Wragge Lawrence Graham & Co's property experts look at the key issues affecting landlords and tenants.

Is a tenant who breaks its lease entitled to a rebate of rent?

Key points

  • Where a lease ended part-way through a quarter by the exercise of a break clause, the court refused to imply a term entitling the tenant to a repayment of the rent it had paid in advance for the period after the break date
  • Would a tenant be entitled to make an apportioned payment of rent on the quarter day prior to the break date if, as at that quarter day, all the conditions to the operation of the break had been met so that the lease would definitely terminate?

Background

In May 2013, we reviewed the High Court decision in Marks and Spencer plc v BNP Paribas Securities Services Trust Company (Jersey) Ltd.

The High Court decided that, if a break date fell part way through a quarter, a term could be implied into the lease entitling the tenant to recover, after the event, a proportionate part of the rent it had paid in advance for the full quarter. That decision has now been overturned by the Court of Appeal.

Facts of Marks and Spencer plc v BNP Paribas Securities Services Trust Company (Jersey) Ltd

The break clause was conditional on there being no arrears of rent on the break date and on the tenant by that date having paid to the landlord a sum of money as a "break premium" (equivalent to one year's rent).

Having served notice on the landlord pursuant to the break clause to determine the lease on 24 January 2012, the tenant paid the landlord the rent due for the full December 2011 to March 2012 quarter on or around 25 December 2011. About a week before the break date, the tenant paid the break premium required. The break conditions satisfied, the lease term ended on 24 January 2012.

The tenant then sought repayment of the rent and other sums paid in advance which related to the period after the break date. At first instance the High Court considered that an implied term for repayment should be read into the lease.

Court of Appeal decision

Reversing the High Court ruling, the Court of Appeal held that no such term could be implied and that the tenant was not entitled to repayment of rent attributable to the post-break period. It thought that the test for an implied term was not met. This was because, read as a whole against the relevant background, the lease would not reasonably be understood to include such a term.

The court's reasons included:

  • At the time the lease was granted, it would have been obvious to the parties that, because rent was paid quarterly in advance, rent might have to be paid for a period beyond the break date. The break clause did provide for other particular consequences of termination on operation of the break. On that basis, it would have been easy for express provision to be made for repayment if this had been intended - but the parties had not done so.
  • The fact the lease reserved rent "proportionately for any part of the year" and included provision for quarterly payments of rent to be made as "instalments" would not have led the parties to believe that there was a right to repayment.
  • The break premium could not necessarily be treated as being the landlord's total agreed compensation for the operation of the break. The landlord could also be compensated in other ways. Until the break premium was actually paid (potentially as late as the break date) the landlord would not know whether the lease would terminate. The possibility of the landlord retaining part of the quarter's rent (for the post-break period) could therefore be regarded as compensation for that uncertainty. This point is considered further below.
  • The ease with which the suggested implied term could be drafted was of limited weight and indeed could weigh against such implication (see first bullet point above).

In all the circumstances, the inference to be drawn was that the agreed basis on which the parties had proceeded was that "loss from a payment of rent for the broken period should lie where it fell".

Would it have made a difference if the break premium had been paid prior to the last quarter day before the break?

Potentially, yes. The High Court held that, if the break was operated, the rent payable on the last quarter day before the break could be apportioned provided that the tenant had also paid the break premium by that December quarter day. This was because it would then be certain that the lease would terminate on the break date. The Court of Appeal thought that this "seemed to be correct", but expressly declined to decide the point.

However, the Court of Appeal did not think that this situation, where the break premium was not paid until after the quarter day, was "on all fours" with that scenario. In this case the landlord remains uncertain about whether the lease will terminate on the break date until the break premium is actually paid. In many cases this may not be until the break date itself. The court questioned why the parties should not have proceeded on the basis that the landlord was entitled to compensation for that uncertainty, by retaining the part of the quarter's rent that related to the period after the break date?

Things to consider

In the High Court, the tenant had made its claim on a number of different grounds, not just an implied term. These included that, properly interpreted, the lease contained an express term for repayment, and arguments based on failure of consideration and restitution. The tenant failed on all of these arguments in the High Court but succeeded on the implied term. Unfortunately, the tenant did not cross-appeal against the decision of the High Court on all the other arguments. So, having lost on the implied term point in the Court of Appeal, it had nothing to fall back on.

Whether or not a term will be implied into a lease will always turn on the particular circumstances, factual background, and the relevant express terms of the lease in question. However, given that the terms of the break clause in this case are commonly encountered, the Court of Appeal decision does appear to have made it very difficult for a tenant to seek to rely upon an implied right of repayment in such circumstances.

This is particularly the case given that, in Friends Life Ltd v Siemens Hearing Instruments Ltd (also considered in this month's update), the Court of Appeal stated that "although any question of interpretation depends on the particular instrument, consistency of approach is important and the court should not reach radically different interpretations of break clauses in commercial leases based on slight differences in language which are not obviously intended to achieve different objectives".

