Landlord and tenant update

Citation

Dowden, M. (2009), "Landlord and tenant update", Journal of Property Investment & Finance, Vol. 27 No. 4. https://doi.org/10.1108/jpif.2009.11227dab.001

Landlord and tenant update

Article Type: Law briefing From: Journal of Property Investment & Finance, Volume 27, Issue 4

Scottish Newcastle v. Raguz: whose sense is “common sense”?

Published reaction to the House of Lords ruling in Scottish & Newcastle v. Raguz [2008] UKHL 65 has been overwhelmingly positive. It has been hailed as a return to common sense and, tellingly, as a relief for landlords.

Viewed from the landlord’s perspective, the ruling is eminently sensible. It removes the need to serve on former tenants and their guarantors a protective notice under s 17 Landlord and Tenant (Covenants) Act where a rent review date has passed, but the revised rent has yet to be determined. Until the House of Lords ruling, that need applied even where the normal quarterly rent payments were up to date. In those cases, the protective s 17 notice had, bizarrely, to give the current arrears figure as “nil at the moment, but wait and see”. Failure to serve protective notices while a rent review remained unresolved would severely limit the landlord’s ability to recover any uplift, backdated to the review date, from former tenants and guarantors if the current tenant failed to pay.

The Lords’ ruling was that if a delayed rent review results in an uplift, it becomes due and payable (or “demandable”) as a separate lump sum, usually on the next rent payment date after the review is concluded. If the current tenant fails to pay the uplift, the landlord then has six months within which to serve s 17 notices in respect of the whole lump sum on former tenants or guarantors.

Although welcomed by landlords, the ruling might be viewed with trepidation by former tenants and guarantors who remain “on the hook” in respect of leases that have been assigned. The s 17 procedure applies both to “old” and “new” tenancies for the purposes of the Landlord and Tenant (Covenants) Act 1995. Consequently, it affects former tenants (and their guarantors) who remain bound under the old privity of contract rules, and also former tenants who have entered into authorised guarantee agreements in respect of “new” tenancies.

Delayed review in a falling market

Modern rent review provisions generally state that the rent is altered by reference to market conditions on the specified review date. The hypothetical situation is a letting on that date, between a willing landlord and a willing tenant on the terms of the actual lease, modified by assumptions and disregards.

Although pegged to the specified review date, the process of setting the new rent often goes on long after that date, particularly if it has to be referred to an arbitrator or expert for determination. In Raguz the rent review remained unresolved for more than two years.

The implications of that delay can be severe – particularly in a falling market. When finally determined, the rent and rent uplift must reflect market conditions at the review date. It is highly likely that rent reviews dating from 2006-2007 remain unresolved. A snapshot of the market at any date up to September/October 2007 would be very different from the falling market over the past few months. On standard drafting, therefore, it is entirely conceivable that a review pegged to a 2006-early 2007 date would produce a rent increase. Imposing such an increase now would clearly increase pressure on the current tenant, and might well tip some over the edge. That would leave former tenants and guarantors vulnerable to a s 17 notice claiming a lump sum for the whole period since the review date now that the Raguz position has been reversed.

Can the rent review reflect a falling market?

A third party valuer must follow the contractual directions in the rent review clause. The valuer must review the rent as at the specified date, and the figure arrived at must be applied to the whole of the next review period. Any uplift, plus interest, becomes payable along with the next instalment of rent. Any departure from that approach (e.g. to agree a stepped rent or to forego all or part of the uplift) would usually require the parties’ agreement. If the landlord stands on its contractual rights, the valuer must give effect to those rights.

Having no ability to reflect changes in market conditions after the review date, a valuer’s scope for mitigating the harshness of a delayed rent review must be found elsewhere. In any rent review it is legitimate for the valuer to consider the terms of the lease that the hypothetical tenant would be taking, and to assess whether any of its provisions or restrictions are “onerous”. If there are any onerous provisions, the valuer may discount the rent.

