Tenancy Deposit Schemes - how the new rules affect landlords selling up

Practical Law UK Articles 3-361-4962 (Approx. 7 pages)

Tenancy Deposit Schemes - how the new rules affect landlords selling up

by Sarah Allen, Wragge & Co LLP

Introduction

The much publicised legislation governing the taking of deposits under an Assured Shorthold Tenancy (AST) is now in force. As from 6 April 2007, a landlord who grants an AST and takes a deposit from the tenant, needs to ensure that the deposit is protected in accordance with sections 212-215 of the Housing Act 2004 (HA 2004).

Little thought appears to have been given, however, to what happens when a landlord wishes to sell its interest in the property, subject to an AST. Whilst many buy-to-let residential landlords would not anticipate selling subject to the AST, some do trade their properties with a sitting tenant. In the commercial sector, mixed use sites, for example a parade of shops with flats above, regularly change hands. In these circumstances, the incoming landlord will be subject to the new legislation.

There are two ways in which deposits can be protected:

Through a custodial scheme.
Under a custodial scheme, the deposit is passed by the landlord to the scheme administrator, who will deal with the arrangements for repayment at the end of the tenancy.
Through an insurance scheme.
Under an insurance scheme, the landlord retains possession of the deposit but pays a premium to the scheme administrator. This premium pays for an insurance policy to cover the risk that the landlord does not return the deposit to the tenant in circumstances where the deposit should be returned.

The government has granted contracts to three scheme administrators to run the schemes. There is only one custodial scheme provider but a choice of two insurance schemes:

Custodial scheme: The Deposit Protection Service (DPS).
Insurance scheme: Tenancy Deposit Solutions Limited (TDSL).
Insurance scheme: The Tenancy Deposit Scheme (TDS).

A landlord under an AST must protect any deposit received and provide certain "prescribed information" (which will include details of the scheme which is being used to protect the deposit) to tenants within 14 days of receipt of the deposit.

Acting for purchasers

If a deposit is not protected through one of the three schemes, or if the prescribed information is not given to the tenant by the landlord, there are two sanctions:

No notice may be served on the tenant under section 21 of the Housing Act 1988 (which enables landlords to recover possession under AST on giving 2 months' notice after the first six months of the tenancy provided any fixed term has expired).
This is likely to be the most important sanction for a commercial client acquiring a site for development.
It appears that the intention of the legislation is that the right to serve a section 21 notice should merely be suspended, so that once the deposit has been protected and the requisite information has been given to the tenant the right will revive, although it is not clear that the legislation as drafted has this result.
The landlord must pay the tenant a fine of three times the amount of the deposit.

It is, therefore, vital to ensure that the requirements of the legislation are complied with.

A vendor should be asked for information about the scheme used to protect any deposit and for a copy of the prescribed information provided to the tenant, so that compliance can be ascertained and any necessary transfer of the deposit to the purchaser can be arranged. How this will happen in practice is still far from clear and will depend on the type of scheme being used.

Transferring the deposit under the custodial scheme

The custodial scheme appears to have made provision in its terms and conditions for the transfer of a deposit within the scheme on a sale of the landlord's reversion.

The DPS has created a Change of Landlord Form, which can be used to notify the DPS of any change in landlord.

The terms and conditions are not entirely accurate. The definition of "Transfer", for example, refers to "the transfer of a Tenancy from one Landlord to a new Landlord", rather than the transfer of the reversion. The intention, however, seems clear.

The incoming landlord is required to register with the DPS, but this appears to be a purely administrative procedure and, unlike the insurance scheme, there are no bars to registration.

The DPS notifies the tenant of the change of landlord. Condition 15(c) states:

"As part of a Change of Landlord no funds will be returned to any party by The DPS and the transferring and Receiving Landlords are responsible for any financial recompense that may become due to Tenant(s) (such as through loss of interest) as a result of a Change of Landlord".

Since the deposit is held throughout by the DPS, it is unclear why there should be any loss of interest. No time limit for notification of a change in landlord is laid down by the rules, although Condition 14 provides that:

"Landlords must ensure that all information held by The DPS in relation to Tenancies, Tenants and Deposits for which they are responsible are up to date and factually correct".

