Service Charges in Mixed-Use Developments
19th December 2014
By their very nature, mixed-use developments involve multiple parties with competing interests. This often leads to disputes regarding the management of the estate and the cost of maintaining it.
This paper will consider the following (disparate) issues:
- Management obligations
- Construction of service charge covenants
- Reserve Funds
- The Right to Manage
The title structure at mixed-use developments is often complicated. There may be a freeholder, several head leases and hundreds of underleases. The tenants are likely to have different priorities in terms of the provision of services and repairing obligations depending on the extent of their property, the length of their term and the nature of user. They will not want to pay for services they consider they do not benefit from and they will only want to pay their ‘fair share’ of the services they use.
When working out the service charge regime at a new development, a logical starting point is to decide who will be responsible for the management of the estate. Options include:
- Head lessee(s)
- Management Company/Management Trustee
- Residents Management Company
The most suitable option will depend on the size and nature of the development and the interests to be carved out. The choice may be obvious for a small building comprising residential and commercial units (where the freeholder or a single head lessee will usually be responsible) but less so for a large estate with multiple buildings with different users.
A Management Company (“ManCo”) may be responsible for managing the estate (particularly where the developer is associated with the ManCo and the development presents an opportunity to generate revenue) and the head lessee may be responsible for the structure of the building. The regime may be further complicated if only parts of a building (usually the upper residential parts) are demised under a head lease while other parts of the building are let to (usually commercial) tenants under leases granted directly by the freeholder. In such circumstances, the head lessee may be responsible for maintaining and repairing the structure of the building but cannot recover a contribution of the cost from the commercial tenants because there is no direct contractual relationship.
These matters all need to be considered when designing a service charge regime and drafting service charge provisions in leases at a new development. It may, for example, be necessary for the freeholder to recover a contribution from the commercial tenants through a service charge in the commercial leases and for the head lease to provide for the freeholder to contribute towards the costs incurred by the head lessee.
Obviously, the objective is to create a regime that is logical and ‘fair’ (or at least acceptable to the various parties) and for the service charge provisions to clearly define the parties’ obligations so that: (i) the parties understand their respective repairing obligations; (ii) the costs of performing those obligations can be recovered in full; and (iii) the apportionment of the costs between the respective parties is clear.
The use of definitions and plans is absolutely crucial. Where the obligations to carry out works and services (and the obligation to contribute towards the cost of such) are complex it may be necessary to identify multiple service charges, for example:
- Residential Service Charge;
- Commercial Service Charge;
- Building Service Charge;
- Estate Service Charge; and
- Parking Service Charge.
In such circumstances, the proportion of the costs payable by the tenant for each service charge is likely to vary.
Construction of Service Charge Clauses
The principles that apply to contractual interpretation are very established and familiar. Those principles apply when interpreting service charge clauses.
In the particular context of service charges, the most important feature of the background which tends to fall for consideration is the fact that the provisions constitute a scheme whereby the landlord seeks to recover from the tenant(s) the cost of works. That consideration has, however, given rise to somewhat conflicting results.
In Universities Superannuation Scheme Ltd v Marks & Spencer Plc  1 E.G.L.R. 13 the relevant provisions were construed having regard to the need for the landlord of a shopping centre to recover the full cost of maintaining the centre for the benefit of its tenants. But in Gilje v Charlgrove Securities Ltd  1 E.G.L.R. 41 the Court of Appeal held that that same consideration should lead to an approach which was more favourable to the tenant. The landlord, in that case, was held not to be entitled to recover the notional rental cost of a flat which it was obliged to provide to a resident caretaker.
There is no presumption that a landlord is entitled to recover 100 per cent of his costs: see Rapid Results College v Angell  1 E.G.L.R. 53.
Generally, in a residential context, any lack of clarity is likely to be resolved in favour of the paying party: see Jollybird v Fairzone  2 E.G.L.R. 55 and Paddington Basin Developments Ltd and ors v Gritz & ors  UKUT 0338. The distinction between residential and commercial leases in this context was also specifically remarked upon by the Chancellor in Wembley Stadium Ltd v Wembley (London Ltd)  1 P.& C.R. 3 at .