Those discounts can be significant (anecdotally, up to 30 per cent for severe restrictions on use). Consequently, in any ongoing rent review there is likely to be very close focus on the impact of provisions such as use limitation, prohibitions or restrictions on alterations, keep open covenants, conditions on the exercise of break clauses, restrictions on assignment or underletting.

The length of the hypothetical term will also merit close scrutiny. In Canary Wharf Investments (Three) v. Telegraph Group [2003] 3 EGLR 31 a hypothetical term of 25 years, which had been entirely appropriate when the lease was originally granted, was found to be so far out of line with market changes between the grant of that lease and the review date that a discount of (reportedly) 10 per cent was justified. With average lease terms falling, tenants may seek to persuade valuers that a lease specifying a minimum hypothetical term of 10-15 years should also now produce a discount.

Procedural challenge?

If a tenant’s concerns over the potential for a delayed review to produce a crippling lump sum demand for a rent uplift cannot be allayed by reference to onerous provisions, then the focus may shift to procedural matters. A recent run of cases (including Metropolitan Property Realizations v. Atmore [2008] EWHC 2925 (Ch)) indicates that tenants are increasingly willing to challenge arbitration and expert determination on the grounds of procedural irregularity. However, the scope for challenge is limited, and the court is generally reluctant to intervene. As Sales J observed, the court should not read an arbitration award “with a meticulous legal eye endeavouring to pick holes, inconsistencies and faults … and with the objective of upsetting or frustrating the process of arbitration”. Accordingly a high threshold must be crossed before a court could be justified in intervening in an arbitration award.

The former tenant or guarantor

A former tenant or guarantor who remains “on the hook” will generally have no part to play in a rent review that takes place after the date of their assignment. Rent review is matter for agreement between the current landlord and tenant or, if they cannot agree, for third-party determination in accordance with the rent review clauses of the lease. The former tenant or guarantor may only become aware of the fact that the review remained unresolved long after the review date when they receive a s 17 notice demanding a full, backdated, uplift. Viewed from that perspective, the “common sense” heralded in Raguz might appear very subjective indeed.

Excluding 1954 Act security of tenure – the need for a “term certain”

The ability to exclude or “contract out” from the security of tenure given to business tenants is extremely important to landlords. Where security of tenure applies the end of the contractual term does not mean the end of the tenancy. The tenant is entitled to remain in occupation, and to call for a new lease, unless the landlord can rely on one of more of the very limited statutory grounds for regaining possession. Even if the landlord can rely on one of the statutory grounds, termination of the tenancy is likely to involve payment of compensation.

A 1954 Act protected tenant is in an extremely strong negotiating position if its landlord wishes to obtain vacant possession (e.g. to redevelop). The presence of a protected tenant can lead to significant delay, and can add greatly to the cost, of any project proposed by the landlord. Consequently, where a tenant has agreed to exclude 1954 Act protection it is essential to ensure that the exclusion is valid. Until June 2004 the “contracting out” process required the parties to obtain a court order authorising their agreement to exclude security of tenure. That process was altered so that “contracting out” is now achieved by the landlord serving a warning notice on the tenant, and the tenant signing a simple declaration or swearing a statutory declaration. In either case, it is possible for a court order or exchange of notices to be wholly ineffective. The ability to “contract out” is a limited statutory exclusion from the general rule that an agreement designed to deprive the tenant of its security will be void. If the strict criteria for “contracting out” are not met, the process will be a nullity and the tenant will be 1954 Act protected.

“Contracting out” must take place before the tenancy is created

An agreement to “contract out” is possible only between parties who “will be” landlord and tenant in relation to a tenancy. The 2004 reforms tightened this restriction so that the “contracting out” process must now be completed before the parties enter into the tenancy or become contractually bound to do so.

