Brown's Operating System Services Ltd v Southwark Roman Catholic Diocesan Corporation

This is an appeal from the decision of HH Judge Crawford Lindsay QC, sitting in the Central London County Court, in a claim in respect of service charges falling due under a lease of which the Southwark Roman Catholic Diocesan Corporation was the landlord and Brown’s Operating System Services Ltd was the tenant. Mr Geoffrey Brown is the managing director of the tenant company and he has represented his company before this court, as he did in the County Court. Judge Crawford Lindsay upheld the landlord’s claim for unpaid service charges and Mr Brown now appeals against that decision.

The landlord is the owner of a building known as St Agnes House, adjacent to St Mary’s Church in Blackheath. In the early 1980s, the whole building was let to a company owned by Mr Bernard Hills. He converted it into 5 business units. He sublet first one, then two, then three of them to Mr Brown. When Mr Hills’ lease expired in 1993, he did not renew. Mr Brown remained in occupation and entered into a new lease for three units directly with the landlord. This was for 15 years (with a break clause) at an annual rent of £38,000, subject to review.

Mr Hills remained responsible for the management of the building. His duties included the collection of service charges from the tenants. The policy in relation to the service charges was to build up a surplus from the annual charges to cover future expenditure. By 2002, this surplus had reached a very substantial sum and Mr Brown considered that that sum stood to his credit and that he should therefore be entitled to a service charge ‘holiday’. This the landlord refused and Mr Brown decided to leave. He gave 6 months’ notice to quit under the break clause and left the premises by 23^rd June 2003. He refused to pay the last two quarters’ service charge, which amounted to almost £10,000. The landlord sued for that sum with interest. It also claimed some other small sums but no issue arises about them on this appeal. Mr Brown defended the claim alleging that the money held by the landlord as surplus had been more than enough to cover the two quarters’ service charges. He also counterclaimed for the sum of £2,263.54 which he alleged was still held by the landlord to his credit. The judge held that the surplus was a reserve fund that had been built up for the benefit of the building and that the landlord was entitled to retain it at the end of the lease. Thus, Mr Brown had not been entitled to refuse to pay the charges for the last two quarters of his occupancy. The counterclaim also failed.

It is convenient at this stage to set out the relevant terms of the lease. The tenant’s covenants were set out in clause 4. Under a sub-heading ‘Service Rent’ Clause 4(4) provided that the tenant was obliged:

Clause 1 provided definitions and 1(a)(9) provided:

The landlord’s covenants were set out in clause 5 of which subclause 3(a), headed ‘Repair and Services’ provided:

Part 1 of the Second Schedule comprised a list of the services which the landlord had to provide in pursuance of his clause 5(3)(a) obligation. These were the usual things, such as repairs, maintenance, cleaning of the building, its common parts, gardens and car park. Heating was to be provided, insurance arranged and rates and taxes paid. Part II of the Second Schedule comprised another list covering the landlord’s powers to provide staff and pay rates and taxes, management and administration expenses. Also, at (c) the list included:

Schedule III was headed ‘Calculation of the Service Rent’ and covered the practical operation of the service charge arrangements. Paragraph 1 provided that service charges were to be calculated by reference to an accounting period. In practice this became the year from 1^st April to 31^st March. Paragraph 2 provided that the Service Rent for Mr Brown’s 3 units was 68.25% of the Total Service Cost. Paragraph 2(b) provided that, at the beginning of each accounting period, the landlord would give the tenant an estimate of the Total Service Cost for the coming year and the tenant would pay his share of it in advance in four equal instalments on the usual quarter days. Thus, in the course of a year, Mr Brown would have to pay four instalments of 68.25% of the estimated Total Service Cost.

