Service charges in the supreme court: Arnold v Britton and ORS [2015]

On 10 June 2015, the Supreme Court gave judgment in the case of Arnold v Britton and ors [2015] UKSC 36, by far the most significant case concerning service charge provisions to reach the appellate courts in recent years. It is a decision which every major landlord and managing agent should be aware of and will doubtless become a standard citation in contested service charge cases. It therefore deserves a detailed consideration.

The facts of the case were as follows. The development (a leisure park in Wales) contained 91 chalets. Those chalets were each let to tenants on long leases of similar terms. The Appellant Lessees were tenants under 25 of the leases. Each lease contained at clause 3(2) a covenant to pay service charges. A representative example of the covenant in question is as follows:

To pay to the Lessor without any deduction in addition to the said rent a proportionate part of the expenses and outgoings incurred by the Lessor in the repair maintenance renewal and the provision of services hereinafter set out the yearly sum of Ninety Pounds and value added tax (if any) for [the first three years OR the first year] of the term hereby granted increasing thereafter by Ten Pounds per Hundred for every subsequent [three year period OR year] or part thereof.

The provisions in 4 of the leases were varied from triennial to annual increases.

The Appellant Lessees had originally made an application in the County Court for pre-action disclosure in 2011. The Respondent Landlord duly responded with an application for declaratory relief concerning the interpretation of the service charge provision. The pre-action disclosure application was duly stayed pending the outcome of the declaratory relief proceedings.

Amongst the declarations sought, was a declaration that strictly speaking the sum payable under clause 3(2) was not a ‘service charge’ as defined by section 18 of the Landlord and Tenant Act 1985. In the County Court, HHJ Jarman QC found in favour of the Appellant Lessees. That decision was reversed on appeal by Morgan J in the High Court. That decision was in turn referred up to the Court of Appeal which unanimously upheld Morgan J’s decision. The Supreme Court itself granted leave to appeal.

Essentially, the Respondent landlord contended that the effect of the provision was that the lessees were required to pay an initial £90.00 service charge per year, increasing at a compound rate of 10% every three years (for the first 70 chalets) and every year for the last 21 to be let as well as the 4 which had been varied.

The issue before the Supreme Court was whether that interpretation was correct. Naturally, the Appellant Lessees did not think so. They contended that:

(1) The Respondent Landlord’s construction results in an “increasingly absurdly high annual service charge”;

(2) The obligation under the leases was “to pay a fair proportion of the lessor’s costs of providing the services” and that that would be subject to a maximum of £90.00 in the first year, with that maximum increasing by 10% each year on a compound basis;

(3) In the alternative, the lessor could not recover more by way of service charge than could be recovered under each of the first 70 leases.

Lord Neuberger took the opportunity to re-state the principles of contractual interpretation. He does so succinctly:

When interpreting a written contract, the court is concerned to identify the intention of the parties by reference to “what a reasonable person having all the background knowledge which would have been available to the parties would have understood them to be using the language in the contract to mean”… focussing on the meaning of the relevant words… in their documentary, factual and commercial context. That meaning has to be assessed in the light of (i) the natural and ordinary meaning of the clause, (ii) any other relevant provisions of the lease, (iii) the overall purpose of the clause and the lease, (iv) the facts and circumstances known or assumed by the parties at the time that the document was executed, and (v) commercial common sense, but (vi) disregarding subjective evidence of any party’s intentions (at [15]).

That passage should become the standard citation in skeleton arguments in service charge cases where interpretation of the lease is in issue.

But Lord Neuberger sought to clarify or amplify that passage (and address the prior case-law) with reference to 7 factors:

(1) Emphasis on commercial common sense and surrounding circumstances cannot undervalue the importance of the language of the provision in question, from which is gleaned the meaning of the provision (at [17]). What is key here is that the parties have “control” over the wording, and must be presumed to be focussed on the issue when agreeing that wording;

(2) The less clear the wording, the more readily a Court can depart from natural meaning. The converse is also true (at [18]);

(3) Commercial common sense cannot be invoked retrospectively. It is relevant “only to the extent of how matters would or could have been perceived by the parties, or by

reasonable people in the position of the parties, as at the date that the contract was made” (at [19]);