“Contracting out” is only possible where the tenancy is for a “term certain”

An agreement that purports to “contract out” a periodic tenancy, or a tenancy that is not granted for a “term certain” will be ineffective. Any court order made before the 2004 reforms took effect purporting to authorise an agreement to exclude security of tenure in these circumstances will be a nullity, as will a tenant’s declaration or statutory declaration made since the 2004 reforms took effect. The Court of Appeal has recently held that “contracting out” was ineffective where a lease defined the term as a fixed period together with “any period of holding over or extension … whether by statute or at common law or by agreement”. The county court judge had decided that the “contracting out” process had been valid, so a landlord’s notice to quit given after the expiry of the fixed term brought the tenancy to an end. The Court of Appeal rejected this view. The words of extension used when defining the term meant that it could not be seen as a “term certain”. This ruling represents a potentially major trap for landlords. References to periods of extension or holding over were introduced as a drafting response to the House of Lords ruling in City of London v. Fell and was designed to ensure that the liability of former tenants or guarantors did not fall away when the lease reached its contractual expiry date. That wording has become a standard feature of many precedent leases, and is often not deleted when the lease is “contracted out”. The approach taken by the Court of Appeal in Newham LBC v. Thomas Van-Staden [2008] EWCA Civ 1414 means that where those words have not been deleted, the lease will not validly exclude 1954 Act security of tenure.

Waiving the right to forfeit

A landlord waives its right to forfeit a lease if it unequivocally affirms the existence of the lease, in full knowledge that the tenant has committed a once-and-for-all breach of covenant.

The grant of a licence to assign or sublet will operate as an affirmation of the lease, as will the acceptance of rent that falls due after the date upon which the right to forfeit arose. However, if the landlord merely accepts rent that was due before the right arose, no waiver will have arisen.

Demanding rent

In Greenwood Reversions v. WEF [2008] EWCA Civ 47 it was clear that the landlord had not intended to waive its right of forfeiture. It had stopped demanding rent so as to preserve its right to forfeit the lease. However the court had to consider the effect of a solicitor’s letter threatening forfeiture proceedings unless all outstanding sums due to the landlord (which plainly included sums due after an unlawful assignment) were discharged.

The tenant argued that a demand for rent had the same effect as the acceptance of rent, and that the strict rules applicable to the payment of rent applied to the demand. The Court of Appeal ruled that it did not need to consider the point for two reasons:

1. 1.

   The assignment operated to vest the lease in the assignee, and the landlord’s solicitor had not actually demanded rent from the assignee. The demand for unpaid rent and service charges was made of the previous tenant (who remained liable in contract to the landlord), and was merely copied to the actual lessee.

2. 2.

   The letter could not be interpreted as unequivocal confirmation that the landlord was electing to affirm the lease. It threatened forfeiture proceedings unless the arrears were discharged, and made it quite clear that only upon payment of the rent would the landlord accept the tenancy as continuing.

The court has tended to lean against forfeiture. Consequently, landlords are wary of demanding rent if tenants have committed once-and-for-all breaches of covenant. The Court of Appeal accepted that an unqualified demand for future rent will operate as a waiver.

Processing a cheque

As a matter of law, the right to forfeit might be waived by acceptance of rent by the landlord with knowledge of the breach, even though the landlord had no intention to waive. Acceptance of rent as a result of error, or on a “without prejudice” basis might indicate that the landlord had no intention to waive, but that does not prevent waiver. The test is objective. Has the landlord had acted so as to recognise the continued existence of the lease and the continuing relationship of landlord and tenant?

In Seahive Investments v. Osibanjo [2008] EWCA Civ 1282 the tenant sent a cheque for £10,000 “to discharge the outstanding Bankruptcy sum and the remainder as part payment for arrears of rent”. The landlord processed the cheque, keeping the amount due to settle the bankruptcy debt but returned the amount attributable to rent. The tenant argued that by processing the cheque the landlord had accepted the rent, and so had waived the right to forfeit. The court disagreed. Processing the cheque was not in itself conclusive of the question whether the payment was accepted as rent. It was evidence of payment to the landlord, but for waiver of forfeiture it also had to be shown that the payment had been accepted and accepted as rent by the landlord. Expressly accepting only the sum related to the bankruptcy debt was not an acceptance of the balance as rent.

