In this case, the Court of Appeal took a traditional stance by holding that mortgagees in possession are exposed to the full risk of forfeiture.

Lenders whose security comprises leasehold property will usually be very aware of the dangers of forfeiture. If the lease is terminated, their security disappears. For this reason, they will normally seek to insist that the landlord agrees to inform them of any breaches of covenant or of the service of any section 146 notice. But where an unqualified assurance from the landlord is not possible, or where notification is not given, where does a mortgagee stand? Recent case law indicates that the picture is far from rosy.

Section 146 Notices
Where a landlord decides to forfeit for non-payment of rent, no preliminary notice needs to be served. He can proceed by way of peaceable re-entry (save where this is outlawed, as it is if the property is residential, or in many of the stages of insolvency) or it can commence court proceedings. In the latter event, the lender will need to depend for information upon any right he may have to be notified of those proceedings.

Where the forfeiture is for the breach of any other covenant, the landlord must serve what is known as a “ Section 146 notice” (served pursuant to S146 of the Law of Property Act 1925) before taking any steps to obtain possession. The notice must specify the breach complained of, and indicate that the lease will be forfeit if the breach is not remedied within a reasonable period of time. The section 146 Notice must be served on the "lessee", and the section makes clear that this includes any subtenant. But what of a mortgagee?

It has long been held that neither a mortgagee by subdemise nor one that holds a legal charge has a right to be served with a section 146 notice; the courts quite simply feel that the risk of forfeiture is one of the "risks of the game" from which the mortgagee must seek its own protection. However, back in the mid 1950s, it was conceded that the position might be different where a mortgagee had taken actual possession of the premises. This little chink was not investigated for a further 50 years, when in Target Home Loans Ltd -v- Iza Ltd [2000] 02 EG 117, it was held that this was indeed the case. In the Judge’s view, the purpose underlying a section 146 notice was to ensure that the tenant had an opportunity to remedy the breach so as to avoid forfeiture. Where a mortgagee had taken possession, it was ordinarily in the best position to do this. Furthermore, it would have the greatest interest in taking the necessary steps to avoid forfeiture and where relevant, of claiming the benefit of the Leasehold Property (Repairs) Act 1938.

This approach has now been challenged in Smith –v- Spaul [2003] 17 EG 148.

The Facts
In Smith, the claimant landlord of a block of flats was seeking to forfeit the lease of a flat following a breach of the covenant to repair. She had in fact served on the tenant's mortgagee a copy of the section 146 notice; as the mortgagee was in possession of the property at the time.

The mortgagee served a Counter-Notice, claiming the benefit of Section 1 of the 1938 Act. (This requires landlords in receipt of such a notice to seek permission of the court to bring a claim where more than three years of the term remain unexpired). However, the landlord then commenced proceedings for forfeiture without seeking leave from the court, as required by section 1.

The trial judge dismissed the landlord's claim on the basis that the mortgagee had been entitled to serve the Counter-Notice and that, as a result, the landlord could not proceed to forfeit without leave.

It is clear that the party entitled to claim the benefit of the 1938 Act is the same party that is entitled to be served with the section 146 notice. The question for the Court of Appeal, therefore, was whether a mortgagee in possession has the right to be served with a section 146 notice.

Arden LJ decided that that no mortgagee had such a right and that Target Home had been wrongly decided. She pointed out that the tenant is bound to the landlord and their essential relationship is unaffected by any mortgage, even where a mortgagee takes possession. The tenant can still remedy the breach, either by redeeming the mortgage and regaining possession itself, or by remedying the breach with the mortgagee’s consent. She did not depart from the traditional stance that a mortgagee must accept the risk of forfeiture, deciding that a mortgagee has the right to claim relief from forfeiture, and therefore does not need the additional protection of a section 146 notice or, where applicable, the benefit of the 1938 Act.

Notice of Forfeiture
Ideally for lenders, leases should contain a proviso that the mortgagee is given notice of any court proceedings. Otherwise, the mortgagee will not be sure of knowing whether proceedings for forfeiture are being instigated and, generally speaking, a mortgagee can claim relief only while the landlord's court proceedings to forfeit are extant. (Once the landlord has regained possession, the court will set aside a judgment only in exceptional circumstances: see Rexhaven Ltd v Nurse (1995) 28 HLR 241.)

However, a mortgagee in possession will usually be aware of the risk of forfeiture without the need for positive notification: a defaulting mortgagor is likely to be a defaulting tenant. Moreover, it is often in the interests of a landlord who wishes to see breaches remedied to ensure that a mortgagee is aware of the position.

It used to be the case that the Civil Procedure Rules required the landlord seeking possession to name all those of whom he was aware who might be entitled to relief; this would cover known mortgagees whether or not in possession. Copies of proceedings would therefore be served on them and they would be aware of what was happening. This is now the case only where the property is residential. Hence, a mortgagee of a commercial lease gets no assistance from the system and must take its own precautions.

Key Points:
• The tenant is bound to the landlord and their essential relationship is unaffected by any mortgage, even where a mortgagee takes possession.

• The tenant can still remedy a breach, either by redeeming the mortgage and regaining possession itself, or by remedying the breach with the mortgagee’s consent.

• A mortgagee in possession is not therefore entitled to be served with a Section 146 Notice, nor to claim the benefit of the Leasehold Property (Repairs) Act 1938.

• Mortgagees of commercial leases are no longer automatically served with copies of forfeiture proceedings.

David Bailey 020 7544 5585 davidb@sghlaw.com