(4) The Court must be slow to reject natural meaning simply because it appears the term was imprudent. It is not the function of the Court “to relieve a party from the consequences of his imprudence or poor advice” (at [20]). Judges should neither attempt to assist an unwise party nor penalise an astute one;

(5) When interpreting, the Court can only take into account facts or circumstances which existed at the time of making the contract and which were known or reasonably available to both contracting parties (at [21]);

(6) If a plainly unintended or uncontemplated event subsequently occurs, if it is clear what the parties would have intended, based on what the parties had in mind when they entered into the contract, then the Court will give effect to that intention (at [22]);

(7) Service charge clauses are not subject to any special rule of interpretation. There is no justification for construing such clauses ‘restrictively’, as was advocated (at [23]).

Factor (7) should be of particular importance to landlords and to solicitors familiar with the case of McHale v Earl Cadogan [2010] EWCA Civ 14. Lord Neuberger is here seeking to limit the effect (or rather perceived effect) of the judgment of Rix LJ in that case by approving merely the principle that “the court should not “bring within the general words of a service charge clause anything which does not clearly belong there”” (at [23]). That should come as some relief to landlords and managing agents.

That dispensed with the general principles, at least insofar as the majority were concerned. We must turn now, as did Lord Neuberger, to the specific clause in question.

The starting point was that Lord Neuberger considered that, absent the commercial consequences, the natural meaning of the words were ‘clear’ (at [24]). He further thought that the provision for the annual increase was ‘plainly included to allow for inflation’ (at [13]). The clause was in 2 parts. The first to provide for a service charge. The second to quantify that charge.

As to fixed-sum service charges, Lord Neuberger saw no issue with that approach and thought it readily explainable, given the trouble which service charge provisions usually cause between landlords and tenants. Doubtless professional landlords, managing agents and solicitors working in this field will be familiar with the common defence complaining of increases

beyond inflation. Usually a tenant will be arguing for something closer to the clause which was in issue in this case.

It is true that the clause provided for payment of a ‘proportionate part of the expenses and outgoings incurred.’ Arguably, the cumulative increase leads to a point in time at which the payment is not proportionate and exceeds the costs of providing services. But, and this is the crucial point, if the purpose of the second part of the clause is quantification, “the fact that, in the future, its quantum may substantially exceed the parties’ expectations at the time of the grant of the lease is not a reason for giving the clause a different meaning” (at [28]). The fact that the parties did not intend the subsequent consequences or effect is no reason to depart from the natural interpretation. Furthermore, Lord Neuberger would question whether there is any basis on which the Court could so interpret, “In my judgment, there is no principle of interpretation which entitles a court to re-write a contractual provision simply because the factor which the parties catered for does not seem to be developing in the way in which the parties may well have expected” (at [41]).

But for the subsequent history of inflation, the issue would not have arisen. But that history coupled with the natural meaning of the clause in dispute led to the following scenario: assuming a lease granted in 1980, service charges would be over £2,500.00 in 2015. By 2072, the service charges would be over £550,000.00. It is no wonder the tenants were concerned. It puts one in mind of the wheat and chessboard problem.

It was that reality which gave the Appellant Lessees not simply their incentive, but their primary interpretive weapon. The argument in essence was this, that those figures starkly highlighted the “extreme unlikelihood” of the Respondent Landlord’s position and supported the interpretation of the compounding figure as a maximum cap.

Notwithstanding those realities, Lord Neuberger was unconvinced by the argument as it involved a departure from natural meaning and the insertion of words not present within the clause. Further still, the clause appeared to be framed precisely to avoid a lessor assessment of the appropriate proportion of cost to allocate to each chalet. The Appellant Lessees’ interpretation would have had the effect of forcing such an exercise to be undertaken.

Even dealing with the realities, at the time many of the leases were agreed, inflation was running at a higher rate that 10% and had done so for a number of years prior. The 10% agreed compound increase was a “bilateral gamble” on inflation (at [36]).

As to the varied leases, whilst “improvident”, that fact in and of itself was no reason to depart from the natural interpretation.

Nor did the Appellant Lessees’ interpretation produce anything other than a less unlikely scenario. That is, because the alleged ceiling would have increased at such a rate as to have “become so absurdly high that it would be meaningless” (at [42]).

