Underleases and collateral agreements

Citation

Dowden, M. (2003), "Underleases and collateral agreements", Journal of Property Investment & Finance, Vol. 21 No. 3. https://doi.org/10.1108/jpif.2003.11221cab.001

Underleases and collateral agreements

Malcolm Dowden

Underleases and collateral agreements

In December 2002 the House of Lords refused leave to appeal in Allied Dunbar Assurance Plc v. Homebase Limited [2002] EWCA Civ 666. That decision deals a significant blow to the use of side letters or collateral agreements in conjunction with underleases. With every indication that 2003 will see falls in commercial rent levels this ruling threatens to thwart tenants seeking to divest themselves of surplus premises and liabilities. So is there any room left for side letters?

In Homebase the Court of Appeal upheld the ruling in Bocardo SA v. S&M Hotels [1980] 1 WLR 17 that conditions precedent to the grant of an underlease must be complied with before any question could arise as to whether a landlord was unreasonably withholding consent. Common conditions precedent are that:

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  any underlease must be granted at not less than the rent passing under the headlease (often moderated to a requirement that an underlease must be granted at not less than the current market rent); and

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  the underlease must contain covenants in the same form as those in the headlease.

In a falling market overrented leases are, in effect, unassignable. Underletting represents the only practical means of shifting surplus space or of mitigating liabilities. If underletting at less than the passing rent is prohibited then tenants may well find themselves locked into an unmanageable commitment. To meet this situation, tenants have granted underleases that comply with the requirements of the headlease and by separate agreement covenanted to indemnify the undertenant against certain obligations (for example, payment of rent over a certain level). These side-arrangements have generally been personal to the parties in order to avoid the suggestion that they might bind successors in title (a concern highlighted by the decision in System Floors v. Ruralpride [1995] 7 EG 125) and/or the superior landlord.

Homebase has confirmed that underleases and side letters are interdependent documents – the test being whether one would be signed without the other. Consequently, tenants will be under a duty to disclose any side letters, and those letters must be read together with the proposed form of underlease to determine whether conditions precedent have been met.

Perhaps more significantly, Homebase has overturned the view that making personal the tenant's obligations to the undertenant means that the superior landlord cannot be bound and so has no interest in them. Chadwick LJ focused on the effect of the Landlord and Tenant Act 1954 to show that superior landlords might become bound by concessions between tenant and undertenant. When a business lease is renewed under the 1954 Act section 35 directs the Court to have regard to the terms of the "current tenancy". In Chadwick LJ's view these would include concessions even though expressed to be personal to the parties to the underlease. Consequently, in circumstances where a superior landlord became the "competent landlord" for the purpose of renewal proceedings, the court might conclude that those concessions (for example, a limited repairing obligation) ought to be carried into the renewal lease.

Importantly, Chadwick LJ's reasoning will be inapplicable where the underlease is "contracted out" from the security of tenure provisions of the 1954 Act. If there is no right to renewal then section 35 cannot operate to foist upon the superior landlord concessions agreed by its former tenant.

Equally, where the only concession relates to rent then section 35 would have no bearing. Rent under a renewal lease is governed by section 34, which requires the court to assess the open market rent. The rent previously payable, and any concessions granted in relation to that rent, may be considered. However, if a concession were granted some time before the renewal proceedings then its evidential weight would be limited (the analogy being a "stale" comparable).

If the underlease were contracted out, therefore, a major obstacle to the use of side letters would be removed. However, contracting out is not in itself sufficient. Chadwick LJ observed that the superior landlord has a commercial interest in the amount of the rent passing pursuant to an underlease. That rent represents an "obvious source" from which the tenant can fund the rent payable under its own lease. This may be so, but if the tenant can show that it has other sources of revenue then the force of this point might be substantially diminished. In any event, where the superior landlord has taken direct covenants from the undertenant, or where the Law of Distress (Amendment) Act 1908 is employed, it would, in the event of non-payment by its own tenant, be able to look to the undertenant for payment, thereby tapping into that "obvious source".

The rent passing under an underlease is also of commercial concern to the superior landlord to the extent that it represents a valid comparable for the review of the headlease and any other lettings. Indeed, Homebase itself stemmed from the landlord's concern to avoid prejudicing the review of rents for nearby units by acknowledging that the proposed underlease rent (being considerably lower than that passing under the headlease) represented the open market rent. This concern lies at the root of conditions precedent relating to underlease rents. However, rent review surveyors are adept at spotting such artificial means of avoiding unfavourable comparables and it is open to doubt how far this subterfuge in fact aids landlords. Moreover, where rent reviews are referred for determination the skilled and experienced practitioners who act as experts or arbitrators will look for fresh comparables, discounting rents and rental concessions arrived at before the relevant review date when market conditions might have been appreciably different. Consequently, where an underlease concession is given far enough (say, 12 months) in advance of headlease rent review its effect on that review ought to be nil or negligible.