Practical tips:

  • Where a lease requires rent to be payable in advance, unless the lease states otherwise (which it rarely will), as a matter of law the tenant is not entitled to apportion final rent payments upon termination of the lease, whether by forfeiture, surrender or the exercise of a break clause.
  • When exercising a break clause in a lease which does not make provision for repayment of post-break rent, it remains the case that, despite the cash-flow difficulty and/or actual financial loss that may be suffered in having paid (even ultimately irrecoverable) monies for a period beyond expiry, the relative sums involved will generally make payment of the full advance rent due a preferable course of action to the alternative of taking the risk of losing the right to determine the lease through non-compliance with break conditions.
  • Where a break is wholly unconditional, tenants may feel that they want to rely on the views expressed by the Court of Appeal in this case to make an apportioned payment of rent on the last quarter day (on the basis that it cannot affect the operation of the break). However, it is important to keep in mind that these views were not a binding part of the decision, and another court may take a different view. There is a risk that the landlord may pursue the tenant post-break for the balance of the rent, and this would need to be taken into consideration.
  • When agreeing heads of terms for new leases which are to include a break, a tenant should seek to include express provision for repayment of post-break rent. A further protection for the tenant would be - where commercially acceptable - to set the break date(s) to fall on the day before the end of the rent quarter, in order to minimise the potential period of 'lost' rent.

Service charge

Key point

  • A service charge fund built up over a number of years by way of provision for future works could be utilised against the cost of works taking place after the operation of a break clause by a tenant, where the works took place in the same service charge year as the break

Facts of Friends Life Management Services Ltd v A & A Express Building Ltd

Like some of the other cases we are considering in this month's update, the dispute in Friends Life Management Services Ltd v A & A Express Building Ltd arose as a result of the exercise of a break right in a lease.

It concerned how the service charge provisions in the lease would operate where a break had been exercised. Could a tenant subsequently receive credit for monies it had paid via the service charge for anticipated future major works, where those works did not take place until after the operation of the break?

A lease of business premises was terminated on 24 March 2010 after the tenant exercised a break clause. Under the lease's terms, the landlord provided services to the building and recouped an appropriate proportion of those costs through a service charge mechanism.

Not uncommonly, the tenant had to pay quarterly payments on account of the service charge based on an estimate of the anticipated costs for the relevant service charge year (which ran from 1 January to 31 December). When calculating the service charge costs, the lease allowed for the inclusion in the total expenditure of an additional amount "...by way of provision for anticipated expenditure in any future Financial Years...", with a view to providing for future major works to the building.

Between 2006 and 2009, provision had been made for such future expenditure. The sums recovered through the service charge amounted to some £875,000 (of which the tenant paid over 90%, as it occupied six out of the seven floors in the building).

Major works were carried out by the landlord, but only after termination of the lease under the break clause. The works were started in autumn 2010 and continued on into 2011. The total cost of the works was over £1 million.

There were a number of issues in dispute. Two of the key questions are considered below.

What expenditure could be included in the service charge year during which the break operated?

The High Court held that the final service charge year under the lease was the complete year ending 31 December 2010 and not, as the tenant had argued, a shorter period ending on 24 March 2010. In relation to that year:

  • Only costs actually incurred in 2010 could be included. The landlord had paid the contractors carrying out the works over a period of time which spanned 2010 and 2011. Sums incurred in 2011 could not be included in the accounts for the 2010 service charge year.
  • Neither could the landlord include in the 2010 service charge account a provision for future major expenditure for 2011.

What should happen to the £875,000 provision which had been built up?

The landlord argued it could keep the whole of the tenant's proportion of the £875,000. The tenant argued it must all be repaid, because none of the matching costs became payable before its lease ended.

The court held that, under the terms of the lease, the whole of the £875,000 had to be brought into account in the final service charge year of the lease (2010). As this amount exceeded the cost of the works in that year, the tenant was entitled to a percentage of the excess, calculated by reference to their period of occupation in the service charge year.

Things to consider

In the absence of an express provision entitling a landlord to keep monies paid in anticipation of future expenditure, there is a risk that unspent monies from a tenant will have to be returned at the end of the final service charge year of its lease.

In multi-tenanted properties, landlords should consider forthcoming lease expiries and lease breaks when programming major works. Other tenants may also be mindful of this as any reduction in the anticipated expenditure "pot" could result in an increased liability for them.

The fact that landlords will need to incur expenditure before the end of the final service charge year is likely to mean disruptive works are undertaken with departing tenants in situ (although it would clearly be possible to agree to defer works if tenants are prepared to forego reimbursement).

The case raises interesting questions about the position if a lease is assigned with successive tenants each making significant contributions to the anticipated expenditure "pot". Is the final tenant entitled to all the unspent monies? If a lease is assigned in circumstances where the assignor has contributed significant sums in respect of anticipated expenditure, consideration should be given to whether provision should be made for this as between the assignor and the assignee at the point of assignment.