Other examples of cases in which it has been held, following this approach, that the liability of the tenant was not sufficiently clearly spelt out to be recoverable are:
- Woodtrek v Jezeck  1 E.G.L.R. 13 (the cost of collection of rent);
- Boldmark v Cohen  1 E.G.L.R. 41 (the recovery of interest on money borrowed by the landlord);
- Williams v LB Southwark (2001) 33 H.L.R. 22 (the full cost of an insurance policy where the landlord enjoys a discount given by way of a “loyalty bonus”); and
- Mullany v Maybourne Grange (Croydon) Management Co Ltd (1986) 277 E.G. 1350 (the cost of replacement of windows, under a clause permitting recovery for “providing and maintaining additional services or amenities”).
It has been held that these cases represent a line of authority in support of the principle that service charge clauses are to be construed restrictively. In McHale v Earl Cadogan  1 E.G.L.R. 51 Rix LJ said at :
“… it is the policy of the authorities not to bring within the general words of a service charge clause anything that does not clearly belong there. To put the matter another way, service charge provisions have been construed restrictively.”
In Arnold v Britton  EWCA Civ 902, however, the Court of Appeal rejected a submission that service charge clauses are to be construed restrictively and should not be construed, in the absence of clear wording, so as to entitle the landlord to a profit over and above his actual outlay in providing the contracted services. At first instance ( EWHC 3451 (Ch)), Morgan J said at :
“I do not see why a service charge clause in a lease should be subject to a special principle… I consider that what is required is that the court must examine the wording of the charging provision, in its context and against all the admissible background and in the light of the apparent commercial purpose of the clause, and then decide what the provision means and how it operates.”
The Court of Appeal approved this statement and held that a service charge clause in a lease is not subject to any special principle of construction.
The Supreme Court has granted permission to appeal and the appeal is listed to be heard on 27 January 2015.
“Sweeping up clauses”
There is conflicting authority on what costs can be recovered under such clauses. In Lloyds Bank v Bowker Orford  2 EGLR 44 (Ch D) David Neuberger QC held that a clause which allowed the landlord to recover the costs of providing “any other beneficial services” did not entitle it to recover costs relating to external repairs, internal decoration and repair of the common parts.
In Holding & Management Ltd v Property Holding & Investment Trust Plc  1 W.L.R. 1313 the lease allowed the landlord to recover “such … works … as the maintenance trustee shall consider necessary to maintain the building as a block of first class residential flats”. The maintenance trustee was not entitled to recover the cost of substantial external works under the sweeping up clause. There was already a detailed repairing provision in the lease. The Court of Appeal held that the clause did not give the maintenance trustee “a free hand to require the residents to pay for all works, whatever they might be, which the [maintenance trustee] might consider necessary to maintain the building as a block of first class residential flats.” The clause was directed at works which were necessary to maintain the amenities and facilities which from time to time are appropriate for the building as a block of first class residential flats.
By contrast, landlords were successful in recovering the cost of works under sweeping up clauses in Sutton (Hastoe) Housing Association v Williams (1988) 20 H.L.R. 321 (replacing wooden windows with UVPC ones) and Sun Alliance and London Assurance Co Ltd v BRB  2 E.G.L.R. 237 (window cleaning systems).
In Canary Riverside Property Limited v Schilling LRX/65/2005 the Upper Tribunal held that the costs of resisting an application to appoint a manager under s.24 of the 1987 Act fell within a charging provision which entitled the landlord to recover the “proper and reasonable fees and disbursements of managing agents, solicitors, counsel, surveyors … employed or retained by the Landlord for or in connection with the general overall management and administration and supervision of the building.”
In Conway v Jam Factory Freehold Ltd  UKUT 0592 (LC) the Deputy President held that the costs of dealing with a s.24 application were costs incurred “in the management of the building”. At  Deputy President said “The management of a complex residential building necessarily and routinely involves dealing with inquiries, complaints and criticism. If leaseholders seek the appointment of a new manager, or seek to persuade a landlord to make changes in the style or approach to management, the landlord’s participation in such discussions would, in my view, also be “in the management of the building”.”
Thus, it appears that the courts and tribunals have been moving away from a restrictive approach to the construction of service charge clauses.
This is one of the most common sources of disputes.
