehold right as much more than a mere personal right. Although it arises from a contract it is treated as a quasi real right. It continues therefore, even though the landlord may dispose of its property and the tenant may assign its lease. This is not automatically the case in many civil law systems.

Your client will be concerned to find out exactly what these differences are and to ensure that each property in which it is investing will provide the security that it would expect from what is commonly considered in the UK as an institutionally acceptable lease. This is where the relevance of a coherent report, which understands and explains the differences in the various jurisdictions, comes into play.

The report should incorporate all the standard areas which an investor would expect to see in a report but in order to be useful should note where the documentation differs to such an extent as to veer away from what we might call "institutionally acceptable". For example, the following aspects of leases which an investor would take for granted as being standard in an institutional lease in a common law jurisdiction may become impossible or even illegal in a civil law jurisdiction and should be considered and drawn to the client's attention:

(i) Privity of contract

Under English law if the landlord disposes of its interest the lease continues although the outgoing landlord will have a continuing duty to the tenant by way of privity of contract unless and until released. Such privity of contract does not apply generally in continental European law. Under Czech law the code even provides that the tenant has the right to terminate the lease if the landlord disposes of its interest. Similar, although less stringent rules apply in Belgium.

(ii) Term

Under English law, generally landlord and tenant are free to agree whatever period for the lease they want. In many civil jurisdictions the code limits the term of the lease. In Germany and Italy it is 30 years, in Poland it is 10 years, in Sweden, depending upon where the building is situated, it is either 25 or 50 years. Under French law a commercial tenancy agreement may not last less than 9 years. However, in Germany the parties can avoid this consequence, should they desire a term of more than 30 years by agreeing to a registered lease under the Condominium Act (WEG). This registered lease can be transferred or sublet, and fixtures and fittings can be pledged to a creditor but the lease itself may not be mortgaged.

(iii) Alienation by tenant

The common law approach is that since the lease is a property right the tenant may deal with that right by assignment or underletting unless there are controls in the lease.

The general civil law approach, because the lease is treated as a personal agreement, is that the tenant may not alienate the lease unless the lease specifically permits this to happen.

(iv) Repair and decoration

The norm in the common law commercial lease is that the landlord repairs and decorates the structure (which is generally not demised) and common parts, passing the cost to the tenant by means of the service charge. In addition, the tenant is obliged to repair and redecorate the premises leased to the tenant.

Throughout almost all civil law jurisdictions the tenant will usually have to bear the costs of repair and redecoration of the non structural parts of the unit leased only and the landlord is usually responsible for common areas and structural and external parts of the building often without any right to recover the costs from the tenant.

Whereas in Poland privity of contract allows the parties to agree on a different solution, German mandatory law forbids such an approach. The German Code (the BGB) does not even oblige the tenant to redecorate the premises, although in practice tenants usually assume this obligation voluntarily.

(v) Landlord's right to terminate for tenant breach

The common law permits the landlord to re-enter and take back the premises where the tenant is in breach. Where the tenant is not in occupation, the landlord may still do this but where the tenant is in occupation, statute law now requires that a court order is obtained.

Civil law jurisdictions generally require that a court order be obtained before a landlord can terminate the lease for breach of the tenant’s obligations but the relevant civil code may impose periods of "grace"before a landlord's right of re-entry may be exercised. Thus, under the Polish code, in certain circumstances the rent arrears must be at least seven months before a court application is possible.

(vi) Distraint, also called distress

Under common law, the landlord is entitled to "distrain"for unpaid rent by entering the property and removing and selling goods within the property to the value of the unpaid rent. No court order is required and the landlord is entitled to assume that the goods in the property belong to the tenant even though in fact they may belong to a third party.

This right is very much a common law right which is not generally available under civil law systems. Certain civil law countries, such as Germany and Poland, create a lien or pledge over the tenant's chattels in the premises which can be held as security for rent arrears. Generally, however, security can only be exercised by authority of the court.

These are just a handful of examples of how the investment market differs in each European jurisdiction. Central European systems, however, tend to reflect the UK/US Style of lease to a greater extent, probably due to the fact that the investment market in these countries is less mature and has therefore been able to import aspects of the common law investment lease into the local system by virtue of the UK/US activity in these countries.

It is often possible to circumvent the potential pitfalls by innovative structuring of the transaction but the basic principle, that the client needs first to be aware of these pitfalls, should still be the main consideration. Hence the need for organisation and a comprehensive form of reporting exercise.

This article was first published in the Legalease special real estate report, June 2001.

For further information please contact Charles Romney on +44 (0)20 7367 2727 or at charles.romney@cms-cmck.com or on +44 (0)20 7367 2447 or at sally.badham@cms-cmck.com.