In this case, the Supreme Court considered to what extent lessees could escape what appeared to be a very bad bargain indeed. The crux of the case was: to what extent can commercial common sense defeat a contractual provision which defies it?
The case concerned a number of chalets in a leisure park in the Gower peninsula, each of which was subject to a 99 year lease from 25 December 1974.
In issue was the interpretation of the clause in the leases providing for the lessees to pay the landlord a sum for the upkeep of the site. In its earliest manifestation, in leases granted in the early 1970s, this lessee’s covenant read as follows:
“3(2) To pay to the lessors without any deduction in addition to the said rent a proportionate part of the expenses and outgoings incurred by the lessors in the repair maintenance renewal and the provision of services hereafter set out the yearly sum of £90 and VAT (if any) for the first three years of the term hereby granted increasing thereafter by ten pounds per hundred for every subsequent three year period of part thereof.”
There were, in total, 5 versions of this clause in various different leases. The remaining four versions were found in leases granted between 1977 and 1991, and in variations to older leases which were made between 1998 and 2002.
The most significant difference between this earliest version of the clause and the subsequent versions was that the latter versions provided for the charge to be compounded on an annual, rather than a triannual, basis. That is, in the leases granted from 1977 onwards (and in the varied leases), the charge increased by 10% every year.
Of further relevance was the recital to the leases, which stated that other leases were intended to be granted “upon similar terms in all respects to the present demise”. Also common to all versions of the lease was a covenant of the lessor that other leases on the site “shall contain covenants on the part of the lessees thereof to observe the like obligations as are contained herein or obligations as similar thereto as the circumstances permit.”
In circumstances in which there was very little information in evidence as to how agreement had been reached on the leases and the variations to existing leases, the lessees sought to argue that the figure given in the clause was an upper limit on the amount chargeable and not – as the lessor contended – a flat rate charge. This argument hinged on the first part of the clause referring to “a proportionate part” of the expenses and outgoings. The lessees also argued that the covenants pertaining to the similarity of leases on the site were binding upon the lessor to the effect that the sum payable by any individual lessee would be compounded only once every three years, irrespective of what that lessee’s particular lease provided. They argued that something akin to a ‘building scheme’ had been created by the covenants.
The leading judgment was delivered by Lord Neuberger, with the agreement of Lords Sumption and Hughes. Lord Hodge gave a concurring judgment, and Lord Carnwath dissented.
In the leading judgment, Lord Neuberger referred to the test set out by Lord Hoffmann in Chartbrook Ltd v Persimmon Homes Ltd1, stating that the meaning of a contract must be assessed by reference to “what a reasonable person having all the background knowledge which would have been available to the parties would have understood them to be using the language in the contract to mean”. He identified 6 factors as being relevant to this:
- The natural and ordinary meaning of the clause;
- Other relevant provisions in the lease;
- The overall purpose of the clause and the lease;
- The facts and circumstances known or assumed by the parties at the time the document was executed;
- Commercial common sense; but
- Disregarding subjective evidence of any party’s intentions.
Lord Neuberger then went on to summarise 7 principles, which may be paraphrased as:
- Commercial common sense should not be used to undermine the importance of the language actually used in the contract;
- The less clear the drafting of a provision, the more ready the court will be to depart from its natural meaning; but the court should not hunt for problems with the drafting of a contract solely in order to justify departing from its natural meaning;
- Commercial common sense must be assessed as at the date the contract was entered into, and should not be invoked retrospectively only once it has become clear that the bargain “has worked out badly, or even disastrously, for one of the parties”;
- The court should be slow to reject the natural meaning of a term merely because it appears to have been an imprudent term to have agreed, even at the time of entering the contract;
- Surrounding factual circumstances may only be taken into account to the extent that they were known or reasonably available to both parties;
- When an unanticipated event occurs, and it is clear what the parties would have intended had they contemplated or intended that event to occur, the court will give effect to that clear intention;
- Service charge clauses are not subject to any special rule of interpretation; they need not be construed “restrictively”. The meaning of the comment by Rix LJ in his judgment in McHale v Earl Cadogan2 was only that the court should not “bring within the general words of a service charge clause anything which does not clearly belong there”.
The conclusion reached by Lord Neuberger as to the interpretation of the clause in issue was that the first part of the clause, which refers to the “proportionate part of the expenses and outgoings”, is merely descriptive of what the lessee must pay for; the second part of the clause describes how much the lessee must pay. Lord Neuberger found there to be no tension between the two parts of the clause in the way contended for by the lessees. In rejecting the lessees’ argument, he stated that it was unlikely that the parties would have agreed a cap to expenditure which was so large as to be virtually meaningless.
The lessees’ argument on commercial common sense had relied to a great extent on evidence as to prevailing interest rates throughout the periods in which the leases were agreed and the variations executed. Though prevailing interest rates were high in the 1970s, they argued, it was extremely unlikely that the parties contemplated the rates remaining at that level for the entire duration of the 99 year leases. Lord Neuberger rejected this, pointing to the fact that the earliest manifestation of the clause provided for compounding at a rate well below prevailing interest rates at the time – the equivalent of roughly 3% per annum. He found that the clause was in some sense a ‘wager’ on the movement of prevailing interest rates over time, and that the outcome of that wager was immaterial to what was agreed between the parties in the first instance.