There are a number of methods of apportionment: a specified fixed percentage, rateable value, floor area, number of bedrooms or “living space factor”. All have their advantages and disadvantages and all will produce, to some extent, winners and losers. Alternatively, the lease might provide that the tenant is to pay a “fair and reasonable” proportion, as determined by the landlord, its managing agent or its surveyor (acting reasonably). Some leases provide for a combination of methods.
The apportionment of service charges can be a complex matter in a building with a variety of modes of occupation (business, leisure, residential) or as between different buildings on a large estate. Different contributions may be appropriate to different users and there may be more than one fair or reasonable method which may be adopted.
In Rowner Estates Ltd, LRX/3/2006 (Lands Tribunal, unreported, 2007) which concerned the “due proportion” to be paid by the residential tenants of the landlord’s costs of maintaining a mixed use development, the Lands Tribunal approved an apportionment which disregarded the relative floor-space of the residential and commercial parts but took into account the difficulty the estate company was having in letting commercial units.
The RICS Real Estate Management Standards, 1st Ed. (March 2013) states at para 3.1.9:
“The basis and method of apportionment of service charges should be demonstrably fair and reasonable to ensure that individual occupiers bear an appropriate proportion of the total service charge expenditure, reflecting the availability, benefit and use of services. It is very common within mixed use developments that not all the occupiers benefit from the services to the same extent. In such circumstances, the costs will be allocated to separate schedules and the costs apportioned only to those tenants that receive the benefit or use of the service. Apportioning the costs within that schedule can then itself be ‘weighted’ on the perceived extent of benefit and use.”
Para 4.7 of Managing Mixed Use Developments: RICS Guidance Note (September 2012) states:
“There can be a difference between benefit and use. For example, an office occupier decides not to use the lift and instead utilises the stairs to reach his demise. Whilst he might choose not to use the lift, he still benefits from the availability of the lift service and should therefore contribute to the on-going maintenance costs. The principle as to the amount of the contribution will vary on a case by case basis. A discounted charge may be appropriate in some circumstances, with the costs being weighted towards each occupancy and use type.”
Allocating costs to schedules can itself be contentious. It may not be obvious which schedule the cost should be allocated to and, in many cases, it can be argued that the cost could properly be allocated to more than one schedule. The allocation of costs to schedules may determine whether the tenant is liable to contribute to those costs at all and, if so, the proportion of such contribution. The tenant will obviously want to minimise his service charge liability. Whether a cost has been properly allocated is really a question of construction.
“Fair and reasonable”
It is often desirable, particularly in large mixed-use developments, for the freeholder/head lesee to retain an amount of flexibility when apportioning costs. Thus, the discretion to determine a “fair and reasonable” proportion is common. What is “fair and reasonable” is a matter of construction and will depend on the circumstances of each case.
In the commercial context, where a landlord carries out expensive and long-term repairs rather than short-term patch repairs and the unexpired term of the lease is short the tenant’s fair proportion of those costs should be determined by reference to fact that the tenant enjoyed the benefit of the repairs for a short period of their lifespan: see Scottish Mutual Assurance Plc v Jardine Public Relations Ltd (1999) EGCS 43.
In Friends Life Management Services v A&A Express Building  EWHC 1463 (Ch), Morgan J observed that at :
“No doubt that apportionment exercise should involve a consideration of the significance of that item to the Premises as distinct from other parts of the building, which includes property in addition to the Premises. It might be, for example, that the landlord would apportion the expenditure on an item by reference to the floor area of the Premises as a proportion of the total floor area of the Premises and the other property.”
In that case, the tenant of office premises and a car park sought a determination of the service charge payable for the last accounting period under the lease. The tenant exercised a break clause to determine the lease on 24 March 2010. Thereafter, in 2010 and 2011 the landlord procured the carrying out of major works to the premises at a cost of over £1m.
Morgan J held, amongst other things, that (1) the last accounting period of the lease was the year to 31 December 2010 (as opposed to 24 March); (2) the costs actually incurred on major works in 2011 should not have been included gross annual expenditure in the accounts; and (3) as regards apportionment, it was implicit that there should be an apportionment by reference to the duration of the tenancy during the last service charge year and the right method of apportionment to imply was apportionment on a day to day basis.
These issues are unlikely to arise in a residential context, save perhaps in the case of forfeiture.