Para 2(c) provided:

Standing alone it would seem that that provision would entitle a tenant to have his share of any retained excess used immediately at the start of the next accounting period, by having it set off against his first quarter’s estimated service rent. However, that was not apparently what was contemplated because, under paragraph 2(d) of the Third Schedule, it was provided that:

It seems clear that, when paragraphs 2(c) and 2(d) are read together, the lease did not entitle the tenant to set off any excess that had arisen from the payments on account during the year against the first instalment of the following year. Rather, the lease provided that any excess arising from the payments on account was to be retained by the landlord (together with any sums (if any) in reserve) until such time as the sums estimated as being necessary for the year proved insufficient for the work actually done and the landlord needed to draw on the excess and reserve. Then, the Landlord would have to make use of the excess and/or reserve before making any further demand from the tenant.

Clause 4 of the Third Schedule provided:

It was apparent from documents before the judge and before this court that, what happened in practice was that, at the beginning of each accounting period, Mr Hills would send to Mr Brown a demand for service rent for the forthcoming year. In fact, the total service cost (apparently estimated) for each of the years 1993/94, 1994/95, 1995/96, 1997/98 and 1998/99 was £17,000.04. Mr Brown would pay his share on the quarter days. At the end of each year, Mr Hills would send the tenants an audited statement of the actual sums expended during that year. If the amount received on account pursuant to the demand made at the beginning of the year exceeded the actual expenditure, the excess was described as ‘Allowance for Future Repairs Renewals and Redecorations Carried Forward’. The amount so ‘carried forward’ was the exact difference, to the penny, between the amount received from the tenants and the amount spent.

At the end of each year up to March 1997, the amount demanded and paid by instalment was always more than was required for the year’s actual expenditure. A surplus of £9,942 had accumulated, on which the share attributable to Mr Brown’s contributions was £6,785. In the year ending March 1998, the actual expenditure exceeded the estimated amount which had been paid by the tenants and the landlord drew on the surplus, reducing it to £6,375. The following year, expenditure again exceeded the amount collected and it was necessary to draw on the surplus. However, the landlord did not exhaust the surplus; he used some of it but also made an additional demand on the tenants. At the end of that year, March 1999, the surplus stood at £3,005. Soon afterwards, in fact on 19^th May 1999, Mr Hills wrote to Mr Brown giving notice of the landlord’s intention to increase the annual service charge from £17,000 per annum, at which level he said it had been fixed for 12 years. (That meant that it had been held at that level for some years under the old lease). He explained that costs were rising and it had been necessary to raise an additional levy during the past year for external decoration and new security locks. He then said:

Mr Brown wrote back complaining about three matters, two of which are germane to the present dispute. First he complained that that the landlord had levied an additional sum during 1998/99 instead of using up the whole of the retained surplus. The landlord’s explanation for that, which Mr Brown did not accept was reasonable, was that there had been a cash flow deficit in the middle of the year when the work was being carried out and it had been necessary to raise an additional levy. Mr Brown’s point was that no levy should have been raised because, when the regular instalments came in later in the year, the situation would have been put right. Second, he complained about the size of the increase in the service charge. His complaints appear to have fallen on deaf ears.

After that time, Mr Hills’ practice remained exactly as it had in the past. He served a demand at the beginning of the year and, if there was a surplus at the year end, he designated that as an allowance for future repairs and renewals. By the end of March 2000, the surplus had increased to £7,690. In the following year, (2000/2001), the demand at the beginning of the year was raised to £24,720 but expenditure outstripped that sum and the surplus was drawn upon, reducing it to £6,026. In 2001/2002, the demand was for £25,440; expenditure was low and the surplus increased to £15,081. In 2002/2003, the demand remained the same (£25,440) and the expenditure was such that the surplus would have increased slightly to £15,516. However, by that time, Mr Brown had been refused his ‘service charge holiday’ and had decided to quit and refused to pay the last two instalments for that year.

Unfortunately, there is no transcript of the judgment of HH Judge Crawford Crawford Lindsay QC. It appears that the tape on which his ex tempore judgment was recorded has been lost. Fortunately, the landlord’s counsel kept a note. Judge Crawford Lindsay has seen it and accepts that it represents his reasons but observes that his judgment was longer than the note would suggest. It is adequate for our purposes although far from ideal.