A "repayment ID" is needed to release the deposit at the end of the tenancy. This consists of two identification numbers: one belonging to the landlord and one to the tenant. The numbers are personal to the particular landlord and tenant and so it is assumed that the incoming landlord will be issued with its own repayment ID.

Although not mentioned anywhere in the scheme terms and conditions, the DPS advises that it will not be possible, before the end of the tenancy, for the incoming landlord to remove the deposit from the custodial scheme and transfer it into one of the insurance schemes (perhaps to bring the method of protection of deposits into line with other holdings it has).

Transferring the deposit under the insurance schemes

If an insurance-based scheme has been used, the vendor will have physical custody of the deposit and so this will need to be transferred to the purchaser, as is usually the case on an acquisition of a tenanted building where a rent deposit exists.

The legislation does seem to envisage that a landlord should be able to withdraw a deposit from the protection of an insurance scheme. It would appear from the legislation that:

Once the landlord notifies the scheme of its intention to withdraw a deposit, the deposit is to remain protected under the existing scheme for 3 months.
The landlord will be under an obligation to arrange alternative protection for the deposit before that period expires.
The landlord must then provide the tenant with updated prescribed information.

(Paragraphs 5(1A)(b), 5A(2), 5A(7) and 5A(9), Schedule 10, HA 2004.)

This mechanism could be used on a sale of the building to enable the purchaser to set up alternative protection for the deposit without the tenant losing the deposit protection in the interim.

Unfortunately the position under the two insurance schemes does not accurately reflect the legislation.

Position with TDSL

TDSL has stated unequivocally that it will not allow transfers of the deposit protection between landlords, despite the provisions of the HA 2004.

In support of this approach, TDSL cites rule A4.1 of its scheme rules, which provides that membership is not assignable. In most instances, however, it would not be the membership itself that the vendor would want to assign, but rather the benefit of the protection relating to particular deposits.

Transfer of deposit protection would appear to be prohibited by the TDSL rule A1.3, that the landlord must be named on the tenancy agreement. This rule also applies where the deposit is held by an agent and it is the agent that is the member of the scheme, rather than the landlord.

TSDL's website suggests that deposits protected by TDSL may be "unprotected" where protection of the deposit has been transferred to another authorised protection scheme, but states that the agreement of the scheme administrator is required for any transfer. There is no provision in the scheme rules for a transfer of deposit protection to another scheme.

The only solution offered by TDSL is that the vendor should terminate the existing AST, and the purchaser should then set up a new tenancy. This solution is not satisfactory. It is not possible to terminate an AST during a fixed term or within the first six months. The solution requires the purchaser to take the risk of buying a property with no income stream.

TDSL say that it accepts that its scheme may not be suitable for all landlords.

Position with the Tenancy Deposit Scheme

The scheme rules for the TDS do contemplate changes in landlord.

Rule 13 provides that:

"The terms and conditions of TDS continue to apply as long as the existing tenancy agreement remains in place, regardless of a change to the ownership or management of the business or the property, as long as the subscription continues to be paid".

The rules also contemplate that the new landlord may choose to place the deposit with an alternative scheme:

"Members must promptly inform the tenants, and within no more than 10 working days, of those properties covered by TDS that they are transferring to another Member (or manager); or otherwise are ceasing to manage or own their properties. They must also tell them who is now managing the property and confirm either that the rules of TDS still apply (if the new manager is already a member of TDS) or that their deposit will be covered by another specified, designated scheme (if the new manager is not a member of TDS)."

The references to "manage" are because the TDS scheme is primarily aimed at agents, rather than landlords, but the scheme is open to landlords, and this is reflected in the definition of "Member". Changes in ownership have to be notified to TDS within 14 days.

Acting for vendors

A solicitor acting for a vendor of a property that is subject to an AST where a deposit has been taken, will need to ensure that, where possible, the existing arrangements for protection of the deposit in the vendor's name are brought to an end, and the client's liabilities under the scheme in relation to that deposit are terminated.

It may be appropriate for the purchaser to confirm in the contract that all necessary arrangements for protecting the deposit post-transfer are in place, for example, that the purchaser:

Has registered with a scheme.
Will protect the deposit within the time-frames laid down, both by statute and under the relevant scheme.
Will provide the requisite information to the tenant within the time-frames laid down, both by statute and under the relevant scheme.

