Common sense prevails

Introduction

The recent House of Lords case, Scottish & Newcastle plc v Raguz [2008] UKHL65, provides a welcome decision for Landlords. The decision overturned the outcome in the Court of Appeal case. The interpretation of section 17(2) of the Landlord and Tenant (Covenants) Act 1995 (the "1995 Act") had been that Landlords would be required to serve warning notices on former tenants and/or their guarantors on rent payment dates pending a review, in order to remain entitled to claim from them in the event of default by a current tenant at a future date.

The House of Lords, by majority decision, clarified that the additional rent that may become payable following a rent review would not be regarded as "due" for the purposes of section 17 of the 1995 Act until the rent review is agreed between the parties or determined by a third party.

Background

Historically, the privity of contract rules in landlord and tenant relationships meant that an original tenant continued to be liable for the tenant covenants under the lease after their interest in the lease has been assigned to a third party. This permitted a landlord to enforce the tenant covenants either against the current tenant under the lease or a former tenant. The law was reviewed in the 1980s and the 1995 Act was later enacted. This abolished the privity of contract rules for new leases from 1 January 1996 (subject to a few exceptions). The position for leases entered into prior to the 1995 Act was largely unchanged. There were, however, a few provisions in the 1995 Act which controlled the exercise of the landlords' rights. One such control was the service of notices under section 17 of the 1995 Act and it is the interpretation of this clause that was the principal subject matter of this case.

The facts of the case

The case involved rental payments due in respect of two underleases originating in 1967 and 1969. Scottish & Newcastle plc were the original tenants. Multiple assignments had since taken place and in 1999 the current tenant was in financial difficulties. The current tenant defaulted on rental payments and by October 1999 administrative receivers were appointed by their lender. The landlord sought to recover the unpaid rent from Scottish & Newcastle plc as a former tenant.

At the time, there were rent reviews outstanding in respect of both leases. Over a series of successive quarter days when rental payments were due, the landlord served notice on Scottish & Newcastle plc in relation to the amounts that were due. At the times of the determination of the rent reviews, further section 17(2) notices were served in relation to the respective amounts due to pay the balance of rent due as a result of the rent reviews. Scottish & Newcastle plc paid the sums requested of them. The payments were made in response to their liability as former tenants. Also, payment was made in order to limit their ongoing liability. The settlement of outstanding arrears was a condition of the landlord permitting an assignment of the underleases, which would stem Scottish & Newcastle plc's liability for any further charges under the lease for the foreseeable future.

Scottish & Newcastle plc raised a claim against Mr Raguz who was the tenant to whom Scottish & Newcastle plc had assigned their interest in the lease. The claim was raised in terms of section 24 of the Land Registration Act 1925 (the "1925 Act") whereby the person to whom a transfer is made covenants with the transferor that the transferee will "keep the transferor and the person with the right in title under him indemnified against all actions, expenses and claims on account of the non-payment of rent….".

The dispute arose as Mr Raguz was refusing to pay on the basis that the notices served by the landlord on Scottish & Newcastle plc were not properly served. Therefore Scottish & Newcastle plc ought not to have paid the sums requested from them. Based on this Mr Raguz believed that he was not responsible for indemnifying Scottish & Newcastle plc for the payment of the additional balance of rent under the rent reviews. Mr Raguz argued that the indemnity under section 24 of the 1925 Act did not apply to sums that the original tenant was not legally obliged to pay. In addition Scottish & Newcastle plc had some commercial gain from paying the sums to the landlord, namely that they were then able to assign the underleases to a third party. It was the opinion of Mr Raguz that the indemnity under section 24 of the 1925 Act did not apply in such circumstances.

The Lower Courts

The Judge at first instance decided that the landlords were too late to recover the additional payments for balancing rent following the determination of the rent review in that their use of the section 17(2) notices did not render Scottish & Newcastle plc liable. The notices under section 17(2) of the 1995 Act for the amount "due" should have left open the option to serve a further notice under section 17(4) of the 1995 Act within three months of the rent review having been determined. However, the judge did agree that Scottish & Newcastle plc were entitled to recover the amounts regardless of that, as the landlord's consent to the assignment was conditional upon such payments and this would have been regarded as "expense" covered by the indemnity under section 24 of the 1925 Act. The Court of Appeal dismissed the appeal. Two issues then arose in the House of Lords: Mr Raguz's appeal against the decision that he was liable under section 24 of the 1925 Act; and Scottish & Newcastle plc's appeal against the interpretation of section 17 of the 1995 Act with regard to the service of notices in relation to outstanding rent reviews.