Contrary to Lord Carnwath’s view, whose lengthy dissent I shall deal with later, Lord Neuberger confirmed that a lessor owes no duty to be ‘fair’ when negotiating the terms of a lease (at [46]).

As to their alternative case, the Appellant Lessees relied upon clause 4(8) of the leases as essentially establishing a letting scheme whereby their clauses 3(2) were in identical terms to those of the first 70 leases (i.e. 10% compounded every three years rather than annually). That for the purposes of mutual enforceability as between lessees. That argument fell down as:

(1) It was not clear the service charge provisions were subject to the scheme;

(2) It appeared that the scheme addressed only future lettings, not past lettings;

(3) Even if the Appellant Lessees were right, it would at best enjoin the Respondent Landlord from further lettings on terms inconsistent with the scheme, not lettings prior to the grant of the relevant Appellant Lessees’ leases;

(4) In any event clause 4(8) permitted of a degree of variation between the terms of leases;

(5) The implied term contended for would at best imply that the first 70 leases do contain a clause 3(2) which is identical to the leases in issue, being a compounding 10% increase per annum;

(6) It is a “fundamental principle” that one cannot imply a term which is inconsistent with an express term (at [56]); and

(7) If contrary to Lord Neuberger’s view the Appellant Lessees knew of the prior version of clause 3(2), it would negative any reliance which the Appellant Lessees could place on clause 4(8).

Interestingly enough, Lord Neuberger considered that the outcome advocated by Lord Carnwath in his powerful dissent was ‘a much more satisfactory outcome in common sense terms’ (see [62]). But he could not agree with it, invoking (though not expressly) what Justice Scalia of the US Supreme Court has referred to as the interpretive rule for a judge being ‘garbage in, garbage out’. Though of course, Justice Scalia was referring to the interpretation

of statute, and one could not fairly lay at the UK Supreme Court’s feet the charge that it here adopted Justice Scalia’s brand of textualism.

The policy implications of this case in the field of service charges are clear. It is raised at paragraph [65] of Lord Neuberger’s judgment, in paragraph [66] of Lord Hodge’s concurring judgment and in Lord Carnwath’s dissent (paragraphs [90] – [93]). Namely, that the statutory provisions governing the reasonableness of service charges did not apply in the instant case, because it involved a fixed-sum service charge. Should the legislation be extended to cover such cases? The Supreme Court leave the point moot.

Lord Hodge gave a concurring judgment, which involved a consideration of those cases where the Courts had remediated a mistake by construction or by the implication of a term. Those cases did not, in Lord Hodge’s view, assist the Court. He stressed the unitary nature of the exercise of interpretation. One does not reach a view on the natural meaning and then see if circumstances can displace the meaning. Rather, one must reach a view on the natural meaning and, if there are two possible constructions, the court is entitled to prefer the construction which is consistent with business common sense (see paragraph [76], approving Rainy Sky SA v Kookmin Bank [2011] 1 WLR 2900). But the basis of the alternative meaning must reside in the words used and the factual matrix. The role of the Courts is not, he stresses, to re-write a bad bargain. Even on the alternative case, for correction, the Court could not act because it must be satisfied not only as to the mistake but as to the nature of the correction to be made (at [78]). The parties’ proper remedy would be either to agree an amendment, or to seek the assistance of Parliament.

Lord Carnwath gave a powerful dissenting judgment which is greater in length than those of Lords Neuberger and Hodge combined. It is framed on the basis that unusual interpretive challenges call for unusual solutions. He noted the preamble to each lease, which was that they should be ‘upon terms similar in all respects’ as indeed he noted the paucity of the evidence of the factual matrix.

The statutory framework did not assist the lessees, because the charges in the instant case did not fall within the definition of service charges pursuant to section 18 of the Landlord and Tenant Act 1985. That provision provides that the charges must or may vary according to the relevant costs of providing services. The Unfair Contract Terms Act 1977 could not avail the appellant lessees because it does not apply to contracts related to the creation or transfer of interests in land.

Assuming a commencement date of 1974, Lord Carnwath calculated that the annual service charge figure to be paid by lessees in 2072 who were on annual compounders would be £1,025,004.00.

