Understanding the commercial effect of clauses

The Supreme Court has confirmed in Arnold v Britton and others [2015] UKSC 36 that the court cannot interpret or rewrite a clearly drafted contract just because the literal interpretation of its terms results in the parties being tied to a prejudicial or uncommercial outcome.

Service charges were payable by 25 long leaseholders of chalets at a holiday park in Wales. Each lease was for 99 years from 1974. The leases provided for the tenants to pay a fixed sum of £90 during the first year of their lease as service charge and for each subsequent year a fixed sum representing a 10 per cent increase on the previous year. The effect of this was that the service charge would increase annually at a compound rate of 10 per cent.

The wording of the leases differed very slightly but typically contained a covenant '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 year of the term hereby granted increasing thereafter by ten pounds per hundred for every subsequent year or part thereof'.

The landlord said that the clause clearly provided for a fixed service charge that increased annually by the stated percentage. The leases were entered into at a time of high inflation and it mattered not that this compounded increase would result in an increase from £90 to £1,025,004 by the end of each lease.

The tenants claimed that the literal interpretation of the clause resulted in such an uncommercial outcome that the provision must be construed with reference to the costs of maintaining the holiday park, and that the fixed sum payable should be a maximum sum payable each year as opposed to the actual sum recoverable.

The Supreme Court refused the tenants' appeal, emphasising seven factors to consider when interpreting a contract:

• The language used is of vital importance and must be given effect unless unclear;
• Drafting errors or lack of clarity do not entitle a court to depart from giving effect to the natural meaning of the words used;
• While reliance must be placed on common commercial sense, this should not undervalue the language of the provision. Commercial sense is not to be invoked retrospectively;
• It is not the function of the court to rewrite a contract because it is a bad bargain or to relieve a party who has entered into an ill-advised arrangement;
• The court can only rely on facts known to both parties at the time when seeking to interpret the meaning of the words used;
• A subsequent event is irrelevant unless it can be said that all parties had this in mind when entering the contract; and
• There are no special rules regarding interpretation of service charge provisions. They should not be construed restrictively in favour of tenants.

This case is an important lesson for practitioners advising upon contracts, particularly as to the need for practitioners to understand the meaning and commercial effect of every clause.

A valid contracting out?

Pre-2004, a court order was required if a commercial lease was to be excluded from, or ‘contracted out’ of, the security of tenure provisions of the Landlord and Tenant Act 1954 (the 1954 Act). This process gave the parties a degree of certainty. The majority of case law in this area concerned the impact of amendments made to a lease after the court order had been obtained.

The Regulatory (Reform) Order 2003 (the 2003 order) introduced a new contracting out procedure involving the service of statutory notices and the making or swearing of declarations. Despite coming into effect over ten years ago, this procedure remains untested in the courts. However, this should not necessarily be assumed to be a sign of its unequivocal success.

The flaws in the process may become evident when advising a purchaser with redevelopment in mind as to the status of tenants. Whether or not a tenant has the benefit of the statutory security of tenure rights will have a significant impact on tactics and timings, and will be crucial to any financial appraisals. Where issues come to light in the due diligence process, these may be useful to assist in negotiating a more favourable sale price.

Verifying that a lease is contracted out involves more than simply checking that the lease itself contains such an endorsement and that there is an accompanying tenant's declaration. Practitioners should be alive to potential flaws, whether acting for buyers, who will be considering the impact on value, or advising tenants or assignees who may potentially (inadvertently) be entitled to statutory compensation.

First, is the lease for a fixed term? If not, the contracting out procedure will be of no effect. It will not be if it is granted for a fixed term and then from year to year, or if the term is defined to include any period of continuation, extension, or holding over.

Second, procedural problems are often encountered. This can include missing or undated warning notices - the latter being an issue where a simple declaration has been made. It is also not uncommon for declarations to be incomplete, with addresses and signatures omitted or referring to an incorrect entity. There may be no authority (or evidence of authority) of those signing the declarations. With statutory declarations, it is difficult to verify that the solicitor/commissioner for oaths is from an independent firm. There is also a lack of certainty that the form of lease granted is not substantially different from when the landlord served its warning notice.

The mandatory nature of the drafting of some of the requirements of the 2003 order and the 1954 Act means that if tested, the courts are likely to have difficulty in overlooking certain irregularities. It would be interesting to see whether the clear intention of the parties (who are both required to be actively involved in the contracting out process) will override any flaws in the drafting of the lease or the procedure followed.

Property funding agreements

In the funding and development of land, there are many tried and tested ways to finance construction work, including traditional bank lending, special purpose vehicles and equity investments, and funding agreements. In funding agreements, a developer agrees to construct a building and a funder agrees to pay for it, on the basis that the funder will acquire title to the site at some later point (normally shortly after practical completion). They can be useful to the respective parties for a number of reasons.

For developers, they provide a secure source of funds throughout construction and (provided the developer controls costs) a calculable 'profit' should be achieved at the end of the process, at which point the developer can walk away.

A key benefit for the funder is that funding agreements can leave the risk with the developer - not least because the funder won't be required to buy the land up front, and if the project goes wrong, the funder can cut their losses and abort the deal.

Funding agreements come in many shapes and sizes, but there are common elements:

• Development obligations: As for a 'vanilla' development agreement, the developer is to carry out and deliver building works according to an agreed set of specifications;
• Pre-lets: Where a third-party tenant has agreed to take a lease of the premises on or shortly after practical completion, the funding agreement must cover off the risk of the project failing to meet the tenant's completion requirements, such as would allow the tenant to walk away. Funders will base their profit calculations on the anticipated initial rental income from the tenant, so it is critical that the risks of the tenant being entitled to terminate are fully assessed and mitigated, perhaps by way of step-in rights; and
• Interim funding obligations: At the heart of a funding agreement are the provisions relating to payments to the developer. These generally come in two tranches:

1. Interim payments: The developer will expect regular payments against development costs as and when they fall due. Typically, the funder will pay (1) an initial contribution towards costs incurred by the developer prior to entering into the funding agreement, and (2) payments on a monthly basis upon receipt of invoices (often for a minimum amount). The funding agreement will contain a list of valid 'developer's expenses' against which the developer can claim, and the funder will normally want an ability to switch off the funding tap if it anticipates costs exceeding a specified upper figure; and

2. Once the building is complete, the funding agreement will provide for the developer's 'profit'. This will normally be calculated according to a formula. It follows, of course, that if costs exceed the agreed total outlay, the developer will not receive a profit. SJ

James Corbett, Ros Cullis, Nik Ireland, pictured, and Miri Stickland are solicitors at Forsters