The decision in the House of Lords

The decision in the House of Lords was based mainly on the interpretation of section 17 of the 1995 Act. In terms of section 17(2) the former tenant is not liable under the tenant's covenants in the lease unless "within the period of six months beginning with the date when the charge becomes due, the landlord serves on the former tenant a notice informing him (a) that the charge is now due; and (b)… the landlord intends to recover" that charge from the former tenant. In addition, section 17(4) states that any amount that the landlord would charge cannot exceed the amount mentioned in the notice served under section 17(2) save in so far as the former tenant has been notified that the amount requested in the section 17(2) notice may increase. The landlord must also serve a further notice (under section 17(4)) on the former tenant within a period of three months after the date of the determination of the uncertain amount that is then subsequently determined.

The interpretation in the House of Lords was that an amount cannot be "due" if it has not yet been determined or agreed. When it is subsequently agreed or determined it then becomes due and accordingly the correct form of notice for the additional amount of rent payable following a rent review would be a section 17(2) notice rather than a section 17(4) notice. It was regarded as contrary to common sense and commercial practice to expect the landlord to be serving a section 17(2) notice with the section 17(4) warning that a sum that has not yet been determined, may be due. Until such times as the rent renew has been determined, no amount is in fact due and therefore the current tenant cannot be in default of payment of it.

The Lords looked to the guidance notes from Parliament from the time of the enactment of the 1995 Act. Although these were useful to show the context in which the legislation was framed, they were not regarded as conclusive. In fact it became apparent from them that the situation as arose in the Scottish & Newcastle plc v Raguz case was not one that was contemplated at the time of the drafting of the notice provisions.

It was held by the majority in the House of Lords that it was unlikely to have been Parliament's intention that a landlord was required to serve notices about the possibility of a default situation every quarter during a rent review in order to protect its position. It was accepted that this interpretation of section 17(2) would require meaning that section 17(4) was erroneously drafted. However, it was regarded as preferable to reach this conclusion as opposed to promoting the practical situation whereby landlords were required to serve protective notices on former tenants at every quarter day pending a review stating that no rent was due and outstanding in order to preserve landlords' rights against a former tenant.

The other matter that was being considered by the House of Lords was in relation to the extent of the indemnity under section 24 of the 1925 Act. It was concluded that Mr Raguz's appeal was to be dismissed and that bearing in mind the covenant was for an indemnity, it was not limited to payments that the assignor was legally liable to make (albeit the majority of the Lords agreed that Scottish & Newcastle plc were liable to pay the money requested by the landlords).

The Message

The leasehold market will continue to have pre-1996 leases for a number of years to come. It is therefore an important decision by the House of Lords to ensure the smooth running of leasehold management issues in respect of such leases that section 17 notices have been interpreted in this way.

Had the decision not been overturned by the House of Lords, landlords would still be required to serve notices on former tenants at every quarter day during the period of outstanding rent reviews. There is no doubt that many opportunities for recovery of rental payments would be lost due to technical issues if the correct notice was not duly served on time. In the current market where there is an increase in tenants defaulting on leasehold property it will be reassuring to landlords that there is a clear interpretation of the notice procedure required in terms of the 1995 Act when dealing with the liability of former tenants.

If you wish to read the full transcript of the case click the link below: http://www.bailii.org/uk/cases/UKHL/2008/65.html  

02 December 2008

Breaking up is hard to do

Many modern commercial leases contain provisions allowing the landlord, or the tenant, or both parties, to opt to end the lease early at some point during the term of the lease.  These clauses, known as break options, have particular relevance in the current economic climate, where tenants in particular are more likely to be looking for ways in which they can validly end their obligations in relation to premises, whereas of course landlords are particularly keen to maintain the income stream that flows from keeping a tenant in place and paying the rent. 