That case also applied the principle that the service charge must be demanded in accordance with the lease. As is commonly the case, the lease required the service charge to be certified at the year-end and the service of the certificate was a condition precedent to the tenant’s liability to pay. As the
Apportionment in the certificate was not in accordance with the instructions of the lease the certificate was invalid. Thus, if apportionment is a matter for the certificate, an apportionment which is not in compliance with the lease will in all likelihood invalidate the certificate.
In the residential context, the approach to determining a “fair and reasonable” proportion is likely to be similar to that when assessing reasonableness for the purposes of s.19: The question is whether the decision is a reasonable one in all the circumstances, even if other reasonable decisions could also be taken (see Lord Mayor and Citizens of Westminster v Fleury  UKUT 136 (LC)).
In Windermere Marina Village Ltd v Wild  UKUT 0163 (LC) the tenants covenanted “To pay a fair proportion (to be determined by the Surveyor for the time being of the Lessors whose determination shall be final and binding) of the expense of all communal services etc.” The Upper Tribunal held that this clause was void by s.27A(6) of the 1985 Act (this subsection renders void any agreement by the tenant which “purports to provide for a determination in a particular manner or on particular evidence of any question which may be the subject of an application under subsection (1) or (3)”). That meant that the LVT was entitled to consider the issue of apportionment afresh: it was not limited to substituting its own view only if it was satisfied that the landlord’s method was unfair.
The impact of this decision could be significant: where a residential lease gives the landlord (or its managing agent or surveyor) a discretion to determine a “fair and reasonable” proportion and provides that such determination shall be final and binding, the landlord will loose all control over the apportionment. The clause will be void and the FTT has jurisdiction to determine the apportionment. A determination under section 27A(1) binds only those who are party to it but the tribunal should bear in mind the possibility of competing interests amongst different occupiers. In such cases, it may be appropriate for notice of the proceedings to be given to any third party (including commercial tenants) who may wish to make representations.
Varying the apportionment
A lease may provide for the tenant’s contribution to be varied in certain circumstances or, more generally, at the landlord’s discretion. If the lease specifies that any adjustment must be certified (usually by the landlord’s surveyor), a failure to comply with such a requirement will result in any variation being ineffective: see Warrior Quay Management Company Ltd v Joachim LRX/43/2006 (Land Tribunal, unreported, 2008). A decision-maker’s discretion will, however, be limited, as a matter of necessary implication, by concepts of honesty, good faith, and genuineness, and the need for the absence of arbitrariness, capriciousness, perversity and irrationality: Socimer International Bank Ltd (in liquidation) v Standard Bank London Ltd  Bus.L.R. 1304.
The Friends Life case raised the interesting issue of what is to happen to a reserve fund when the tenant exercises a break clause to determine the tenancy.
In a number of years, the landlord had included in the service charge accounts a sum which did not relate to actual expenditure in the service charge year but which was included by way of a provision for anticipated expenditure on services in future years (such sums amounted to £875,000 in total).
Morgan J held the landlord was not entitled to charge provision for expenditure which was anticipated in 2011 when it was certain (and known to be so) that the term of the lease had previously ended on 24 March 2010: the accounts for the year to 31 December 2010 should include a credit for the provision of £875,000.
Two fairly recent cases are worth noting.
In BDW Trading Ltd & Comet Square Phase 2 Block Management Co Ltd v South Anglia Housing Ltd  EWHC 2169 (Ch) it was held consultation requirements in respect of qualifying long term agreements (“QLTAs”) do not apply to agreements entered into in relation to buildings which have not yet been constructed or which are not let at the time of the agreement. Section 20 did not apply because the definition of a QLTA in s.20ZA referred to “the landlord”, denoting an existing tenancy.
This accords with plain common sense. It would be absurd to interpret the consultation requirements as imposing an obligation to consult with non- existent consultees. The point for developers is that they can easily avoid the requirement to consult by entering into long-term agreements before letting flats, (although the tenants will still have the protection of s.19).