Before the judge it was argued for the landlord that paragraph (c) of Part II of the Second Schedule permitted the landlord to create a reserve fund for future repairs and renewals etc. That the landlord had done. It had put into the reserve fund the surplus (if any) at the end of each financial year. The audited statements showed these sums and the accumulated sum, describing them as ‘Allowance for future repairs and renewals carried forward’. The fact that the sums allocated to the reserve fund were exactly those sums by which the demand had exceeded the actual expenditure in that year was nothing to the point. Mr Hills gave evidence that he did in fact assess the future needs of the building when deciding what to demand at the beginning of the year. The judge accepted that evidence.

Mr Brown’s main contention was that, under the definition clause, the only costs that could be included in the Total Service Cost were costs, charges, fees, expenses or outgoings which had actually been paid, discharged or incurred. It was an abuse of language to say that a reserve for future outgoings comprised sums that had been ‘paid, discharged or incurred’.

The judge rejected that argument holding that setting aside a sum into a reserve fund could be said to be a ‘sum incurred’. He held that the surplus sums were held in a reserve fund. The only question was to whom did it belong when the lease came to an end?

On that issue, the landlord contended that the reserve fund was built up to defray liabilities that would in the future fall upon the landlord. The sums in the fund were not recoverable by the tenants even if the anticipated works had not been carried out when the lease was determined. The landlord relied on a decision of Rimer J in Secretary of State for the Environment v Possfund (North West) Ltd and others [1997] 2 EGLR 56. In that case, the lease had contained a provision requiring the tenant to pay a depreciation allowance in respect of the cost of maintaining and replacing certain fixtures and fittings, in particular the air conditioning plant. The sums accumulated under that provision had not been expended on the replacement of the air conditioning plant when the lease came to an end. The reversion then changed hands and the tenants entered into a new lease. The former landlord transferred the depreciation fund to the new landlord but the tenant claimed that it should be returned to it. Rimer J held that, on a true construction of the lease, once the sums were paid into the depreciation fund, they became the landlord’s absolute property. One of the factors the judge mentioned in construing the lease was that there was no provision in it for the return to the tenant of unspent funds at the end of the lease. That pointed to an intention that the landlord should keep them. However, the main ground of his decision was that the sums had been paid into a separate fund earmarked for the replacement of the air conditioning plant. The air conditioning plant had a finite life expectancy which was not necessarily co-terminous with the lease. The contributions to the depreciation fund were intended under the lease to go towards the cost of replacing the unit whenever that was necessary, regardless of whether the lease had already ended.

Judge Lindsay observed that the facts of Possfund were different from those of the instant case and that the lease contained different provisions. However, he said that ‘the principles considered there could be applied here’. He noted that in the present case, as in the Possfund lease, there was no provision for the return to the tenant of monies held in the reserve fund when it came to the end of the lease. In the absence of such a provision, he inferred that it must have been in the contemplation of the parties that the amount in the reserve fund might exceed expenditure during the lease. He then concluded that any sum remaining in the reserve fund at the end of the lease must belong to the landlord. He said that he was applying ‘the principles’ of Possfund.

Several other issues were raised. Mr Brown complained that there had been no consultation about the service charges as required by paragraph 4 of Schedule III. The judge held that there had been some consultation but that in any event consultation was not a condition precedent to the recovery of service charges under the lease. Mr Brown had also argued that the accumulation of a surplus or fund was supposed to be for the benefit of the building and its tenants and had to be applied during the currency of the lease. Anything left over belonged to the tenants. The judge rejected that argument. He accepted that the reserve fund was for the benefit of the tenants in that it would avoid the need for sudden demands for capital sums to carry out repairs during the lease but he did not accept that the tenant’s contribution to any sum left over at the end of the lease should be returned to him.

