UK: Real Estate Bulletin - Winter 2016

Last Updated: 5 February 2016
Article by Clyde & Co LLP

Welcome to the first 2016 edition of the Real Estate Bulletin.

Consortium Commercial Developments Ltd v ABB Ltd

By Keith Conway

Previous Real Estate Bulletin articles have considered terminal dilapidations and the considerable importance of both landlords and tenants making their cases on liability and quantum clear at an early stage of any dispute in order to comply with the Dilapidations Protocol. The recent case of Consortium Commercial Developments Ltd v ABB Ltd [2015] EWHC 2128 (TCC) is an example of the court's flexible approach to analysing the expert valuation evidence should a dispute ultimately proceed to a trial and of the effect this may have on any eventual liability of the former tenant for terminal dilapidations.

Facts of the case

In 1996 Consortium Commercial Developments ("Consortium") granted a lease to ABB which came to an end in June 2011. The premises were a B1 hybrid unit located on a business park in Milton Keynes. Four years later, the disrepair existing at the expiry of the lease and failure to re-instate the premises had not been remedied. Consortium's position was that it did not want to fund the costs of the works without first recovering those costs from ABB. Consortium also wished to await an improvement in market conditions, before incurring the costs of the works and re-letting the unit. Therefore Consortium made a claim for dilapidations against ABB. Consortium's claim was limited by s.18 of the Landlord and Tenant Act 1927 to damages amounting to the diminution in value of the premises caused by the disrepair at the end of the lease.

The claims

By the time the case came to trial, surveyors instructed by the parties had agreed that the costs of reinstatement and remedying the disrepair under the lease totalled GBP 315,258.77 and that the necessary works would take 12 weeks. Consortium also claimed for loss of rent and rates over this 12 week period. This claim was based on the previous passing rent of GBP 160,000 pa and rates of GBP 728.60 pw, resulting in a further claim for GBP 45,666.24.

ABB had previously sublet the property in 2003 and, upon vacation, the sub-tenant had paid GBP 160,000 to ABB in respect of its terminal dilapidations liabilities. ABB had then made attempts to re-let the premises in its unrepaired condition with no success. ABB had refused to pay any amount to Consortium for dilapidations (not even the GBP 160,000) and Consortium therefore claimed 6% pa interest (a higher interest rate than the norm), as a means of penalising ABB for not accounting for this recovery, or any dilapidations, to Consortium.

Expert evidence

Consortium's expert valuer valued the premises in repair at GBP 1.15 million and in disrepair at GBP 600,000. ABB's expert valuer disagreed with these figures and contended for GBP 775,000 in repair and GBP 700,000 in disrepair. Therefore Consortium's case was that the diminution in value was GBP 550,000, compared to ABB's case that the diminution amounted to only GBP 75,000.

Consortium's valuer considered that the premises had a rental value in repair of GBP 77.12 psf whereas ABB's valuer's consideration of the relevant comparables produced a rental valuation in repair just above GBP 52.00 psf.

Decision

The judge was critical of both expert valuers' approaches. Judge Bartlett QC found that Consortium's expert valuer had not carried out a proper analysis of the relative relevance of the comparables used and his evidence lacked a proper explanation in relation to the in-repair valuation of GBP 1.15 million. The judge placed greater reliance on ABB's expert's valuation but found that ABB's expert valuer had not factored in appropriate adjustments to the comparables to reflect a true rental value in repair.

Using what he considered to be the most appropriate comparable, a property with a rental value of GBP 54.44psf, the judge made an upwards adjustment for the subject premises' advantages to reach a value of GBP 60.00psf (the comparable had been sold in administration, was an older building, lacked suspended ceilings and full air-conditioning and had less capacity to be converted to office use). Accordingly, this produced an in-repair value of GBP 900,000.

Most significantly, in deciding the out-of-repair value, the judge did not consider it appropriate to then use a pound-for-pound deduction ie to simply deduct the cost of repairs from the GBP 900,000 in-repair value. This was because the judge considered that a hypothetical purchaser of the premises would not bid on this basis. The judge considered the likely reduction that a purchaser of the premises would require in order to carry out the works would be only GBP 15.00 psf in the light of the comparable evidence. The result was a reduction in value of GBP 225,000 and therefore the judge concluded that the diminution in value was limited to this figure.

The judge then went on to consider a second issue: Consortium's claim for reinstatement items and statutory items yet to be carried out totalling just over GBP 16,000. The judge considered that all the reinstatement works were reasonable and recoverable in the circumstances as the items were small and all necessary to re-let the premises in good condition.

Dealing with the third issue and claim for loss of rent and rates for the 12 weeks required to undertake the works, the judge found that, due to the difficult market conditions in 2011 and the over-supply of similar properties, Consortium could not prove, on the balance of probabilities, that this loss was the result of ABB's breaches of covenant nor that it would not have been incurred if the premises had been left in good condition at the expiry of the term.

The judge also went on to reject Consortium's penal interest claim of 6% pa and instead awarded interest at 2.5% pa above the base rate, which he considered was the correct commercial rate.