Indeed, landlords ought to take care when framing conditions precedent to the grant of an underlease to ensure that their efforts to avoid adverse effects at review do not backfire. Clauses requiring underlease rents to be no less than that passing under the headlease have long been regarded as onerous, producing a discount at review. With the additional hurdles placed in the way of side letters by Homebase it is highly likely that tenants' submissions will seek a discount wherever the alienability of the headlease is restricted. To that extent, Homebase might represent a pyrrhic victory for landlords.

Drawing those points together it is arguable – even after Homebase – that side letters remain as part of the commercial property toolbox. When used in connection with a contracted-out underlease or where the only concession relates to rent, and where that concession will have little or no effect on a subsequent rent review, then the objections raised by Chadwick LJ will have been met.

When market conditions are poor, and where the effect of restrictions on underletting would be to render a headlease inalienable, it is surely in the interests of all parties for there to be a mechanism allowing for the grant of underleases. That being so, it is unlikely that side letters and collateral agreements will be relinquished without a struggle.

Service charges – recent developments in commercial property

What is service charge?

A service charge is normally payable by occupiers in multi-occupied buildings (or on sites with more than one building). It is levied to cover the costs incurred by the landlord in running the building, which are not included in the rent payable under the lease.

The landlord's aim is to ensure that all the costs of running the building, both now and in the future, should be recoverable from the tenant. As such, it is good drafting to include clauses that make adequate allowance for services which might be irrelevant now but which become the norm during the life of the building. This reflects the landlord's aim of producing a "clear rent" in order to support – or enhance – the capital value of its investment.

Where there has been a prior estimate of the year's service costs, the charges are normally paid quarterly in advance – the "advance payment". This normally coincides with the rent demand and is usually due on the quarter days. Variations from the budget will then normally be payable (or reimbursed) in arrears, when the total costs have been certified at the end of the financial year.

Service charge obligations are often subject to differing interpretations as to what they should cover and how they should be levied. The steady stream of litigation marks out service charge – along with rent review – as a key point of tension in the landlord and tenant relationship.

The extent of the tenant's interest

The landlord's ability to recover expenditure through service charge depends very largely on the precise drafting and construction of the lease provisions. If an item of expenditure does not fall within a category of recoverable expenditure then it will not be chargeable to the tenant. General "sweeper" clauses cannot be relied upon to pick up items not specifically mentioned elsewhere. Landlords seek to rely upon service charge clauses and, in consequence, they are narrowly construed against the landlord in accordance with the contra proferentem rule. See, for example, Gilje v. Charlgrove Securities Limited [2001] EWCA Civ 1777, in which the notional cost to the landlord of providing a flat for a resident caretaker was held to fall outside the meaning of "moneys expended", and so outside the tenants' obligation to contribute.

In recent years the courts have added a further limitation to the landlord's right to recover expenditure – namely the remaining extent of the tenant's interest. The issue is particularly acute where repairs are needed to buildings where tenants have only short periods left on their leases – and even more so where those leases exclude the security of tenure provisions of the Landlord and Tenant Act 1954.

The court's focus on the limited interest of the tenant has found its fullest expression in Fluor Daniel Properties Limited v. Shortlands Investments Limited [2001] 2 EGLR 103. The judge emphasised that works carried out pursuant to the service charge provisions must be:

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  … such as the tenants, given the length of their leases, could fairly be expected to pay for. The landlord cannot, because he has an interest in the matter, overlook the limited interests of the tenants who are having to pay, by carrying out works which are calculated to serve an interest extending beyond that of the tenants. If the landlord wishes to carry out repairs which go beyond those which the tenants, given their more limited interests, can be fairly expected to pay, then subject to the terms of the lease or leases the landlord must bear the additional cost himself.

It is worth noting the judge's acknowledgement that the point will be assessed "subject to the terms of the lease". Consequently, if the drafting of the service charge provisions make it clear that tenants will be expected to contribute towards major repairs, so that the landlord achieves 100 per cent recovery of costs, however short the tenants' remaining interest, then that clause would be given effect. However, landlords ought to be wary of including such wording. It is likely to result in protracted negotiations on the grant of a lease and (if eventually accepted by the tenant) might well lead to a substantial discount at rent review.