Finally, Mr Brown relied on a balance sheet prepared by Mr Tate, the accountant who also prepared the annual audited service charge statements. This was for the year 1995/96 and it showed the accumulated surplus as a tenants’ asset. Mr Tate had told the judge that he did not produce a balance sheet for any other year besides 1995/96 but that, if he had done, the surplus would have been treated in the same way as it had been treated in that year. It appears from the note of the judgment that we have that the judge did not mention or deal with this point. As I have said, the judge gave judgment for the landlord on the claim and counterclaim.

Permission to appeal was granted by Tuckey LJ on only two of the grounds advanced in the application for permission. These were, first, that the judge had erred in failing or refusing to take into account the balance sheet which, in Mr Brown’s submission clearly showed that the accountant had treated the surplus as a tenants’ asset. Second, the judge had been wrong to follow Possfund. Tuckey LJ deferred a decision on a further ground, leaving it to this court at the hearing of the appeal to decide whether permission should be given. At the end of the hearing, Mr Brown abandoned this last ground and nothing more need be said of it.

Essentially, the same arguments were repeated on appeal as had been advanced before the judge. Because it appeared to us that the real task of the court was to construe the meaning of the lease, we allowed the parties to address us on all issues relating to the lease.

Mr Brown’s first contention was that the definition of the Total Service Cost was such that it did not and could not cover the making of any provision for future costs; it could cover only costs already incurred. I would agree that the language of the definition clause, referring, as it does, to costs etc paid discharged or incurred (in the past tense) does not sit easily with the inclusion of any provision for future repairs etc. However, paragraph (c) of Part II of the Second Schedule allows the landlord to include in the Total Service Cost such sum as the landlord shall in its reasonable discretion think fit as being reasonable provision for expenditure likely to be incurred in the future in connection with the matters mentioned in that schedule (save for future management fees). So, notwithstanding the inappropriate definition of the total service cost, I would hold that the judge was right to say that the lease did contain a power to include in the total service cost some provision for future repairs and renewals. However, it should be noted that such provision could only extend to expenditure likely to be incurred in connection with the matters mentioned in the Schedule. I would construe that provision as permitting the inclusion of future expenditure only to the extent as was likely to be incurred during the currency of the lease. That, to my mind, is an important factor. The tenant’s duty was to pay service charges during the currency of the lease and the landlord’s right to make future provision extended only to such expenditure as was likely to be incurred during the currency of the lease. I will return to that point later.

Mr Brown submitted that what the landlord had done did not amount to the exercise of discretion to include a provision for likely future repairs. If the discretion were to be exercised, one would expect a specific sum to be identified as being the appropriate future provision and one would expect to see something identified in each year. Instead, the landlord simply allocated to future repairs whatever excess (if any) remained unspent at the year end. In some years, there was no such provision; it all depended on what had been spent in that year. That was not an exercise of discretion. In reality, submitted Mr Brown, the sums that were surplus at the year end should properly have been regarded as excess ‘retained on account of any future Service Rent payable by the tenant’ pursuant to paragraph 2(c) of the Third Schedule. I would agree with Mr Brown that what actually happened did have more of the appearance of the retention of excess under paragraph 2(c) than the creation and maintenance of a reserve fund. That said, it is first necessary to decide whether the lease, properly construed, envisaged the creation of a reserve fund and, if so, what was its purpose.

As I have said, in my view, the lease permitted the landlord to include in the total service cost a reasonable sum for future repairs and renewals. However, the lease did not provide for the creation of a reserve fund. Nowhere in the lease does the expression ‘reserve fund’ appear. The nearest approach to such a provision is at paragraph 2(d) of the Third Schedule where there is reference to money held ‘in reserve’ by the landlord as authorised by the Second Schedule. In fact, the Second Schedule does not mention holding money ‘in reserve’; it mentions only including some provision for future expenditure within the Total Service Cost. Plainly the lease is not well drafted. However, I would be prepared to hold that the reference to holding money ‘in reserve’ in the Third Schedule must relate back to the power to include provision for future expenditure in the Second Schedule. But that is not to say that the money held in reserve is a ‘reserve fund’. Indeed, paragraph 2(d) of the Third Schedule suggests that the money ‘held in reserve’ is to be lumped together with any excess retained at each year end and is to be used to satisfy any expenditure in a particular year before any additional demand may be made upon the tenants. In short, far from being a reserve fund designed to cover the cost of any specific repair or renewal, it appears to me that the money held in reserve and the excess retained in a year of light expenditure are both to be treated as sums which will be used to meet the costs incurred in a year of heavy expenditure. In short, these are sums which will help to even out the demands made upon the tenants during the course of the lease.

