A service charge is a mechanism contained in a lease that allows the landlord to recover its running costs for the building from the tenants.  Service charges can be costly and they are therefore often contentious. A particularly stark example of this is the recent Supreme Court case of Arnold v Britton [1]. Housing and Real Estate Litigation specialists Karl Anders and Martin McKeague explain.

A tenant's service charge liability does not arise at all unless and until the landlord has properly complied with the service charge procedure and calculations set out in the lease. As with any other contractual clause, therefore, the wording of a service charge provision is key. The starting point when a dispute arises is the wording of the clause itself, and the general principle is that the letter of the lease is king.

Arnold v Britton concerned the service charge provisions in 25 holiday chalet leases. In accordance with the ordinary natural meaning of the wording of the relevant clause [2], both the High Court and the Court of Appeal had previously agreed with the landlord that the provisions obliged the tenants to pay a fixed yearly service charge amount which rises at the rate of 10% per annum, irrespective of the cost to the landlord of providing services. This interpretation meant, however, that service charges payable per year would top over £½ million by the end of the lease terms in respect of  modest holiday chalets, the use of which is restricted to half of each year only. In light of the disastrous economic consequences of this interpretation, the tenants appealed. The Supreme Court dismissed the appeal and took the opportunity to clarify the correct approach to contractual interpretation.

Correct approach to contractual interpretation

Whilst consideration of commercial common sense can, in the right circumstances, be taken into account, it is not a criterion of contractual interpretation that should undermine the importance of the clear language of a clause.

  • The starting point is the wording of the [lease] contract itself.
  • An objective test - that of what the reasonable business person would understand the clause to mean – is applied to ascertain the parties’ intention at the time the contract was entered into.
  • Commercial common sense can be a consideration, but:
    • it cannot be invoked ‘after the fact’ - it is only relevant to ascertaining how matters would or could have been perceived when the contract was made;
    • where there are two or more tenable interpretations, the most commercially sensible option will be preferred;
    • it is not for the court to depart from clear contractual wording even where that represents a bad bargain for any party.
  • In relation to service charge provisions specifically, there is no general rule that these should be interpreted restrictively to reflect a tenant’s limited interest in the property.  Service charge clauses are to be determined in accordance with general principles of contractual interpretation.

WM Comment

The property industry and commercial litigation commentators alike awaited this decision with interest. The big question was whether commercial efficacy would become enshrined in service charge and other commercial contract clauses. Despite a dissenting judgment [3], the law is now very clear as to the extent to which commercial common sense will influence interpretation.

The question now, therefore, is what you can do if you face an unfavourable outcome in any of your leases or contracts.

  • Consider carefully the wording in the clause itself. If there is real uncertainty, then commercial common sense can be taken into account and may assist.
  • Is there any scope for settlement? It is rare for any contractual interpretation dispute to be clear cut. Even if the odds are against you, the chances are that any grey area and inevitable litigation risk can be exploited in negotiations to encourage a commercial compromise.
  • In any event, it is good to talk. Interpretation disputes often arise by virtue of the fact that there is an ongoing contractual relationship between the parties. It can be in the interests of all concerned for the parties to behave in a reasonable and commercially sensible manner. We understand that, even in light of the Supreme Court’s decision, the landlord in the Arnold v Britton case has informally agreed to renegotiate the service charge provisions in question to index-link the annual increase, as this does represent reasonable modern commercial practice and it may be beneficial to all parties to help tenants to avoid future default.
  • Even if the wording in the contract is clear on face value, has there been a mistake in the drafting of the contract? Ask whether the clause genuinely reflects the parties’ intentions at the time the contract was entered into. If it does not, take legal advice to investigate the potential to pursue a claim for rectification.
  • Alternatively, was the clause entered into in reliance on any misrepresentations? If so, the contract could be set aside and financial compensation could be payable.
  • Finally, consider whether you were properly advised when the lease or contract was completed. It is possible that any losses could be recouped via a professional negligence claim.