A service charge is a mechanism contained in a lease that allows the landlord to recover its running costs in relation to the estate or the common parts of buildings from its tenant. Service charges can be complicated and costly and they are therefore often highly contentious. A particularly stark example of this is the recent Supreme Court case of Arnold v Britton [1]. Commercial and Real Estate Litigation specialists Malcolm Simpson and Martin McKeague explain.

As with any other contractual clause, the wording of a service charge provision is key and the starting point when a dispute arises is the wording of the clause itself. The general rule is that the contract 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 leases, which are of modest holiday chalets, the use of which is restricted to half of each year only. The economic consequences of this interpretation were devastating for the tenants, hence the appeal to the Supreme Court.

The appeal was dismissed and the highest court in England and Wales 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 should not undermine the importance of the clear language of a clause.

  • The starting point is the wording of the contract itself.
  • An objective test - that of what the reasonable businessperson 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.
  • There is no general rule that service charge clauses should be interpreted restrictively to reflect a tenant’s limited interest in the property - such clauses are simply to be determined in accordance with general principles of contractual interpretation.

WM Comment

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

The question now is what you can do if you face an unfavourable outcome in any of your commercial 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 stacked 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.
  • Does the clause reflect the parties’ intentions at the time the contract was entered into? If it does not, is the contract capable of being rectified?
  • 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.