The lessees’ secondary argument – that the covenant as to the similarity of lease was binding, and something akin to a ‘building scheme’ had been intended by the parties – was also rejected. Lord Neuberger found that it was not clear whether a scheme could apply to positive as well as restrictive covenants, and that it was also unclear whether a service charge covenant could be subject to such a scheme even if it could apply to positive covenants. Secondly, the wording of the clause appears to have a prospective, rather than a retrospective, effect. That is, the covenant was that any leases granted in the future would contain similar covenants to those in the existing leases; it was not a warranty that previously-granted leases contained similar covenants. The lessees were also unable to cite any authority that such a covenant would release them of their obligation to pay the service charge to the freeholder, even if it could be construed in the way they contended. Finally, the wording of the clause itself contemplated some degree of variation between the covenants in different leases of property on the site.
The insurmountable difficulty in the lessees’ case on this secondary argument was that it involved implying a term into the lease which was inconsistent with the express provision in the service charge clause.
Lord Neuberger’s reasoning was underlined by the comments in the judgment of Lord Hodge, with the overall tenor of both judgments perhaps best summed up in the following passage:
“The role of the construct, the reasonable person, is to ascertain objectively, and with the benefit of the relevant background knowledge, the meaning of the words which the parties used. The construct is not there to re-write the parties’ agreement because it was unwise to gamble on future economic circumstances in a long term contract or because subsequent events have shown that the natural meaning of the words has produced a bad bargain for one side. The question for the court is not whether a reasonable and properly informed tenant would enter into such an undertaking. That would involve the possibility of re-writing the parties' bargain in the name of commercial good sense.”
This case is almost as interesting for what it didn’t decide as for what it did. Lord Carnwath’s dissenting judgment took a fundamentally different view of the role of commercial common sense in interpreting contracts. In his judgment, where the ordinary meaning of a clause produces a commercial nonsense, it is the role of the court to reinterpret that clause in order to arrive at a different outcome. In contrast, the majority agreed with Lord Neuberger’s judgment that the court may only embark on a process of reinterpretation where there is a plurality of available meanings to the provision in question. In that circumstance, in Lord Neuberger’s judgment, the court may disregard the interpretation which results in a commercially nonsensical outcome, and instead adopt one of the alternative available constructions of the provision – that being the extent of the court’s jurisdiction.
The difference of approach can be crudely summarised thus: Lord Carnwath would reinterpret the clause because a reasonable party wouldn’t have agreed to the effect of the provision’s natural meaning; the majority would not reinterpret the clause because the parties did agree to the effect of the provision’s natural meaning, reasonable or not. It is, perhaps, indicative of Lord Carnwath’s general approach that he referred in his judgment to the Unfair Contract Terms Act 1977 and the Regulations on unfair terms in consumer contracts,3 noting that they did not apply in the present case with some apparent regret.
The case also provides invaluable guidance as to principles of contractual interpretation which are of general application. The place of the ‘reasonable person with all the background knowledge available to the parties’ not appears to be firmly cemented – with all three judgments in this case tracking its prominence through Chartbrook,4 Mannai,5 Belize,6 and Rainy Sky.7 If it were ever in doubt, there now appears to be clarity that this is the uniform test to be applied in interpreting a contract, whether the issue is construction of the express terms, rectification, or implying terms into the contract. This approach has tended to expand the range of possible available meanings to a contractual provision, being a tool for the courts to achieve a commercially sensible outcome. However, Arnold v Britton demonstrates that the test may be applied more restrictively. It is clear that commercial common sense is only a relevant consideration if the interpretation which it prefers is already one which is prima facie available: commercial common sense cannot override the plain words of a contract.
The finding as to the scope of the application of Rix LJ’s comments in McHale v Earl Cadogan8 will also no doubt be welcome news to freeholders. The restrictive interpretation adopted by the majority ousted the application of ss.18-30 of the Landlord and Tenant Act 1985; the clause in issue was not, on the statutory definition, a service charge at all. When a lease provides for a fixed charge, this case is clear authority that considerations of reasonableness will not apply. It appears that the door has been opened to the inclusion of a profit element in service charges, though lessees and their legal representatives may well be more astute in questioning the operation of such clauses in light of the judgment in this case.
It should be pointed out that the case was not an unqualified disaster for the lessees. The freeholder indicated, via her counsel in open court, that she was willing to vary the provision to tie the charge payable to consumer price index inflation. That said, it was admittedly unclear what would be taken as the base sum in this varied provision, and whether there would be any parity with the earlier leases.
This case is a salutary warning to parties negotiating a contract of any kind, but especially a long-term contractual relationship such as a lease: mean what you say, and say what you mean.