It is not just in difficult economic circumstances, however, that the exercise by a tenant of a break option is an unwelcome event for a landlord.  Generally, most landlords mostly want to maintain the status quo - steady income from the rent from tenants who stay put for the duration of the lease - and any notice purporting to exercise a break will be scrutinised carefully to ensure that there are no grounds for invalidity.  Best practice therefore for tenants and their advisers is to adhere scrupulously to the provisions in the lease concerning the conditions for exercising any break and it is here, where clear unabiguous drafting helps both parties to be sure of achieving their desired end result without dubiety or dispute.  The recently decided appeal in the case of Trygort (Number 2) Limited v UK Home Finance Limited and Another demonstrates the difficulties that can arise where the wording is apparently capable of more than one interpretation.

Making a break for it

Trygort let to UK Home Finance commercial premises at 110 West George Street, Glasgow, for a period of three years from 28 May 2004. On 24 December 2005, UK Home Finance moved out of the premises, having previously issued a notice purporting to exercise the break option contained in the lease.

The lease provided for either party to be able to opt to terminate the lease early at any time after 31 March 2005, on giving not less than six months' notice. However the lease also contained a proviso that the tenant wouldn't be entitled to issue any break notice terminating the lease if it has been in breach of its obligations to the landlord in terms of the lease.

Present or present perfect tense?

The effect of this proviso was the subject of the dispute.  Trygort contended that the option to break could not be exercised if the tenant had been in breach of contract at any stage during the currency of the lease, regardless of whether or not it was in breach at the time of exercising the break, the words "if it has been in breach" denoting a breach at any time, and that this was the plain ordinary meaning of the words. If it had been intended that the proviso should relate only to subsisting breaches, then the present tense - i.e "if the tenant is in breach of its obligations" - should have been used. 

UK Home Finance had in fact been in breach of its obligations under the lease in the past, having failed to make payment of landlord's expenses and settle the SDLT payment within the timescales specified in the contract, and having persistently been late in payment of the rent, but it was not in breach of any of its obligations at the time it served the break notice. It suggested that the phase in the lease, being couched in the present perfect tense, meant that any breach would have to still be continuing for the proviso to apply, otherwise, to apply to former breaches, the wording should have referred to the tenant being in breach of its obligations at any time.

Past or present breach?

In the event, the arguments of both parties were rejected as the Lord Ordinary felt that there was uncertainty with both arguments and that both meanings were possible.

Instead he looked at what was the commercially sensible construction of the words, and in doing so relied significantly on the English decision from 1988 in the case of Bass Holdings Limited v Morton Music Limited [1988] 1 Ch. 493. This case follows long standing authority in England for the approach that in such situations the breaches that would apply are subsisting breaches, not spent ones. The reasoning, which has a certain irresistible commercial resonance, is that the likelihood of total and absolute compliance by the tenant with every single obligation on it, at all times, throughout the duration of a full repairing and insuring lease, is practically impossible to achieve, so if that was the requirement before the option could be exercised, it would be virtually incapable of ever being applied. Consequently, the parties cannot have intended that to be the effect of such a clause.  It is however perfectly natural for a landlord to expect a tenant not to be in breach at the time of exercising the break (although, as an aside, from a drafting point of view, it may be wise to exclude minor inconsequential breaches), although not to be concerned over past breaches.  Indeed, he may be happy to see the back of a tenant who has a history of being in default of one type or another.

There is no such settled rule of law in Scotland, however, but the Lord Ordinary considered that the same commercial considerations could be said to apply in this case and this lease (which contained a full range of the usual obligations as to repair, maintenance and redecoration) and that therefore the break option had been effectively exercised, there being no subsisting breach by the tenant at the time of exercise.

A commercially pragmatic approach

Lawyers in Scotland are usually cautious, and rightly so, of relying on the decisions of English courts when determining the outcome in Scottish cases, particularly in relation to property and lease related matters, although very often in the latter instance, such decisions will be persuasive.   The underlying laws can be subtly, and sometimes significantly, different, although there may appear to be similarities superficially. 

The rationale of the Bass Holdings case however, albeit that it reflected settled English law, is rooted in commercial practicality, an approach that has no need of geographical or jurisdictional boundaries.  Commercial pragmatism from the judiciary may be able to come to the rescue of ambiguous drafting, but it seems almost banal to suggest that the parties should acknowledge the commercial realities, adopt that approach when negotiating the terms of the lease, and translate the product of those negotiations into clear and unequivocal language in the contract.

For the full decision in the case of Trygort (Number 2) Limited v UK Home Finance Limited and Another click here

02 December 2008