Part of the factual matrix was, in Lord Carnwath’s view, the figures for inflation up to and including the years of the leases, the political and economic landscape of the time, and the nature and circumstances of the development.

Lord Carnwath departed from the majority view as concerned the letting scheme. In his view:

the existence of such a scheme reinforces the view that each lessee has a legitimate interest in the form and content of all leases within the development, whenever granted. Even if, as in clause 4(viii), the lessor’s responsibility is expressed as an obligation in respect of future leases, it should in its context (including the preamble) be read also as containing an implied representation that leases previously granted are also in substantially the same form (at [118]).

He departed also, insofar as he saw more force in the effect of the McHale [2010] judgment. He agreed that service charge provisions were to be construed restrictively, “if by this it is meant that the court should lean towards an interpretation which limits such clauses to their intended purpose of securing fair distribution between the lessees of the reasonable cost of shared services” (at [120]).

Lord Carnwath’s disagreement with the majority extended also to the role of the Courts in such disputes. He saw a ‘responsibility’ to “ensure that such clauses are interpreted as far as possible not only to give effect to their intended purpose, but also to guard against unfair and unintended burdens being placed on the lessees” (at [123]).

The inherent ambiguity he identified in the relevant clauses was the difference between on one hand the description of the payable amount as a ‘proportionate part of the expenses and outgoings of the Lessor’ and on the other hand as a ‘yearly sum’ determined by a fixed formula. In Lord Carnwath’s view the figure could be the one or the other but not both. That is to say nothing of the absence of a grammatical connection between the two parts of the clauses. That ambiguity required, in his view, a resolution.

The solution proposed by the majority, that the first part of the formula was a description of the character of the payment and the latter part the calculation was not one which Lord Carnwath could accept. That, because in his contention the first part in fact contains a formula – that of proportion. Proportion had no part to play in a fixed sum and so there existed the unresolved ambiguity.

He saw 2 alternatives, those described in all preceding judgments: “Either it is a fixed amount which in effect supplants any test of proportionality under the first part; or it is no more than an upper limit to the assessment of a proportionate amount” (at [128]).

Lord Carnwath thought it unlikely that the parties would have contemplated gambling on inflation, given that it is not thought that the Courts can receive expert evidence on such matters. He thought it inconceivable that a purchaser would have been willing to accept a prediction of continuing inflation at the level of 10% for over 90 years.

Lord Carnwath similarly thought it unrealistic to assume that the Appellant Lessees had no knowledge of the terms of the prior leases. In any event, he thought that information would amount to background knowledge reasonably available to the parties, such that it was relevant to the interpretive process. Here, he turned Lord Neuberger’s fifth factor against the majority conclusion.

Lord Carnwath subjected the matter to the imagined questioning of the officious bystander. Would the parties have really intended to enter into a contract with the long term implications of the instant case? To that, he thought the answer must inevitably be in the negative. That the clause must have been a cap rather than fixed sum. The alternative being both “absurd” and “unreasonable” ([143]) to both parties.

To the riposte, that it is not the role of the Court to relieve a party of a bad bargain, Lord Carnwath challenges the assumption that the natural meaning of the clause is as the majority (and Court of Appeal) found it. Bad bargain is, to his mind, a gross understatement of these leases. The implications of the interpretation of the lessor was from the outset both stark and disastrous.

In conclusion, Lord Carnwath regarded “the consequences of the lessor’s interpretation as so commercially improbable that only the clearest words would justify the court in adopting it.” Not being sufficiently clear, the Court was not justified in adopting the Respondent Landlord’s interpretation.

The majority would respond to Lord Carnwath’s dissent by reference to Lord Neuberger’s third factor. The conclusion drawn by Lord Carnwath, in the majority view of the Supreme Court, was one based on retrospective invocation of commercial common sense. Such cannot guide the Court in its interpretive functions, as much as it might lead to practically desirable outcomes.

What should landlords and managing agents take from this decision? The comfort that the service charge provisions which they seek to enforce are governed by no more restrictive rule of interpretation than any other contractual provision. That no duty of fairness arises on agreeing the terms of a lease. Further still, they have in this judgment an effective interpretive guide. But also a cautionary tale, that clarity of drafting is of paramount importance if those terms are to be properly enforced, and if lengthy litigation is to be avoided.


23ES Commercial

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