After introducing the Pubs Code, what happened to the “unintended consequences”?

The Pubs Code?
Recall that one of the main objectives of the Pubs Code was, broadly speaking, to ensure that tied tenants of the largest pub-owning businesses are no worse off than free-of-tie tenants, yet without placing undue regulatory burdens on businesses. At implementation, the Pubs Code affected those pub companies with at least 500 tied pubs in the UK, and introduced the prospect of the Market Rent Only (MRO) option, allowing tied tenants to go free-of-tie at certain trigger points.

How does an MRO option work?
Under the Pubs Code there are various “trigger events” where an MRO option can be exercised, including periodic rent review, lease renewal, a material change in circumstances likely to lead to a decrease in trade, or a significant increase in the price of a product or service. Where an MRO option is exercised, the market level of rent on the resulting lease is expected to be somewhere between the tied rent, and the combined tied rent and wholesale income received by the Pub Co under the previous lease, thereby threatening the Pub Co landlord with an instant loss of income and potentially value.

In order to retain an element of control, where new tied leases have been issued, and mitigate the risk of value erosion if the tenant pursues an MRO option at some point in the future,  shorter terms have been granted than in the past. In addition, Pub Co’s will be reluctant to commit large scale capital investment on a tied lease basis where the tie may be at risk in the future.

The BBPA, a representative of brewers and pub companies, warned in early 2016 of reduced investment and ultimately further pub closures in instances where pub companies could not recoup their investment within the seven year investment exemption window afforded under the Pubs Code. Yet despite this, the rate of pub closures has continued to decline from the peak in 2009, and we see ongoing appetite amongst pub companies for investment in their tied estates.

Has the Pubs Code achieved its objectives?
The six major Pub Companies affected by the Code were well aware of the impending changes, and many, particularly Marston’s, Greene King and Enterprise Inns, were proactive, continuing to churn the bottom end of their tenanted estates, whilst appearing to take better assets back in house and transfer them into existing or newly established managed or franchised divisions, in line with revised strategies. However, whilst many tenanted portfolios did see contraction, no big sell-off of tenanted pubs (in order to bring any estate under the threshold of 500 tenanted assets) materialised. The resulting cycle is self-reinforcing, with values of managed assets rising faster than tenanted assets.

Of those tied tenanted pubs that avoided the above, how many elected to pursue an MRO option? Well, in honesty, not as many as we expected. According to statistics released by the Pubs Code Adjudicator (PCA), there had been 435 enquiries by January 2017. Of these enquiries 91% were from tied pub tenants, with the majority requesting more information about rent assessment and the MRO process. According to figures quoted by the Morning Advertiser in May 2017, 273 tenants actually proceeded to request an MRO option across five of the six Pub Co’s affected by the legislation, with Greene King not providing any data until its preliminary financial results are released later in June. Whilst appetite for transitioning into MRO has remained high, a number of barriers remain, many of which were highlighted early on by interest groups such as CAMRA during public consultation. Firstly, tenants have been largely ignorant of the details and restrictive notice and response times associated with the legislation, and many are unintentionally allowing their right to request an MRO option to lapse (or be forced to act without receiving appropriate professional advice). The Pub Companies clearly have measures at their disposal to frustrate the process for tenants by drawing out response periods and forcing referrals. To put this in perspective, at the six month milestone, the PCA had recorded 121 referrals for arbitration, with not one case having been completed (although this admittedly excludes those referred to Independent Assessors where determinations have been given, of which there are likely to be several, albeit the exact number challenging to quantify). The adjudicators' first five awards were announced on 9 March 2017, and a further 20 had been awarded by 21 April 2017, at which time 97 cases remained at various stages within the arbitration process. Remember that even when the tenant eventually gets to this point, they are then faced with the implications of trying to achieve an appropriate MRO tenancy, which is another challenge in itself.

In theory, for those that do comply with the various deadlines, the free-of-tie rent offered to tenants should reflect that of free-of-tie market rents for comparable public houses. However, in an effort to disincentivise tenants from breaking the tie, there are a number of significant upfront costs that Pub Co’s can threaten on transitioning to a new commercial lease (as opposed to merely amending the terms of the existing tied lease through a deed of variation – which has become a contentious issue in itself).  Typically, this can include dilapidations, rental deposits, and quarterly rent in advance. The pubs that should benefit the most from exercising an MRO option are those that are trading well and are able to drive large wet volumes. However, it is also these sites that the affected pub companies are more frequently taking back to operate under their own management. If this is the case, tenants lose their ability to renew the lease altogether. Perhaps it is unsurprising then, that according to the Morning Advertiser, of those 273 tenants who requested an MRO option, only eight licensees have managed to successfully enter into a free-of-tie MRO lease in the past 10 months. Whilst this figure may well turn out to be understated as more information comes to light, the true number is unlikely to be materially different.

When is a free-of-tie lease not free-of-tie?
It would be remiss at this point not to mention stocking requirements that apply to MRO tenants of those Pub Companies with brewing operations, namely Greene King, Marston’s and Star Pubs & Bars. Even if a tenant does escape the tie, and manage to improve their wet margins as a result, their new MRO lease can mandate that a percentage of their fridge space and draught lines are taken up with their landlord’s products, albeit purchased from a supplier of the tenant’s choosing. The application of these requirements differs by Pub Co, and thanks to some seemingly contradictory wording in the Pubs Code, the very existence of stocking requirements in MRO-compliant leases has already been challenged, forcing both the Department for Business, Energy & Industrial Strategy and the Pubs Code Adjudicator to issue clarifications that the inclusion of a stocking requirement does not on its own indicate that a lease is tied. No doubt there will be further battles over the detail in this area, and over whether the particular circumstances of a given stocking requirement could be considered unreasonable, which will be determined at the PCA’s discretion.

So what is the answer?
The Pubs Code was in itself a compromise between the objectives of government and the needs of many different stakeholder groups, and whilst its introduction heralded the greatest structural change to the industry since the Beer Orders, the reality is that for many tied tenants, you cannot both have your pint and drink it.
Throughout 2016, both in advance of and post introduction of the Code, the Association of Licensed Multiple Retailers (ALMR) was very vocal in explaining that for many tenants, going free-of-tie may not represent the best outcome, and that using their new rights under the Pubs Code as a bargaining tool in order to get the best possible tied lease may remain the optimal solution. This may well have turned out to be spot on.