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Construction of Service Charges in Commercial Leases

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29th October 2015

Introduction

1. This paper will consider some of the issues relating to the construction of service charge clauses in commercial leases, in particular:
   • Principles of contractual interpretation;
   • Sweeping-up clauses;
   • Apportionment; and
   • Reserve Funds.

Principles of Contractual Interpretation

2. The correct approach to contractual interpretation has been discussed in many cases at the highest level of authority.
3. The starting point is Lord Hoffman’s five principles in Investors Compensation Scheme v West Bromwich Building Society[1]:
   • Interpretation is the ascertainment of the meaning which the document would convey to a reasonable person having all the background knowledge which would reasonably have been available to the parties in the situation in which they were at the time of the contract.
   • The background was famously referred to by Lord Wilberforce as the ‘matrix of fact’, but this phrase is, if anything, an understated description of what the background may include. Subject to the requirement that it should have been reasonably available to the parties and to the exception to be mentioned next, it includes “absolutely anything” which would have affected the way in which the language of the document would have been understood by a reasonable man.[2]
   • The law excludes from the admissible background the previous negotiations of the parties and their declarations of subjective intent. They are admissible only in an action for rectification. The law makes this distinction for reasons of practical policy and, in this respect only, legal interpretation differs from the way we would interpret utterances in ordinary life.[3]
   • The meaning which a document (or any other utterance) would convey to a reasonable man is not the same thing as the meaning of its words. The meaning of words is a matter of dictionaries and grammars; the meaning of the document is what the parties using those words against the relevant background would reasonably have been understood to mean. The background may not merely enable the reasonable man to choose between the possible meanings of words which are ambiguous but even (as occasionally happens in ordinary life) to conclude that the parties must, for whatever reason, have used the wrong words or syntax (see Mannai Investment Co Ltd v Eagle Star Life Assurance Co Ltd).
   • The ‘rule’ that words should be given their ‘natural and ordinary meaning’ reflects the common sense proposition that we do not easily accept that people have made linguistic mistakes, particularly in formal documents. On the other hand, if one would nevertheless conclude from the background that something must have gone wrong with the language, the law does not require judges to attribute to the parties an intention which they plainly could not have had. Lord Diplock made this point more vigorously when he said in Antaios Cia Naviera SA v Salen Rederierna AB, The Antaios [1985] A.C. 191; [1984] 3 W.L.R. 592:”…if detailed semantic and syntactical analysis of words in a commercial contract is going to lead to a conclusion that flouts business common sense, it must be made to yield to business common sense.”
4. In Rainy Sky SA v Kookmin Bank [2011] UKSC 50; [2011] 1 W.L.R. 2900 the Supreme Court held that where there were two possible constructions the court was entitled to prefer the construction which was consistent with business common sense and to reject the other: it was not necessary to conclude that a particular construction would have an absurd or irrational result before having regard to the commercial purpose of the agreement.
5. In The Interpretation of Contracts, Sir Kim Lewison states[4]: “As Lord Hoffman has emphasised, the words that the parties have used are the starting point, and in many cases will be the finishing point too.” In Jumbo King Ltd v Faithful Properties Ltd (1999) H.K.C.F.A.R. 279[5] Lord Hoffmann said:”Of course in serious utterances such as legal documents, in which people may be supposed to have chosen their words with care, one does not readily accept that they have used the wrong words. If the ordinary meaning of the words makes sense in relation to the rest of the document and the factual background, then the court will give effect to that language, even though the consequences may appear hard for one side or the other.”

Construction of Service Charge Clauses

6. 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.
7. In Universities Superannuation Scheme Ltd v Marks & Spencer Plc [1999] 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 [2002] 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.
8. There is no presumption that a landlord is entitled to recover 100 per cent of his costs: see Rapid Results College v Angell [1986] 1 E.G.L.R. 53.
9. Generally, in a residential context, any lack of clarity is likely to be resolved in favour of the paying party: see Jollybird v Fairzone [1990] 2 E.G.L.R. 55 and Paddington Basin Developments Ltd and ors v Gritz & ors [2013] 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) [2008] 1 P.& C.R. 3 at [44].
10. 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 [1999] 1 E.G.L.R. 13 (the cost of collection of rent);
    • Boldmark v Cohen [2002] 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”).
11. 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 [2010] 1 E.G.L.R. 51 Rix LJ said at [17]:”…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.”