This may be difficult where the deposit is protected by TDSL. In this situation, a decision will need to be taken whether the deposit is physically transferred to the purchaser. A transfer of the deposit would cause the vendor to be in breach of the terms and conditions of the scheme, with the result that its membership of the scheme could be terminated. This could result in the vendor being unable to take deposits in the future, or being restricted to using the custodial scheme.

There is also the issue of what would happen if the deposit is transferred and, at the end of the tenancy, there is a dispute over the deposit. In this situation, the scheme provider would contact the old landlord with a request to lodge the deposit with the scheme.

Appropriate indemnities could be sought from the purchaser to cover these sorts of risks, but the vendor should be advised that this may not be a sufficient remedy in the event that the vendor's membership of the scheme is terminated.

If the deposit is not transferred, a purchaser will require comfort that the deposit continues to be held in accordance with the provisions of the scheme, particularly since the purchaser will be unable to serve a section 21 notice if the deposit is not correctly protected.

One solution might be for an account to be opened in the joint names of the incoming and outgoing landlords in which the deposit could be held. Drafting will be needed to deal with the return of the deposit at the end of the term. The purchaser will no doubt want exclusive control over this as it will want the final say as to whether the conditions for the return of the deposit under the tenancy agreement have been met.

Conclusion

If clients ask for advice about which scheme to use when accepting deposits, their future intentions for the property should be ascertained. If it is possible that the client may wish to dispose of the property subject to the tenancy in the future, then one of the schemes that permits transfers between landlords should be chosen.

Since the legislation only applies to an AST granted on or after 6 April 2007, it may be some time before the practicalities of transferring deposits between landlords are put to the test.

Summary

Acting for a landlord on the grant of an AST where a deposit is taken

Take instructions from the client as to whether they are likely to want to dispose of the property at some stage. If so, choose one of the schemes that has the facility to transfer deposit protection between landlords.
Check whether there are criteria that must be satisfied for a landlord to become a member (this is only the case with the insurance schemes). A purchaser of the reversion may not necessarily satisfy all of the criteria of the scheme.
Ensure that the requirements of the legislation in relation to protection of the deposit are met (see PLC Property Practice note, Tenancy Deposit Schemes).

Acting for a vendor landlord

Find out at an early stage which scheme is being used to protect the deposit(s) and check the terms and conditions of the scheme regarding transfer.
If the custodial scheme is being used, ensure that appropriate transfer notices are served on the DPS.
If the insurance scheme run by TDS is protecting the deposit, this protection may be transferred to the purchaser, although time limits apply. Alternatively the purchaser may wish to make its own arrangements to protect the deposit, in which case take steps to "unprotect" the deposit and advise the purchaser of its obligation to protect the deposit before the current protection expires. The deposit should not be unprotected before completion in case the sale does not proceed.
In either of the above two cases, require a covenant from the purchaser in the sale contract that they will register with a scheme before completion and following completion will take steps to perfect protection of the deposit within any time limits laid down by statute or by the scheme rules. This covenant should be supported by an indemnity in favour of the vendor in the event that this is not done.
No transfer of deposits is permitted under the terms of the TDSL scheme. Specific drafting to deal with such deposits should be included in the sale contract and instructions sought from the client.

Acting for a purchasing landlord

Make enquiries of the vendor at an early stage to ascertain which scheme is being used to protect the deposit(s) and whether the scheme permits transfer.
Where transfer is permitted and the incoming landlord has a choice about how to protect the deposit, take instructions from the client in good time (currently this is only possible under the TDS scheme).
If the scheme permits transfer between landlords and the deposit is to remain protected by the same scheme following completion, ensure that the appropriate notices are served on the scheme provider within any time limits laid down by the scheme.
Serve updated prescribed information on the tenant to ensure compliance with the legislation.
No transfer of deposits is permitted under the terms of the TDSL Scheme. Specific drafting to deal with such deposits should be included in the purchase contract and instructions sought from the client.
Remember that no notice under section 21 of the Housing Act 1988 may be served to terminate an AST and obtain vacant possession where the legislation governing tenancy deposit protection has not been complied with.

Tenancy Deposit Schemes - how the new rules affect landlords selling up | Practical Law