Commercial service charges – when are they reasonable?

Background

The claimant, Criterion Buildings Ltd, is the landlord of One Jermyn Street, part of the Criterion Building at Piccadilly Circus; and the defendant, Mckinsey and Company Inc. United Kingdom, is the former tenant of the property.

The claimant’s interest in the property was pursuant to a headlease dated 7 August 1992 and the defendant’s interest was pursuant to an underlease dated 12 March 1993, a supplemental lease dated 21 December 2005 (the leases) and a deed of variation of the same date.

The claimant landlord issued proceedings against the defendant tenant for non-payment of service charges in the sum of £2,232,259.65, plus costs and interest.

The issues in dispute at the date of the trial were as follows:

1. apportionment: the way in which service charges are apportioned between the various sub-tenants of the claimant as head lessor
2. sinking fund: the sinking or reserve fund contributions said to be due by the sub-tenants
3. goods lift: the cost of works to goods lifts in the property, and
4. set off: a separate issue relating to a question of possible arrears of rent, arising out of a claim to set off.

The decision

1. The apportionment issue – the claimant landlord won

It was accepted the defendant covenanted to pay a “due proportion” of the total costs and expenses expended by the claimant in providing the services defined in the leases. “Due proportion” was defined as “a fair proportion to be determined” by the claimant, taking into account “the use made of and the benefit received from the services and expenses and each of [the tenants]”.

However, the defendant contended the method by which the “due proportion” was calculated was flawed, resulting in the proportion charged to the defendant being unfair and favouring another tenant (the Criterion Restaurant and Theatre) at the defendant’s expense.

This case is a timely reminder the burden of proof lies with the tenant to show the landlord has acted unreasonably

The claimant’s case was that it had only ever demanded a due proportion calculated by reference to the internal floor areas of the tenants’ demise (albeit disregarding the demise occupied by Lillywhites, which was accepted) and this method of apportionment had been revised in 2014 by the claimant’s managing agents as the previous six-schedule method was too complex. The claimant contended the two-schedule method of apportionment, with which the previous six-schedule method was replaced, did not require revising further.

It was acknowledged by the court there was a disparity in relation to the Criterion Restaurant and Theatre and this was on the basis the auditorium area is only occupied on the ground floor, due to the balconies of the theatre. On this basis, the Criterion Restaurant and Theatre’s proportion of service charge was reduced.

The court held that in determining a fair proportion, the claimant was able to make a subjective decision as to apportionment, provided the decision is rational. The fact the leases provide the claimant was required to take into account the use made of the respective demises was, therefore, of relevance. In order to challenge the landlord’s decision, the defendant would have had to show the claimant acted irrationally in devising the methodology for apportionment; the court held the defendant had not been able to show any such irrationality and therefore the “due proportion” charged to the defendant was fair.

2. The sinking / reserve fund issue – the claimant landlord won

The defendant’s case on this point was that it had been overcharged by some £1,505,782.75 between June 2015 and June 2019, as the claimant had charged for contributions to a sinking or reserve fund which were not contractually due under the leases. Specifically the defendant claimed the claimant did not distinguish between amounts charged for a sinking fund and amounts charged for a reserve fund, going so far as to say the claimant did not properly establish a sinking or reserve fund in accordance with the terms of the leases. Further the defendant suggested that the claimant had funded “routine service charge expenditure through demands for … a contribution to a sinking fund”. The claimant denied the allegations.

The court considered what, precisely, the claimant’s managing agent did and whether the certificates it produced, and the calculations on which such certificates were produced, were in accordance with the terms of the leases. The court held the claimant had complied with the terms of the leases, as they produced a number of certificates at the end of each service charge year and those certificates showed clear contributions to a sinking and reserve fund; there was no requirement, on the basis of the terms of the leases, for the landlord to go further and provide its reasoning as to how the sums are arrived at.

Again, in order to challenge the determination of the claimant regarding the sum/amount of the service charge sinking fund/reserve fund, the court held the burden of proof was on the defendant to show the determination was not reasonable. The court considered the evidence on which the defendant relied was insufficient to show the claimant’s decision was unreasonable or in manifest error and therefore decided this issue in the claimant’s favour.

3. The goods lift issue – the claimant landlord won

The defendant challenged the sums charged (though not the quantum of them) via the sinking fund for the modernisation or replacement of the goods lifts in question, in the year 2017 to 2018. This issue fell to be determined by the court on the basis of various expert reports and whether the claimant properly demanded sums at the time it did, based on the reports which it had obtained specifying when such replacement works ought to be undertaken.

The court considered the claimant acted reasonably in exercising its discretion to build up a sinking fund for the purposes (amongst other things) of the replacement of the lifts in question and, therefore, the sums had been properly charged.

4. The set-off issue – the claimant landlord won

This issue relates to a provision in the deed of variation whereby the defendant was entitled to reimbursement of certain costs relating to the “Tenant’s Works” carried out in December 2010, subject to providing the claimant with a receipted invoice issued by the contractor. If the claimant failed to reimburse the defendant as required, the sums could be offset against rent due.

This issue rested on whether the invoices provided to the claimant which the defendant was claiming were “receipted invoices” within the meaning of the deed of variation. The court found “the phrase ’receipted invoice’ in clause 2.2 of the deed of variation in the plain and ordinary meaning of the words used refers to an invoice which has been endorsed by or on behalf of the invoicing party so as to acknowledge that the invoice has been paid. This is not that case…”.

On this basis, none of the invoices in question were held to be “receipted invoices” and, therefore, the defendant was not entitled to reimbursement or, in the event of a failure to reimburse, set-off of those sums.

Commentary

This case is of significance for practitioners advising on the reasonableness of commercial service charges when acting for both landlords and tenants.

It is important to bear in mind, in the first instance, a landlord must act in accordance with the terms of the lease. Service charge provisions are often complex and the wording of any particular service charge clause requires careful consideration when determining if the landlord has indeed complied with it.

However, where the matter in question is how the landlord/landlord’s managing agent has come to its determination, in circumstances where the landlord or its agent/surveyor has a discretion, then this case is a timely reminder the burden of proof lies with the tenant to show the landlord has acted unreasonably.

On the basis of this case, tenants will need to show not simply that service charges are too high, but that a landlord has failed to properly apply its discretion. At a time when tenants will be at pains to reduce their service charge liabilities if at all possible, they will at the same time need to be able to provide the evidence necessary to show a landlord has acted unreasonably, irrationally or in manifest error; therefore, commercial tenants will need to think carefully when considering the benefit of bringing claims for unreasonable service charges.