Business Tenancies - Case Law
Who is Entitled to Surplus Service Charges When a Lease Expires?
Brown's Operating System Services Ltd was the tenant of business units in a building in Blackheath in London under a lease from Southwark Roman Catholic Diocesan Corporation. The lease was granted in 1993 for a 15 year term (with a break clause) and service charge was also payable for the costs of maintenance and repairs to the building.
The landlord had a policy of retaining the excess of the service charges left at the end of the year to build up a surplus to cover future expenditure. This excess was described in the accounts as an ‘allowance for future repairs renewals and redecorations carried forward'.
By 2002, the surplus had reached a very substantial sum and the tenant was of the view that a proportion of the surplus stood to their credit and that they should be entitled to a service charge ‘holiday'. The landlord disagreed and so the tenant decided to leave, giving 6 months notice to quit under the break clause. The tenant maintained that they were entitled to the payment holiday and refused to pay the last two quarters' service charge which amounted to almost £10,000.00 on the basis that the surplus held by the landlord more than covered those two quarters. The landlord sued for that sum with interest and won, as the judge took the view that the surplus held by the landlord was a reserve fund that had been built up for the benefit of the building and that the landlord was entitled to hold on to it at the end of the lease. The judge also held that any sums remaining in the reserve belonged to the landlord and not to the tenant.
The tenant, unhappy with the outcome at first instance, decided to appeal against the decision in the Court of Appeal. At appeal, the tenant argued that the definition of ‘total service cost' as set out in the lease was such that it did not cover the making of any provision for future costs and therefore could only cover costs already incurred. The tenant also argued that what the landlord had done did not amount to exercising discretion in including a provision for likely future repairs otherwise they would have set up a separate reserve fund in the service charge accounts rather than merely carrying forward the excess at the end of the accounting period.
The tenant also maintained that the surplus in the accounts was the property of the tenants, relying on a statement to this effect in a balance sheet prepared by landlord's accountant which identified the accumulated surplus as a tenants' asset.
The Court of Appeal took the view that the terms of the lease allowed the landlord to include some provision for future repairs in the total service cost, however this provision could only extend to expenditure likely to be incurred during the term of the lease. It was also held that the lease itself did not provide for the creation of a reserve fund designed to cover the obligations which the landlord would have to meet at some future time, after the expiry of the lease.
In the Court's opinion, the money held by the landlord on the termination of the lease was either held in reserve under the lease in the sense of providing for future expenditure within the total service costs, or was the excess of the tenant's payments on account over actual expenditure, which the landlord was entitled to retain only on account of future service charge payable by the tenant.
Furthermore there was no provision in the lease for what should happen to any unspent money left in the service charge accounts and held by the landlord at the expiry of the lease.
From that the Court ruled that that any money unspent at the end of the lease belonged to the tenants and that the terms of the lease obliged the landlord to return to the tenant any unspent money at the date of termination whether termination was by effluxion of time or the operation of a break clause. The tenant succeeded in winning their appeal and the landlord was required to repay both the two instalments of service charge originally claimed and the balance of the tenant's share of the surplus service charge.
Comment
This case serves as a reminder to commercial landlords of the need for careful drafting to ensure that leases set out clear and accurate definitions for service charge costs and provide landlords with the entitlement to retain adequate sums to enable future works to be carried out.
Where there are specific items, such as an air conditioning plant, that have a finite life span and will need replacing, it is vital that landlords ensure that the lease provides for the setting up of a separate reserve fund which is earmarked for the replacement of such items and that there is no entitlement for tenants to recover any unspent sums at the end of the lease. It is important for landlords to have the reassurance of a well drafted lease which will enable them to retain contributions taken from tenants for the replacement of major items irrespective of whether or not the lease has already ended.
Mary Cutts
Solicitor
Lemon & Co Solicitors
This article gives a general view and cannot be relied upon in any particular case. The need for specific legal advice must always be considered. For further information, contact Mary Cutts or another member of the commercial property department at Lemon & Co on 01793 496341 or alternatively, please visit our website at www.lemon-co.co.uk for articles on other legal issues.
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