The real question in issue, as it seems to me, is whether the money held by the landlord (whether held in reserve or retained as excess) was held to its own account or to the account of the tenant. The judge held that that money was held to the landlord’s account. It is apparent that, in so holding he relied heavily upon the decision of Rimer J in Possfund. Mr Peters for the landlord submitted that the judge was right to do so. I do not agree and I consider that the judge fell into error in thinking that Rimer J was laying down any principles of law. He was not; he was simply construing the lease in that case. The lease in that case was different in a number of material respects from the lease in the present case. It is not necessary to set them all out and compare and contrast them. Suffice it only to say, by way of important example, that the lease in Possfund contained a specific provision for the creation of depreciation allowance fund in respect of a specific item of plant, the air conditioning system. In construing the lease, Rimer J mentioned that there was no provision in the lease for the return of the unspent contents of the depreciation fund at the end of the lease; he regarded that as a pointer towards the conclusion that it was intended that the fund belonged at all times to the landlord. But he was not saying that, if a lease does not contain an express provision for the return of a ‘reserve fund’ or ‘money held in reserve’, it will follow that the money belongs to the landlord. He was not saying anything about leases in general; only about the lease he was construing. In my view, Judge Lindsay was wrong to attempt to apply any principles from Possfund to the present case. There were none to be applied.

Accordingly, it is necessary for this court to construe the provisions of this lease and in particular to decide what was intended should happen to any money held by the landlord when the lease came to an end. Mr Brown submitted that in construing the lease, it was important to see how the accountant had dealt with the money ‘held in reserve’. The balance sheet for 1995/96 showed the surplus as ‘Tenants Service Charge reserve’. Not only was the fund described in that way, it was apparent from the layout of the balance sheet that these sums were not treated as a provision for future liability to repair. Rather they were treated as the equivalent in a company balance sheet of the shareholders reserve or distribution fund. I would therefore accept Mr Brown’s submission that Mr Tate, the accountant, treated the money held by the landlord as being held to the tenants’ account. However, in my view that is not a decisive point as Mr Brown submits. Mr Tate might have been wrong. What matters is what the lease meant and that is a matter of law, initially for Judge Lindsay but now for this court.

There is no provision in the lease dealing with what should happen to any unspent money still held by the landlord at the expiry of the lease. Mr Peters contended that, absent such provision, it should be inferred that the landlord should keep any surplus. The landlord had exercised its discretion to set aside such sums as it reasonably anticipated would be required during the lease. It could not be right that, just because the works had not been accomplished during the lease, the landlord would have to return the unspent balance. I do not accept that submission. In my view, the lease required only that the tenants pay for the works reasonably required during the lease. There was no obligation upon them to contribute to any future works, after termination of the lease. In my judgment this lease did not create a fund designed to cover the obligations which the landlord would have to meet at some future time, possibly after the currency of the lease.

Mr Peters submitted that, even if the landlord might have had to return unspent money left over at the end of the lease, it was unthinkable that it should have to return a tenant’s share of the unused balance at the date of premature termination. I can see that, if the lease were forfeit on account of the tenant’s breach of covenant, the landlord might well be aggrieved if it had to return money it had been holding in anticipation of works to be carried out at a later date but during the currency of the lease. Of course it would be open to a landlord to make express provision that sums held should remain its property or to make a provision such as appeared in the Possfund lease, where there was held to be a special depreciation fund allocated to cover a specific replacement whenever it took place, whether before or after the termination of the lease. No such provisions were made. It is possible (and it is not necessary to consider the point in this appeal) that, if the lease were terminated by forfeiture on account of the tenant’s breach of covenant, the landlord might be able to recover, as damages, the money it was holding in anticipation of works to be carried out during the currency of the lease.