Why you need to follow the lease to the letter when serving a break notice

Key points

  • In the case of an alleged failure to correctly exercise an option, there are two questions:
    1. Is the provision in question a requirement of the agreement?
    2. If yes, has it been complied with?
  • If the answer to the second question is no, then the exercise of the option will be invalid
  • There is no room for the concept of substantial compliance

Background

In our September/October 2013 update, we considered the High Court decision in Friends Life Ltd v Siemens Hearing Instruments Ltd. The High Court held that a break notice was effective, even though it didn't comply with the requirements of the break clause in the lease. The Court of Appeal has now reversed this decision.

The break clause required written notice to be given to the landlord, and was subject to notice timing and other pre-conditions for the exercise of the break. Unusually, the break clause also required that the tenant's notice "must be expressed to be given under section 24(2) of the Landlord and Tenant Act 1954".

Within the notice period specified in the break clause, the tenant served a notice on the landlord. The notice made reference to the break clause in the lease, but no reference was made in the notice to s.24(2) of the 1954 Act. The landlord claimed that such an omission rendered the break notice ineffective.

Why did the break clause refer to the 1954 Act?

The reference to s.24(2) of the 1954 Act was not a mistake. Its inclusion was a result of a debate raging in the legal world at the time the agreement for lease was entered into. There was a school of thought that a tenant could, at the same time as serving a break notice, also serve a notice on the landlord under section 26 of the 1954 Act. Section 26 enables a tenant whose lease is protected by the Act to request a new lease from the landlord. The concern was that a tenant could use this mechanism in a falling market to break an overrented lease, and at the same time secure a new lease at a lower rent.

This possibility was removed by a case called Garston v Scottish Widows Fund and Life Assurance Society. However, the draft lease to be entered into by the tenant in Friends Life was left unamended to allow for the possibility of the decision in Garston being appealed, and so the lease was granted with the 1954 Act wording still left in the break clause.

High Court decision

Although the High Court had concluded the break notice did not comply with the break clause, it nevertheless held that the omission of the required wording did not invalidate the notice. It thought that the information that would have been provided to the landlord by the omitted wording was neither necessary nor relevant. The judge thought the consequences of non-compliance should be considered, and the parties could not have intended that exercise of an important right like a break right would be "dependent on compliance with a meaningless formula".

Court of Appeal

The Court of Appeal reversed the High Court decision. It noted that options (including break options) are a form of unilateral, or "if" contract. In a simple form of option agreement, it is up to the promisee whether he does or doesn't do the thing (usually, serving a notice) which will trigger an obligation on the part of the promisor ("If I do this, then you will do that"). But, if he does it, then the promisor's obligations will crystallise.

There is a well-established principle of law that the terms of unilateral contracts such as options must be fully and strictly complied with. Failure to do so invalidates the exercise of the option. This is so that the promisor can know whether his obligations have been triggered or not. In this sense, options are interpreted differently, and more strictly, than other contractual and statutory provisions.

Two questions

The Court of Appeal held that there were essentially two questions.

  1. Was the stipulation that the notice should be expressed to be given under section 24 of the 1954 Act a "requirement" of the break clause? The court thought that the word "must" in the break clause was "an emphatic and imperative word". Compliance with the stipulation was therefore mandatory and not merely permissive.
  2. Had the requirement had been complied with? Clearly, it had not - and this had not been in dispute by either party.

In other cases of contractual interpretation, there might then be a third question - what are the consequences of non-compliance? However, where unilateral or "if" contracts are concerned, the answer to this is simple and well established by the common law - the exercise of the option is invalid. There is no room for the notion of substantial compliance. The question is whether the relevant event has occurred - and that question has a yes or no answer.

The break clause required the break notice to say on its face that it was being served under section 24 of the 1954 Act. The break notice did not do this. The break had therefore not been validly operated.

Things to consider

The courts are increasingly being asked to rule on questions of compliance with pre-conditions to the exercise of break clauses. Establishing full compliance with the terms of such conditions is key, given that break provisions will be strictly construed against a tenant. This case presented a rather different issue, with the tenant seeking to establish the validity of its break notice despite the failure to follow the required form of wording.

The High Court's comments on interpretation and construction issues were seen as introducing an unwelcome element of uncertainty for landlords when trying to assess the effectiveness or otherwise of defective break notices. The Court of Appeal's reversal of the High Court decision may be seen as a return to a more consistent approach on the question of the need for compliance where a particular form of notice has been specified, however "meaningless" that requirement may appear to be.

In the case of options, the Court of Appeal emphasised that although each case would depend upon construction of the particular terms of the provision in question, a consistent approach was important and radically different interpretations of commercial lease break clauses with evidently similar intentions should be avoided.

The clear message is to ensure that when exercising break rights, all the relevant provisions are carefully considered and every requirement fully and strictly complied with, however irrelevant or trivial such requirements may seem.

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