Comments

Consortium recovered less than half of its original claim, whereas ABB was found liable for an amount over three times as much as it had contended itself liable. The case shows how the judge was free to use and adapt the expert evidence of both parties to form his own judgment of the appropriate damages due to the landlord. Furthermore the judge did not consider it significant that the tenant had recovered dilapidations monies from its subtenant and had still failed to carry out the required works. It is very likely that the legal costs incurred by both the landlord and tenant were substantial and this once again emphasises the importance of meaningful and realistic without prejudice negotiations.

No change here!

By Sarah Buxton

On 2 December 2015, the Supreme Court delivered its much anticipated judgment in Marks and Spencer plc v BNP Paribas Securities Services Trust Company (Jersey) Ltd and another [2015] UKSC 72. Following on from our discussions in two previous editions of the Bulletin, the Supreme Court upheld the Court of Appeal's decision that it was not appropriate to imply a term into the lease entitling the tenant to a refund of the rents it had paid in advance in respect of the period after the break date.

Prior to the High Court decision in this case, it was well established law that if the break date was in the middle of a rental period, a tenant would not be entitled to recover any rent paid in advance in respect of the period after the break date unless the lease made express provision for this.

However, the tenant successfully argued before the High Court that there should be an implied term in its lease giving rise to a right to recover rents paid in advance following the exercise of a break clause in respect of the period between the break date and the end of the relevant quarter. The judge was influenced by the fact that the tenant was required to pay a substantial premium as a condition of it exercising the break option. He felt this was a clear indication that the parties had not intended for the landlord to also reap the benefit of the rents paid in respect of the period after the break date.

The landlord appealed and the Court of Appeal unanimously overturned the first instance decision, rejecting the suggestion that the right to recover the apportioned part of the quarter's rent should be implied into the lease.

Decision

The Supreme Court has also now found in favour of the landlord, dismissing the tenant's appeal of the Court of Appeal's decision. It upheld the Court of Appeal's decision that it was not appropriate to imply a term into the lease entitling the tenant to a refund of the rents it had paid in advance on the grounds that such a term was not necessary to make the contract workable.

The Supreme Court took the opportunity to clarify the law on implied terms – essentially, in order for a term to be implied into a contract, it must be either necessary for business efficacy or be so obvious that it goes without saying. The Supreme Court placed significance in this case on the fact that the terms of the lease were very full, professionally drafted and had been carefully considered between the parties. Lord Neuberger, giving the leading judgment, also confirmed that he was satisfied that the long-standing Court of Appeal decision in Ellis v Rowbotham [1900] that the Apportionment Act 1870 does not apply to rent payable in advance should be approved.

Conclusion

The judgment will be welcomed by landlords who will be once more reassured that, save in very exceptional circumstances (for example, where the contract could not work or would lead to an absurdity), a tenant will only be entitled to a refund of rents paid in advance in respect of a period after a break date if the lease expressly makes provision for this.

As a result of this decision, prudent tenants will continue to ensure that an express right to recover the apportioned part of the quarter's rent is included in a break clause in a new lease (although landlords in a strong bargaining position may well seek to resist this). Alternatively, tenants should try to agree a break date falling immediately before the rent payment date to avoid an overpayment. For older leases which do not include such provisions, this judgment provides some certainty for the parties and should deter tenants from raising such disputes in the future.

Cavendish Square Holding BV v Makdessi: Penalties revisited

By Tim Foley

In the Autumn 2014 edition of the Bulletin we considered the question of whether large deposits in property transactions could be considered unenforceable penalties. That article considered the effect of the rule against penalties and bemoaned, in the context of deposits, the different legal treatment of penalties, as contrasted with forfeitures and the confusion caused by contrasting legal precedents.

At the end of last year the Supreme Court handed down its judgment in Cavendish Square Holding BV v Makdessi which re-stated the law on penalties, so it is worth revisiting the area to assess where the land now lies. Has Makdessi really changed the approach that parties should take?

Penalties and forfeitures: what are they?

For over 100 years the leading authority on the question of penalties was the decision of the House of Lords as set out by Lord Dunedin in Dunlop Pneumatic Tyre v New Garage and Motor Company [1914] UKHL, a decision focussed upon the difference between a liquidated damages clause and a penalty. Dunlop decided that, where a clause requires the payment of money upon the commission of a breach of contract then, provided the sum payable is a genuine pre-estimate of the loss that might flow from the breach, the clause is an enforceable liquidated damages clause. However, if the sum payable is not designed to compensate likely loss but rather to deter breach, then the clause is an unenforceable penalty and is automatically void.

However, there is a distinction to be drawn between an obligation to pay money upon a breach of contract (a classic penalty scenario), and a provision which envisages the loss of existing rights, such as the benefit of an existing deposit paid towards a purchase price. A contractual provision of this description is not a penalty but a forfeiture, since it operates on sums already paid prior to the breach, rather than extra sums which become payable because of the breach. Although there would seem to be little difference in the practical effect of each type of provision (the contract breaker is out of pocket either way) the legal treatment of them varies markedly.