No special principle

12. In Arnold v Britton [2015] UKSC 36, however, the Supreme Court 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.
13. The facts were as follows. The appellant lessees appealed against the decision of the Court of Appeal ([2013] EWCA Civ 902) on the interpretation of their leases. The leases were long leases of holiday chalets at a leisure park. The relevant clause (clause 3(2)) in one of the leases was a covenant by the lessee in the following terms:”To pay to the Lessors without any deductions in addition to the said rent a proportionate part of the expenses and outgoings incurred by the Lessors in the repair maintenance renewal and the provision of services hereinafter set out the yearly sum of Ninety Pounds and value added tax (if any) for the first three years of the term hereby granted increasing thereafter by Ten Pounds per Hundred for every subsequent Three year period or part thereof.”
14. There were several minor variations of this clause in the leases of other chalets but all were very similar. The essential issue was whether the clauses provided for annual compounded increases, at the rate of 10 per cent, in the charges payable, as the respondent landlord contended (and both Morgan J and the Court of Appeal held); or whether the figure given in the clauses was a cap up to which the landlord could recover the actual expenditure on the provision of services. The tenants’ case was that the effect of compounding was that the service charge was already over £3,000 per annum for the relatively limited services provided for the holiday chalets and, by the last year of the lease, the total would be over £1 million. The tenants argued that this was uncommercial and nonsensical and so required the clause to be regarded and read as a cap. The landlord submitted that there was no evident ambiguity or mistake in the wording; the landlord’s interpretation was not absurd since at the time the leases were made and at times thereafter annual inflation exceeded 10 per cent.
15. At first instance ([2012] EWHC 3451 (Ch)), Morgan J said at [43]:”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.”
16. 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.
17. The Supreme Court (Lord Neuberger, Lord Sumption, Lord Hughes and Lord Hodge; Lord Carnwath dissenting) dismissed the lessees’ appeal. Lord Neuberger, giving the lead judgment, emphasised seven factors relevant to the construction of contracts:
    • The reliance placed in some cases on commercial common sense and surrounding circumstances should not be invoked to undervalue the importance of the language of the provision which is to be construed. The exercise of interpreting a provision involves identifying what the parties meant through the eyes of a reasonable reader, and, save perhaps in a very unusual case, that meaning is most obviously to be gleaned from the language of the provision. Unlike commercial common sense and the surrounding circumstances, the parties have control over the language they use in a contract. And, again save perhaps in a very unusual case, the parties must have been specifically focussing on the issue covered by the provision when agreeing the wording of that provision.
    • The less clear the relevant words to be interpreted are (i.e. the worse their drafting), the more ready the court can properly be to depart from their natural meaning. However, that does not justify the court embarking on an exercise of searching for, let alone constructing, drafting infelicities in order to facilitate a departure from the natural meaning. If there is a specific error in the drafting, it may often have no relevance to the issue of interpretation which the court has to resolve.
    • Commercial common sense is not to be invoked retrospectively. The mere fact that a contractual arrangement, if interpreted according to its natural language, has worked out badly, or even disastrously, for one of the parties is not a reason for departing from the natural language. Commercial common sense is only relevant to the extent of how matters would or could have been perceived by the parties, or by reasonable people in the position of the parties, as at the date that the contract was made.
    • While commercial common sense is a very important factor to take into account when interpreting a contract, a court should be very slow to reject the natural meaning of a provision as correct simply because it appears to be a very imprudent term for one of the parties to have agreed, even ignoring the benefit of wisdom of hindsight. The purpose of interpretation is to identify what the parties have agreed, not what the court thinks that they should have agreed. Experience shows that it is by no means unknown for people to enter into arrangements which are ill-advised, even ignoring the benefit of wisdom of hindsight, and it is not the function of a court when interpreting an agreement to relieve a party from the consequences of his imprudence or poor advice. Accordingly, when interpreting a contract a judge should avoid re-writing it in an attempt to assist an unwise party or to penalise an astute party.
    • When interpreting a contractual provision, one can only take into account facts or circumstances which existed at the time that the contract was made, and which were known or reasonably available to both parties. Given that a contract is a bilateral arrangement involving both parties, it cannot be right, when interpreting a contractual provision, to take into account a fact or circumstance known only to one of the parties.
    • In some cases, an event subsequently occurs which was plainly not intended or contemplated by the parties, judging from the language of their contract. In such a case, if it is clear what the parties would have intended, the court will give effect to that intention.
    • There is no general principle that service charge clauses should be construed “restrictively”: service charge clauses are not subject to any special rule of interpretation. Even if a landlord may have simpler remedies than a tenant to enforce service charge provisions that is not relevant to the issue of how one interprets the contractual machinery for assessing the tenant’s contribution.
18. The Court held that the natural meaning of the clause 3(2) was clear: the first half of the clause provides that the lessee is to pay an annual charge to reimburse the lessor for the costs of providing the services which he covenants to provide, and the second half of the clause identifies how that service charge is to be calculated, namely as a fixed sum, with a fixed annual increase. The alarming consequence of this interpretation was not a convincing argument for departing from the natural meaning of clause 3(2).
19. This is a landmark case, not only in relation to service charges, but also as regards the general principles of contractual interpretation. For many years, lessees have successfully argued that service charge clauses should be construed restrictively. Support for this proposition is found in Rix LJ’s judgment in McHale v Cadogan [2010] EWCA Civ 14, [2010] 1 EGLR 51. Lord Neuberger explained that what Rix LJ was saying, quite correctly, was that the court should not “bring within the general words of a service charge clause anything which does not clearly belong there”. This case makes clear that service charge clauses are not subject to any special rule of interpretation. It also clarifies that the courts must not, by invoking commercial common sense and the factual background, undermine the language of the provision in the contract.

