Know your tenants: Rise in investment fraud puts investors and asset managers at risk

Written on 17 Sep 2015

With continued pressure on global equity markets and interest rates remaining at rock bottom, the market for alternative investments is booming. As a consequence, investment fraud is also on the rise. In an attempt to provide an air of legitimacy, fraudulent operations, offering investments in areas such as art, fine wine and rare coins, are increasingly being run from prestigious addresses within the City of London.

These schemes cause major harm, often to vulnerable victims. More than £1.73bn was reported to Action Fraud as having been lost last year (the true figure is likely to be much higher). But these schemes also present a significant risk to landlords, investors and managers of the properties from which they operate.

Know your statutory obligations: Serviced offices

Recent efforts by the City of London Police and Trading Standards, collaborating under the banner ‘Operation Broadway’ have highlighted a direct risk to providers of serviced offices. In the past six months, police have visited a number of serviced offices and have fined two serviced office providers approximately £30,000 each (including costs). Those fines were for offences committed by the serviced office providers under the Consumer Protection from Unfair Trading Regulations 2008 and the London Local Authorities Act 2007, by failing to carry out adequate checks on those using their offices.

Each of those offences carries a potentially unlimited fine, not to mention the reputational damage caused by a criminal conviction. Businesses operating in this sector should be aware of their statutory obligations, to ensure that they are not unwittingly put at risk by those operating from their premises.

Know your covenants: From landlords to asset managers

For those at a direct risk of a fine, this and the resultant negative PR are likely to provide incentive enough to ensure that their premises are not being used for illicit purposes. Where criminal behaviour has been found, however, this could also have serious implications for upstream leasehold covenants and other contractual obligations.

A typical commercial lease will include covenants to comply with all laws relating to the occupation and use of the property, which will include consumer protection and anti-money laundering legislation. Where the tenant is able to sublet, the headlessee’s covenants might include ensuring the compliance of their sub-tenant, or at least reflecting their own covenants in the sub-lease and enforcing those covenants.

Where a covenant has been breached due to illegality, this may not be capable of remedy and can leave tenants and sub-tenants exposed to the risk of forfeiture. The recent case of Freifeld v West Kensington Court [2015] EWCA Civ 806 demonstrates that a court will be cautious about ordering forfeiture of a long lease that would give the landlord a significant windfall, but will not rule this out. An investor in a long lease of office space could find their investment at serious risk if an investment fraud at their premises gives rise to a breach of covenant.

On the other hand, a landlord who is not due a windfall could find themselves having to make a difficult decision about whether to waive a potentially serious breach or face the uncertainty and cost of forfeiting the lease and finding an alternative tenant.

As well as parties with a proprietary interest, a finding of illegality will also have serious implications for asset managers and their subcontractors. One of their key roles is to ensure compliance by the property’s occupiers with leasehold and other obligations. Termination of their asset management agreement may mean losing not only an on-going revenue stream, but potentially also more lucrative success fees payable on a sale of the property.

Know your options

The London commercial property market is showing no sign of slowing down, as it remains an attractive prospect to domestic and overseas investors alike. However, any investment or involvement in commercial real estate can carry with it complex legal issues and risks. The risk of property being used as a vehicle for money laundering is well known, and is something the Government is looking to address, with plans to introduce greater transparency of beneficial ownership. Nevertheless, the attraction of prestigious addresses as a base for investment fraud provides a salutary reminder of the importance of knowing the legal, as well as commercial, risk landscape when it comes to commercial property.