Whereas a penalty is always void a contractual forfeiture is enforceable come what may, but the Court has jurisdiction to grant relief from forfeiture where the circumstances are such that it would be manifestly unfair to allow the forfeiture to take effect.

The law after Makdessi

The facts of Makdessi concerned the sale of 60% of the share capital of a large media business in the Middle East to the WPP Group of Companies by Mr Makdessi and his business partner Mr Ghossoub. Messrs Makdessi and Ghossoub intended to retain the remaining 40% of the shares. Payment was to be made in instalments over the years following the sale. Importantly the valuation of the business took account of the considerable goodwill that resided in Mr Makdessi in particular, since as founder of the business he had personal relationships with many key clients and employees. In order to protect that goodwill Mr Makdessi became subject to restrictive covenants which prevented him from setting up competing business or soliciting employees. In the event of his breach of those covenants the sale contract provided that as a "defaulting shareholder" Mr Makdessi would (1) lose his entitlement to any instalments of the price that were then outstanding and (2) become obliged to transfer his remaining shares to Cavendish upon valuation terms that were unfavourable to him. In due course Mr Makdessi breached his restrictive covenants, a fact he admitted shortly before the High Court trial, but sought to argue that the defaulting shareholder provisions were unenforceable as they were penal in nature. Cavendish won before the High Court but lost in the Court of Appeal and appealed to the Supreme Court.

In giving its judgment the Supreme Court swept away the existing legal test for the assessment of a penalty and restated it. The Court considered that Dunlop had come to achieve the status of a quasi-statutory code. The test for whether a clause is penal was restated as follows:

"The true test is whether the clause is a secondary obligation which imposes a detriment on the contract breaker which is out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation. The innocent party can have no proper interest in simply punishing the defaulter. His interest is in performance or in some appropriate alternative to performance. In the case of a straightforward damages clause, that interest will rarely extend beyond compensation for the breach.... but compensation is not necessarily the only legitimate interest that the innocent party may have in the performance of the defaulter's primary obligations."

A primary obligation is an obligation to do (or refrain from doing) something. An obligation that arises if the primary obligation is not performed is a secondary obligation. In a classic liquidated damages clause the obligation to pay liquidated damages is always a secondary obligation since it only arises if there is a breach of a different obligation of the contract.

The Court emphasised that the notion of "deterrence" did not form part of any assessment as to the penal nature of a clause as there is nothing objectionable about seeking to influence the behaviour of the other party by deterring a breach of contract (contrast the pre-Makdessi law which indicated that deterrence was the hallmark of a penalty). The Court did make clear, however, that if a clause strays into the territory of punishment then that is characteristic of a penalty. The question of whether a clause is intended to punish is to be determined by reference to whether it is "grossly disproportionate" or "unconscionable" when assessed against the innocent party's interest in enforcing the contract.

All very interesting but what's the difference?

It is a question of construction of the contract as to whether a particular clause is penal. That is a judgment that the Court has to make as at the time the contract was entered into, and not at any later stage, since what happens after the date of a contract is not of any assistance in the determination of its meaning. However in order to safely avoid a later finding that a particular obligation is penal the parties will have to ensure, when drafting the contract, that the consequences of that clause are not disproportionate or unconscionable compared to the legitimate interest in seeing the contract performed. In my view that can only be done by seeking to assess in advance the likely downside of a breach of contract as compared to the (potentially penal) consequences of the clause in question. As an intellectual exercise that seems to be no different to the putative genuine pre-estimate of loss that the law required before Makdessi. It would seem, therefore, that while the legal approach has changed the commercial approach need not.

The future

Makdessi is an interesting case but it is unlikely to be the last word in this area. Dunlop was the leading authority for 100 years and we doubt the Makdessi test will have such longevity in unrefined form as there is already academic debate about the questions that are left unanswered by the judgment. One area for potential development is the question of the different treatment of penalties and forfeitures. Back in 2014 we focussed upon the difference between the two concepts as the law as it then stood recognised a dichotomy between them. In Makdessi two law lords took the view that there is no reason in principle why a provision cannot be both a penalty and a forfeiture. While future litigation will be required to crystallise the thinking formally it would appear that the approach in future might well be as follows:

  1. Consider if the clause is penal (applying the new Makdessi test). If it is penal then it is automatically unenforceable.
  2. If the clause is not penal then consider whether it operates as a forfeiture and, if it does, whether it is appropriate to grant relief against forfeiture

Coming back to the issue of deposits in contracts for the sale of land, it was previously thought that provisions relating to the loss of deposits upon a failure to complete could not be a penalty. It is now clear that this is no longer the case. While it might be thought to be good news for buyers, provided sellers are sensible and go no further than is necessary to protect their position in the contract, the right to retain a deposit will still prove a powerful deterrent against default.

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Real Estate Bulletin - Winter 2016

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