“Sweeping up clauses”

20. There is conflicting authority on what costs can be recovered under such clauses. In Lloyds Bank v Bowker Orford [1992] 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.
21. In Holding & Management Ltd v Property Holding & Investment Trust Plc [1989] 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.
22. 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 [1989] 2 E.G.L.R. 237 (window cleaning systems).
23. 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.”
24. In Conway v Jam Factory Freehold Ltd [2013] 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 [42] 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”.”
25. In Assethold Limited v Watts [2014] UKUT 0537 (LC) the Upper Tribunal (Martin Rodger QC, Deputy President) held that the legal costs incurred by the landlord in party wall proceedings were recoverable through the service charge as the cost of “all works installations acts matters and things as in the reasonable discretion of the Landlord may be considered necessary or desirable for the proper maintenance safety amenity and administration of the Development”. It is significant that legal costs were recoverable notwithstanding that the language of the provision in question was general and made no specific reference to legal costs. The Deputy President held: “It seems to me to be wrong in principle to start from the proposition that, with certain types of expenditure, including the cost of legal services, unless specific words are employed no amount of general language will be sufficient to demonstrate an intention to include that expenditure within the scope of a service charge. Language may be clear, even though it is not specific.”
26. This case represents something of a shift in the approach to the recovery of certain items of expenditure through the service charge and it is now more likely that a cost will be recoverable in the absence of specific language (consistent with the decision in Arnold v Britton).

Apportionment

27. This is one of the most common sources of disputes.
28. 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.
29. 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.
30. 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.
31. 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.”
32. 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.”
33. 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”

34. It is often desirable, particularly in large mixed-use developments, for the freeholder/head lessee 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.
35. 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.
36. In Friends Life Management Services v A&A Express Building [2014] EWHC 1463 (Ch), Morgan J observed that at [55]:”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.”
37. 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.
38. 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.
39. 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.

Varying the apportionment

40. 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 [2008] Bus.L.R. 1304.

Reserve Funds

41. 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.
42. 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).
43. 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.

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[1] [1998] 1 W.L.R. 896

[2] In BCCI v Ali [2002] 1 A.C. 251 at 269 Lord Hoffmann qualified this. He said: “When…I said that the admissible background included ‘absolutely anything which would have affected the way in which the language of the document would have been understood by a reasonable man’, I did not think it necessary to emphasise that I meant anything which a reasonable man would have regarded as relevant. I was merely saying that there is no conceptual limit to what can be regarded as background. It is not, for example, confined to the factual background but can include the state of the law (as in cases in which one takes into account that the parties are unlikely to have intended to agree to something unlawful or legally ineffective) or proved common assumptions which were in fact quite mistaken. But the primary source for understanding what the parties meant is their language interpreted in accordance with conventional usage: ‘…we do not easily accept that people have made linguistic mistakes, particularly in formal documents.’ I was certainly not encouraging a trawl through ‘background’ which could not have made a reasonable person think that the parties must have departed from conventional usage”.

[3] The House of Lords reaffirmed this exclusionary rule in Chartbrook Ltd v Persimmon Homes Ltd [2009] A.C. 1101.

[4] 5th Ed, Ch 1, Section 7, para 1.07.

[5] cited with approval by the CA in Holding & Barnes Plc v Hill House Hammond Ltd [2002] L. & T.R. 7.

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