In Fluor Daniel the court developed the approach taken in Scottish Mutual Assurance PLC v. Jardine Public Relations Limited [1999] EGCS 43. In that case the landlord proposed major works to replace the roof of premises. The landlord had struck a deal with an incoming tenant under which it would look to the outgoing tenant for the cost of repairing the roof. The court accepted that the roof was in need of repair, and concluded that the works did not go beyond repair. However, the lease did not entitle the landlord to charge the tenant for the cost of carrying out works that would fulfil its obligations over a period of 20 years or more, when such works were not necessary to fulfil those obligations over the shorter period of the tenant's lease. The works had been executed not for the purpose of fulfilling the landlord's obligation to the existing tenant but for the purpose of satisfying the requirements of a prospective tenant. Considerable moneys had recently been expended on short-term repairs, and there was no evidence that those works had been ineffective. There was therefore no pressing need to commence long-term repairs prior to the end of the current tenant's term, which was imminent. The total amounts expended by the landlord were not "reasonably and properly expended or incurred".

It was, however, reasonable for the landlord to expend money on short-term repairs, as the roof was in a state of disrepair and had the potential to leak. Therefore, in respect of those items or elements of the works, the tenant was liable to make a contribution of 40 per cent.

Recovery of overpaid service charge

In Kleinwort Benson Limited v. Lincoln City Council [1998] 3 WLR 1095 the House of Lords held that a local authority was entitled to recover from the bank money it had paid under a mistake of law. This ruling removed a distinction between mistakes of law and mistakes of fact that for more than 200 years had barred recovery where the mistake was one of law. Commercial property practitioners were quick to spot the potential for reopening claims where service charge had been overpaid because of a mistake of law (usually a mistake as to whether the sums were properly due). The limitation period was applicable to claims dating from before Kleinwort began to run with that decision. Consequently, there were some predictions that tenants and former tenants might seek to reopen claims dating back many years. So far at least, these dire predictions have not been borne out. The availability of defences, in particular change of position or estoppel, may deter potential claimants.

Damage, insured risks and service charges

Where commercial premises are damaged by an insured risk there is usually a provision suspending payment of rent until they have been reinstated. P&O Property Holdings Limited v. International Computers Limited [1999] 2 EGLR 17 concerned premises in Manchester damaged by the Arndale Centre bombing. The suspension clause referred to the "rents reserved". The court held that, since the landlord remained responsible for the provision of services and insurance during the period covered by the rent suspension, the tenant remained liable to contribute towards those items. In the absence of clear wording to the contrary a rent suspension clause will apply only to the main rent (often known as the "rent first reserved"). They do not apply to other sums that are generically reserved as "rents" (usually an attempt by the landlord to facilitate recovery by way of distress or to avoid the need to serve a section 146 notice before forfeiture).

In practice, prospective tenants often seek to amend the rent suspension clause so that it applies not only to the rent first reserved but also to service charge, insurance rent and other sums due under the lease. Whether the landlord is realistically in a position to accept such amendments will depend upon the nature of its own obligations during a rent suspension period and (where premises are in multiple occupation) the provisions contained in other leases. A tenant is unlikely to succeed if the landlord would then be left with irrecoverable expenditure and/or where other tenants remain liable for such items during the rent suspension period. In any event, tenants may well be able to look (at least in part) to their own insurers under the terms of a business interruption policy.

Human rights

The Human Rights Act 1998 came into force on 2 October 2000. Its effect was to introduce into UK law the European Convention on Human Rights. Parliament is required to legislate and the courts to rule in accordance with the Convention. One of the many issues to be hotly debated in view of the new regime is the extent to which parties may oust the jurisdiction of the court in the event of a dispute over service charges.

Service charge provisions frequently provide that the end-of-year certificate issued by or on behalf of the landlord will be "final and binding". This may or may not be qualified by a saving for manifest error and/or by a provision allowing any dispute to be referred to a third party, acting as expert or arbitrator. Where there is no such qualification, how far can the court intervene?

Public policy generally leans against provisions that seek to exclude the court's jurisdiction. In Re Hawk Insurance Co Limited [2001] EWCA Civ 241 the court held that an ouster clause would be upheld only where it was limited to arbitration on specified issues. In such cases, disputes may be referred to a third party acting in a quasi-judicial capacity and in accordance with the rules set out in the Arbitration Act 1996. In those circumstances, the court accepts that the parties will receive a fair hearing in accordance with Article 6 of the Convention.