The carbon reduction commitment and “green leases”

The extended Carbon Reduction Commitment (CRC) is likely to begin operation in April 2010. CRC is designed to reduce energy use. It applies to organisations that annually use more than 6,000 MWh of electricity through half hourly metering – typically a £500,000 electricity bill, based on 2008 consumption. Companies and organisations affected by CRC will need to buy allowances, initially at a fixed price of £12 per tonne of CO². Once CRC is in full operation, the price of allowances will be determined by auction.

The need to buy carbon allowances is expected to increase energy costs between 7 and 15 per cent. There will be an element of repayment or “recycling” with the best performers (identified in a government-published league table) recovering up to 100 per cent of the cost of their allowances. Eventually, the worst performers might recover nothing.

Effect on landlords and tenants

Where a landlord is a CRC entity, its tenants will also be affected. Where a landlord is the “contracting party” who pays the energy bills for a building, the energy associated with those bills will have to be reported to the CRC administrator as part of the landlord’s energy consumption. The key question is whether or not landlords will be entitled to pass on the cost of its CRC allowances to their tenants, whether directly or through service charge provisions.

Existing service charge provisions are unlikely to allow landlords to pass to the tenants all of their CRC costs. Even if landlords could claim that the “cost of electricity” is sufficiently wide to cover the cost of buying allowances, that is unlikely to justify recovery of the landlord’s administrative costs. However, if a landlord is entitled to pass on the cost of allowances, then tenants may face difficulties when it comes to recovering a share of recycling payments received by their landlords. Tenants would need to be able to monitor receipt of those payments, and to show a contractual entitlement to recoup a fair share.

It is not yet clear whether or not legislation will be introduced to regulate existing leases. For new leases, landlords and tenants should consider:

1. 1.

   Whether or not tenants should be entitled to recycling payments. If so, how should their share be calculated?

2. 2.

   If a lease has been assigned, should revenue recycling payments be paid to the current tenant or to the former tenant who actually paid the cost? One suggestion made by the Department for the Environment, Food and Rural Affairs is that instead of returning payments to tenants, they could be placed in a sinking fund to meet the cost of enhanced energy efficiency.

3. 3.

   Should the landlord be entitled to charge tenants a part of its CRC administration costs? What if the landlord is a CRC entity primarily because of its other business activities?

4. 4.

   How should landlords with a portfolio of tenanted buildings divide up costs and payments between those buildings and any other element of the landlord’s business?

How should responsibility be allocated between landlords and tenants where both are CRC entities? Should a CRC tenant be able to arrange its own energy supply contract in order to control its own emissions and recycling payments?

An argument for “green leases”?

A particular risk for landlords is being tipped over into CRC status by the activities and energy use of their tenants. The landlord of a multi-let scheme will generally retain control over its structure and also over the plant and equipment serving it. The landlord can therefore exercise some control over issues such as solar gain, insulation, air-tightness and the energy performance rating of plant and equipment. However, the landlord has little control over day-to-day energy consumption. Unchecked energy use by tenants might make the difference between a landlord being just below or just above the threshold, and subject to the full costs and administrative obligations of CRC.

One possible response would be increased use of “green leases” or schedules imposing specific obligations on tenants in respect of energy use and cooperation with the landlord’s environmental policies. However, a tenant signing up to any such obligation would want to ensure that success or failure depends upon its own efforts and actions. One tenant cannot be expected to police another.

For existing buildings, and even for new builds that do not measure up to best practice, the introduction of a green lease might be viewed simply as an invitation to share the pain and cost of improving the performance and rating of the landlord’s capital asset. Unless linked with incentives that promise sufficiently direct and short-term cost benefit – or at least a guaranteed share of CRC recycling payments – that invitation would be easy to decline.

Malcolm Dowden LexisNexis