Redefining service charges

The Building Safety Act 2022 (the Act) is probably one of the biggest shake-ups we have seen in the real estate sector in the last 20 years.

The Act, containing 171 sections and 11 schedules, was born out of the Grenfell tragedy of 2017, but its effect goes far beyond the development of high-rise residential properties. It is ambitious, hugely complex and multi-faceted.

Construction, planning and property practitioners all need to get to grips with the new regimes that apply (or will apply) across their practice areas, particularly as the regimes continue to take shape and come into force over the course of the coming months. 

Our area of focus for this article is occupied buildings, in particular the impact the Act has on the operation and recovery of service charges.

While practitioners well versed in residential service charge disputes will be au fait with the protections for leaseholders imposed by the Landlord and Tenant Act 1985 (the 1985 Act), commercial service charge provisions in leases have historically enjoyed freedom of contract. This is not to say that they are dispute-free (far from it), but they are generally a question of interpretation. This position is changed by sections 112 and 133 and schedule 8 of the Act for residential and mixed-use relevant buildings.

Identifying the caps, restrictions and bans

Michael Gove, as secretary of state for levelling up in January 2022, stated that “no leaseholder living in their own flat will have to pay a penny to fix unsafe cladding”. The Act delivers on that guarantee by imposing a blanket ban on landlords recovering via the service charge any costs of remediation works for removing or replacing an unsafe cladding system in a relevant building where a tenant of residential premises has a qualifying lease (see below).

Schedule 8 also provides extensive protection for any tenants of qualifying leases against remediation costs for relevant defects in the form of various caps and restrictions to service charge recovery. The detail in schedule 8 is extensive, but put simply the new regime amounts to a wealth condition (such as the wealth of the relevant landlord and its group means that

it / they should pay to remedy relevant defects) and a value condition (such as tenants of leases below a valuation threshold are not required to contribute). If neither restriction applies, the landlord may recover service charges up to a permitted maximum which is determined by the value of the lease, but may only recover 10% in any 12-month period. Any legal or professional fees associated with relevant defects cannot be charged to tenants of qualifying leases, regardless of their value. 

Practitioners acting for landlords should note that there is a presumption in favour of tenants that they have a qualifying lease. This presumption can be displaced by the landlord giving at least eight weeks’ notice to the tenant requesting a lease certificate. The certificate is used to establish whether the lease qualifies as a qualifying lease and if so, what the permitted maximum service charge will be (assuming the wealth condition does not apply). Tenants who make a false representation on the certificate are at risk of committing a criminal offence under the Fraud Act 2006.

Conversely, a presumption applies against relevant landlords that they met the conditions (and therefore the current landlord is prohibited from recovering costs from any tenants of qualifying leases), unless it provides a landlord’s certificate to its tenant with supporting information in accordance with the leasehold protections within the Act. 

This certificate must be provided in prescribed circumstances including where the landlord demands service charges for relevant defects or becomes aware of such defects, or the tenant requests the certificate or notifies the landlord of a proposed sale of their flat. As the certificates concern the lease and the parties to it on the qualifying date in 2022, provision should be made to ensure any purchaser of the property has the requisite information from the seller on any sale of the property.

Tenants who do not have a qualifying lease still attract some protection, however. Landlords are prevented from recovering remediation costs via service charges under any leases in relevant buildings (including commercial parts of a mixed-use building) where the relevant landlord was responsible for the relevant defect or associated with a person responsible for it. If there is any shortfall in the costs after the caps and restrictions have been applied to the qualifying leases, the landlord cannot increase the contributions of the other tenants to account for it. 

Landlords’ duty to pursue alternative funding

If a landlord is entitled to recover costs of remedying relevant defects from any of its tenants after applying the caps, restrictions and bans under the Act, section 133 of the Act inserts a new section 20D into the 1985 Act to oblige landlords first to take reasonable steps to pursue, and secure where possible, alternative funding. Expected to come into force shortly, the government is considering responses to a recent consultation on the scope of the buildings and the works to be covered by the new section, but it proposes to align them closely with the definitions of relevant building and relevant defect as used by the Act. The duty shall be owed to all tenants of dwellings in such buildings and shall not be limited to those under qualifying leases. 

The draft statutory guidance requires landlords to take a series of reasonable steps to investigate alternative funding sources including whether any grant is payable (for example under the Building Safety Fund), or if monies may be obtained under insurance, a guarantee / indemnity or from a developer or other person involved in the design or works to the building. If any of these routes are potentially available, landlords should use the statutory guidance to clarify the steps they should take to obtain such funds and will require advice and assistance from their lawyers to navigate their duties. For example, when assessing a claim against a third party such as the developer, a landlord will first require independent legal advice on the likelihood of recovering remediation costs and whether there is a feasible claim. Detailed advice on the likely costs of pursuing an action and the risks of doing so will need to be given to assist the landlord to decide whether it is required to pursue the matter. Depending on the strength of the claim, the draft guidance suggests that pre-action correspondence and negotiation should be pursued by the landlord with a view to reaching an early settlement. However, if the costs of litigation are likely to be disproportionate, the landlord may reasonably decide not to pursue the claim. 

It is clear from the draft guidance that landlords should investigate and pursue all potential routes of alternative funding simultaneously and they should not delay remediation works in the meantime. It may be that the landlord can quickly disregard many of the alternatives after some initial investigation in line with the guidance, but it must not approach its duty as a box-ticking exercise. Section 20D gives teeth to tenants by empowering them to apply to the First-tier Tribunal to challenge the landlord’s compliance. Proof of a failure to comply with the statutory guidance may be relied on by the tenant to establish that there was such a failure, and vice versa. If the tribunal finds that the landlord has not properly discharged its duty, it may order that any remediation costs for defects are not to be regarded as relevant costs for the service charge. Property practitioners, whether advising landlords or tenants, will need to be well-versed in the statutory guidance once it is finalised. 

While section 20D does not apply to tenants of any commercial parts in mixed-use buildings, they benefit indirectly as any alternative funding secured by the landlord must be applied to the service charge for the relevant building as a whole. 

Privilege and other considerations

The landlord must share certain information with its tenants to evidence compliance with its duties under section 20D. The draft guidance states this will include a summary with details of the landlord’s pursuits, which should be updated at least annually. A failure to provide such information avoids the tenant’s legal obligation to pay towards the service charge for remediation of the defect.

This may include disclosure of privileged legal advice or other commercially sensitive information, such as insurance and construction contracts. A landlord may be uncomfortable providing this information without duties of confidentiality on the recipient, which is currently missing from the draft guidance. The draft guidance does provide that the information-sharing duties do not override rights to legal professional privilege, but tenants can apply to the First-tier Tribunal if they feel that landlords have claimed privilege unreasonably. This area may prove ripe for satellite disputes between the parties without further clarification in the guidance.

The costs of the landlord’s investigations and any litigation or associated action (including mediation) may be largely irrecoverable from tenants, leaving landlords with a substantial bill. That is the case regardless of whether the current landlord was responsible for the relevant defect or not. For example, the government’s impact assessment dated 2 February 2023 was published with the recent consultation and it highlighted a case study where expenses to pursue a claim against a third party were over £125,000, only 18% of which would be recoverable from leaseholders. This left the landlord with a legal bill exceeding £102,000. No information was given on the percentage of recovery of legal expenses from the third party.

A clearer picture will emerge once the final guidance is published, but it is evident that practitioners must be prepared for what is to come. It is a brave new world for service charge disputes.