It is more difficult to determine whether an expert determination of a service charge dispute would be considered immune from challenge in court. In National Grid Co plc v. M25 Group Limited [1999] 1 EGLR 65 the Court of Appeal considered the extent to which an expert's determination of a rent review might be open to challenge. In that case the landlord opposed the tenant's application to the court for declarations on the construction of the rent review provisions contained in a lease. The Court of Appeal held that the question referred to the valuer was whether any, and if so what, increase ought to be made in the rent. Had the lease stopped there, then the Court would have had no jurisdiction. However, as is usually the case with rent review provisions, the valuer was required to determine the rent in accordance with contractual directions (the assumptions and disregards) from which he could not depart without going outside his terms of reference. The lease did not confer upon the valuer exclusive power to determine whether he was acting within his contractual powers, and so the Court could in that case rule on the construction of the lease – before or after the expert had reached its determination.

It may follow that where an expert is simply directed to determine a service charge dispute then his ruling would be final and binding. By contrast, a provision setting out in more detail the factors to be taken into account by the expert would allow the court to rule on that expert's remit. However, it is probably in this context that Article 6 of the Convention would come into play. Since determination by an expert does not include the safeguards applicable to arbitration it is clearly arguable that reference to an expert might not entail a fair hearing. Faced with such an argument, the court would have to weigh the directions of Article 6 against the commercial interest in swift and cost-effective dispute resolution. Unless and until that question is resolved, parties may be best advised to provide for arbitration under the 1996 Act.

The Service Charge Code

Service charges in residential leases are subject to extensive statutory regulation. Tenants paying a variable service charge may, in case of dispute, refer the matter to the Leasehold Valuation Tribunal who will determine the reasonableness of the charge. Commercial service charges are not subject to statutory regulation (except, to a limited extent, in the context of 1954 Act renewals). Consequently, in August 2000 a working party representing key players in the commercial property industry (both landlords and occupiers) produced the second edition of its Guide to Good Practice. This is generally referred to as the "Service Charge Code". Although voluntary, and essentially aspirational, the Service Charge Code is increasingly called upon in commercial lease negotiations – particularly since compliance was recommended by the Code of Practice for Commercial Leases, issued by another industry-wide working party in April 2002.

As well as figuring in negotiations for the grant of commercial leases, the Service Charge Code has also emerged as a factor in the sale of investment properties subject to occupational leases. It is increasingly common for buyers' solicitors to raise a preliminary enquiry asking whether the outgoing landlord has complied with the Service Charge Code.

What are the key issues?

Service charge is the means by which an owner of premises is able to recover from the occupiers the costs of providing services for the benefit of those occupiers. The key issues are:

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  accountability for service charges;

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  budgetary control; and

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  certification of actual costs.

The Service Charge Code advocates clarity of drafting so that the lease accurately sets out the expenditure recoverable through service charge. It also promotes good administrative and business practice between owners and occupiers, encouraging consultation and communication to ensure that agreed services are provided with optimum quality and cost-effectiveness. As the Service Charge Code proclaims, "excellent communications and transparency in the way services and their costs are managed and administered are key principles to achieving good practice".

Service charge costs

The Service Charge Code recommends that recoverable costs should be restricted to charges and associated administrative costs properly incurred by the owner in the operational management of the property. These costs may include the reasonable costs of maintenance, repair and replacement (where beyond economic repair) of the fabric, plant, equipment and materials necessary for the property.

Service charge costs should not include:

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  any initial costs incurred in relation to the original design and construction of the fabric, plant or equipment;

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  any setting up costs that are reasonably considered to be part of the original development cost of the property;

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  improvement costs above the costs of normal maintenance, repair or replacement;

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  future redevelopment costs; and

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  such costs as are matters between the owner and an individual occupier – for instance, enforcement of covenants for the collection of rent, costs of letting units, consents for assignments, sub-lettings, alterations, rent reviews etc.

Value for money and transparency

The Service Charge Code urges active co-operation between owners and occupiers to ensure that value for money is achieved in the provision of services. Those services should be appropriate to the location, use and character of the property. The owner should keep costs under review and, where appropriate, regularly require contractors and suppliers either to submit competitive tenders or to provide competing quotations. It is also recommended that tendering and/or benchmarking should be undertaken at least once every three years.

In order to ensure transparency, service charge payments should be kept in a separate account, allowing interest earned to be identified and (after deduction of bank charges, tax etc.) credited back to the account.

Communications

In order to encourage and promote a good working relationship and understanding with regard to the provision, relevance, cost and quality of services communications between owner and occupiers should be timely and regular. Communications should be before rather than after an event, and should be part of a consultative process.