In the residential sphere, the Court of Appeal ( EWCA Civ 1395) has at long last reversed the headache caused by the Chancellor’s decision in Philips v Francis  EWHC 3650 (Ch D). It held that the “aggregating approach” (which required a landlord to consult the tenants on any service charge items, however small, once the £250 limit for contributions had been reached) is wrong. To apply that obligation to every item of maintenance and repair gave rise to serious practical and administrative problems and could not have been intended by Parliament. Rather, the correct approach is to identify whether works are parts of a set of works. The question of what a single set of qualifying works comprised has to be determined in a common sense way, taking into account factors which are likely to include where the items of work are to be carried out, whether they are the subject of the same contract, whether they are to be done at the same time or different times, and whether they are different from or connected with each other. This decision will be an enormous relief to landlords and managing agents.
The Right to Manage
As you know, RTM is a no-fault right, exercisable without proving any complaint against the landlord or his managing agents. It confers on qualifying leaseholders of flats (broadly speaking those with leases granted for terms in excess of 21 years) the right to take over the management of their block of flats through the vehicle of a dedicated, tenant-owned company known as an RTM company. Upon the lessees exercising RTM, the RTM company takes over not simply management, but all the obligations and duties arising under the leases of the flats in the block, except the right to forfeit the leases. The qualifying conditions for RTM are very similar to those for collective enfranchisement (the most significant difference being that there is no disqualification for a tenant who holds a long lease of more than two flats).
The right to acquire RTM applies to premises:
- which are a self-contained building or part of a building, with or without appurtenant property;
- which contain two or more flats held by qualifying tenants; and
- in which the total number of flats held by such tenants is not less than two-thirds of the total number of flats contained in the premises.
A building with more than 25 per cent “non-residential” parts, measured by reference to internal floor area, is excepted from RTM: CLRA 2002 Sch.6 para 1(1).
A part of premises is a non-residential part if it is neither occupied, nor intended to be occupied, for residential purposes, nor comprised in any common part of the premises.
The case of KW RTM Co Ltd v Lemonland (Kings Wharf) Ltd LON/00AM/LEE/2006/0003 (LVT, unreported) involved mixed-use units designed for occupiers to live on one floor with a mezzanine work-space. The issue arose as to the status of mezzanine floors. On the evidence, it appeared that most of the units were in fact occupied solely for residential purposes and that the mezzanine floors were used as residential accommodation. The LVT held that actual occupation for residential purposes sufficed to satisfy the “residential purposes” requirement. However, this must now be considered against the Court of Appeal decision in Henley v Cohen  EWCA 480 which concerned an enfranchisement claim under the 1967 Act. It was held that the lessees could not rely on their own breaches of covenant so as to bring the property within the definition of “house” for the purposes of that Act.
In Fencott Ltd v Lyttelton Court RTM Company Ltd  UKUT 0027 (LC) – the UT followed its earlier decision in Ninety Broomfield Road RTM Co Ltd v Triplerose Ltd  UKUT 606 (LC) in holding that that a single RTM company can exercise the right to manage more than one self-contained building.
The most obvious difficulty with the purposive construction to the statutory provisions in these decisions is that the language of s.72 (by the use of the pro-noun “a”) only permits the right to manage to extend to an individual building. This is reinforced by other sections in Part 2 of Chapter 1 of the 2002 Act. The decisions also mean, in theory, a single RTM company can acquire the management functions of multiple blocks in different estates many miles apart and apparently without any connection. This cannot have been the intention of Parliament.
Qualification to exercise the right to manage must, however, be achieved on a block by block basis so the right to exercise the right to manage in respect of a number of blocks cannot be achieved without the consent of qualifying tenants in smaller blocks.
Triplerose also decided that: (1) a single notice will suffice in respect of a number of properties; and (2) the fact that one RTM company is exercising the right over property where there are shared rights between the RTM and the freeholder (see Gala Unity Ltd v Ariadne Road RTM Company Ltd  EWCA Civ 1372) does not prevent another RTM company exercising the right over the same shared property (e.g. roads, paths, gardens and car parking spaces). Thus, a claim to RTM is not invalidated by the specification of premises which include shared appurtenant property rights, already the subject of another RTM. This means that multiple RTMs may have to share management functions; this will not be a happy prospect for any leaseholder who was sufficiently motivated to acquire the right to manage in the first place.
The Upper Tribunal granted permission to appeal to the Court of Appeal in both cases.
Team: Jonathan Upton
Expertise: Service Charges
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