If I refer back to what I said in paragraphs 27 to 29, in my judgment, the money held by the landlord was either money ‘held in reserve’ pursuant to paragraph 2(c) of the Second Schedule or it was excess retained by the landlord pursuant to paragraph (c) of the Third Schedule or it might have been a mixture of the two. Left to myself I would have held that it was excess retained under the Third Schedule. However the judge held that it was money ‘held in reserve’ pursuant to Schedule 2. He heard Mr Hills give evidence and, although I doubt that what occurred could properly be described as an exercise of reasonable discretion, I am prepared to accept that the judge was entitled to hold as he did. However, that said, in my view it makes no difference at all whether the sum held by the landlord was ‘held in reserve’ or retained as excess, because whichever it was it fell to be treated in the same way. The only provision relating to what should happen to the money held by the landlord is paragraph 2(d) of the Third Schedule which provides that that money (whether money held in reserve or retained as excess) is to be applied to meet any authorised expenditure in each succeeding year. Only when the money held by the landlord has been exhausted can the landlord make a further demand or levy upon the tenant.

That paragraph, in my judgment, provides the answer to the question posed in this appeal. From that paragraph, I would infer that any money unspent at the end of the lease belongs to the tenants. It has been held by the landlord ready to be used for the benefit of the tenants in any year in which the authorised expenditure exceeds the amount collected from the tenants. It has been held ready to be used to reduce the amount which the tenants would otherwise have to pay. Its purpose was to even out the demands made on the tenants, to protect them from any sudden demand for a large sum.

In my view, the terms of this lease left the landlord obliged to return to the tenant any unspent money it was holding at the date of termination, whether termination was by effluxion of time or the operation of a break clause.

For the reasons I have given, I would allow the appeal. In my judgment, Mr Brown was entitled to have returned to him his share of the sums held by the landlord at the date at which he terminated the lease under the break clause. Accordingly, the landlord was not entitled to recover the two instalments of service charge which Mr Brown withheld during the six months notice period. Also, the landlord has wrongfully retained the balance of Mr Brown’s share of the sums held, which sums he sought to recover under his counterclaim.

For my part I readily accept:

It is, however, to be noted that the lease nowhere authorises the landlord to set up a reserve fund separate from or as a separate part of the Total Service Cost and the landlord never in fact set up such a fund. The lease contemplated that sums for future expenditure should be part of the Total Service Cost and that is how the parties treated them. It is further to be noted that, by virtue of clause 2(d) of the Third Schedule, if the landlord wished to pay discharge or incur any costs or expenses authorised by the Second Schedule, it could only demand further sums by way of Service Rent if the money held by the landlord (whether by way of reserve or on account of the Service Rent) “shall be insufficient” for the purpose. This likewise shows that the lease contemplates one “pot” although there may be two separate ways for the tenant’s money to get into that “pot”.

In these circumstances, the provisions of clause 2(c) of the Third Schedule apply to all sums provided by the tenant whether they originate from a demand made pursuant to clause II(c) of the Second Schedule or a demand made pursuant to clause 2(a) or (b) of the Third Schedule. They are sums payable and receivable on account of the Service Rent and, if in excess of the Service Rent actually due, that excess can be retained by the landlord “on account of any future Service Rent payable by the Tenant”.

If the lease had expired by effluxion of time as it would have done in 2008 (had it lasted so long), the landlord would not be entitled to continue to retain any excess since it would have been paid on account of future service rent and no such service rent would continue to be due. The fact that the tenant has exercised his right to bring the lease to an end pursuant to a break clause cannot make any difference. Different considerations might well arise if the lease had been brought to a premature end by the tenant’s own breach of covenant, as my Lady says in paragraph 33 of her judgment.

For these short reasons which are no different from those given by Lady Justice Smith I would allow this appeal and give judgment dismissing the claim and for the defendant on the counterclaim.