The Service Charge Code recommends a clear communication structure, with the owner identifying:

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  names and points of contact for managing agents, credit controllers, accounts clerks etc.;

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  names and contact details for on site staff; and

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  their roles and responsibilities.

The occupier should provide details of the person who deals with service charges and of the allocation of responsibility between the site and head office.

Importantly, where significant variances in actual costs against budget are likely, the owner should give prompt notification to occupiers within the relevant service charge year. Similarly, when substantial works are planned full information should be given as to the programme of works, costs and progress.

Promotions

Usefully, the Service Charge Code recommends that the funding of promotional activities should be recognised as a cost to be shared by owners and occupiers. Service charge budgets should state gross expenditure on promotions and indicate how much the owner will contribute. In addition, promotional plans should be prepared and presented in advance of the period to which they relate, with opportunities for consultation and for reviews of effectiveness.

This is a particularly important issue for retail schemes since branding and promotion of shopping centres as well as of their component retailers has emerged as a major item of expenditure. However, landlords must bear in mind that the Service Charge Code cannot override the drafting of leases and so, if the lease does not permit recovery of promotional expenditure, there will be no mileage in arguing for recovery in line with the code.

Income

The treatment of miscellaneous income received by the owner is one of the most difficult areas covered by the Service Charge Code. The code recommends that income derived from a service or activity funded through service charge should be credited back to the service charge account. Examples include income from public telephones or vending machines located in the common parts as well as car parking charges and income from kiosks or barrows.

Many commercial landlords are reluctant to adhere to this recommendation, arguing that the generation of miscellaneous income is an important means of enhancing the value of their investment, and that occupiers derive significant benefits (for example in terms of footfall) from the provision of car parking etc. There are indications that this issue is increasingly featuring in the negotiation and drafting of leases.

Apportionment

The apportionment of costs to each occupier should be on a fair and reasonable basis and occupiers should be provided with an apportionment schedule showing the total apportionment for each unit within the property/complex. Note that this recommendation must be read in conjunction with any lease provision governing the allocation of service charge costs – in particular, where an anchor tenant's service charge is calculated on a weighted basis. Further, where services are provided for the benefit of specific occupiers, the owner should look for payment only to those occupiers.

The occupiers should not be charged (whether through the service charge or otherwise) towards the costs attributable to unlet premises. Also, the owner should meet the cost of any special concession given to a particular tenant. The code states that, for this purpose, a properly constituted weighting formula is not to be regarded as a special concession.

Budgets and accounts

The owner should provide an estimate of likely service charge expenditure at least one month prior to the start of a service charge year. At the end of the year, certified accounts should be provided as quickly as possible and in any event within six months. Budgets and accounts should be set out clearly and comprehensibly.

The Service Charge Code urges a reasonable period within which occupiers may raise enquiries in respect of certified accounts.

Sinking funds and reserves

Where the owner maintains a sinking or reserve fund, money should be held in a separate income bearing trust account, separate from the owner's own money. Contributions to the fund should be clearly set out in the annual budget and certificate. Where the reversion is sold, the seller should pass all sinking fund money, together with accrued interest, to the buyer.

The impact of the code

The second edition of Service Charge Code was published in August 2000, and was incorporated into the Code of Practice on Commercial Leases published in April 2002. The working party responsible for the code included representatives from the British Property Federation and from major owners and occupiers. A range of industry bodies endorsed the code, including the RICS, British Council for Offices, British Retail Consortium and the Property Managers' Association. The British Property Federation is actively encouraging its members (including this firm) to promote both the Commercial Leases Code and the Service Charge Code. However, the practical impact remains difficult to assess.

At one level, since the code seeks to embody best practice, it should merely be regarded as an exhortation to do what ought to be done. However, some of the recommendations – in particular, that dealing with miscellaneous income – have sparked considerable debate and have emerged as potential sticking points in lease negotiations. There is undoubted strength in the proposition that where income is generated using facilities that are paid for through the service charge, that income ought to be credited back to the service charge account. Nonetheless, where the landlord maximises the income-producing potential of an investment, it is at least arguable that he ought directly to reap the benefit – or at least a sizeable proportion of it. That being so, landlords who are keen to adhere to the recommendations relating to communication and transparency might nonetheless balk at the attempt to specify what ought or ought not to be recoverable, and what sums ought to be credited back to the service charge account.

Landlords should also bear in mind that there is an implied term at common law that service charges should be fair and reasonable. The fairness and reasonableness of a charge is probably best demonstrated where the landlord has obtained estimates and (in effect) follows the "value for money" recommendations of the code.