Does my lease do what it says? Interpretation of contracts following Arnold v Britton

This article was produced by Nabarro LLP, which joined CMS on 1 May 2017.

The Supreme Court has given an important ruling on contractual interpretation in the context of a service charge dispute. In Arnold v Britton [2015] UKSC 36, the Justices held in favour of the landlord and strictly interpreted fixed service charge clauses which increase the initial sum of £90 at a compound rate of 10 per cent per year.

This means that, by expiry of the leases in 2072, the annual charge will be over £500,000 per year for a relatively modest set of services, including road maintenance, lawn-mowing, and waste disposal. In reaching its decision, the Supreme Court resisted the temptation to apply commercial common sense retrospectively, despite the uncomfortable headline facts and figures. Instead, the majority of the Justices emphasised the importance of the language used in the contract, and discounted the fact that the leases could have disastrous financial consequences for the tenants.

The court looked at the service charge clause in the leases

The service charge clauses interpreted by the Supreme Court were in leases of chalets at Oxwich Leisure Park. At face value the clauses were fixed service charge provisions which required tenants of 99-year leases to pay compound interest of 10 per cent per year on an initial service charge of £90.

The tenants argued that if the leases were interpreted this way, the service charge would be absurdly high and have disastrous financial implications for them. Instead, they submitted that the service charge clause should be interpreted so that the amount specified was a cap only, and that they were instead only responsible for a fair proportion of the landlord's actual costs of providing the services.

Lord Neuberger gave the lead judgment and emphasised seven factors (the Factors) that should be applied when interpreting contracts:

1. Commercial common sense and surrounding circumstances should not undervalue the language used.
2. The clearer the natural meaning of the words, the less readily they should be departed from.
3. Commercial common sense should not be invoked retrospectively. Just because a provision has worked out badly is not a reason for departing from the natural language.
4. Although commercial common sense is relevant to how matters would have been perceived by reasonable people when a contract was formed, a court should be very slow to depart from the natural meaning of a provision just because it appears to be very imprudent.
5. Only facts known to both parties at the time of the contract are relevant.
6. If an event occurs which was not contemplated or intended by the parties, the court will give effect to what the parties would have intended if it is clear.
7. Service charge provisions are not subject to any special rule of interpretation.

The outcome

The majority of the Supreme Court (with only one dissenting judgment) ruled in favour of the landlord. Although the 10 per cent annual increase appears imprudent now, it is nonetheless the mechanism which the landlord and tenant contractually adopted to increase the service charge and the language of the leases reflects that. Furthermore, at the time when many of the leases were completed, the annual 10 per cent increase was not as dramatic as it now appears. Although inflation has been far lower in recent years, in the 1970s and 1980s, there were a number of years when it was close to 10 per cent. Taking this into account, it is arguable that a 10 per cent increase was not lacking in commercial common sense when the leases were completed.

Clear drafting is key

For practitioners, the decision emphasises the importance of clear drafting. This is in two key respects. Firstly, the clause was interpreted consistently with the actual language used. The court rejected the tenant’s interpretation, which would have manipulated the wording and purpose of the clause, changing it from a fixed service charge into a variable service charge with a cap.

Secondly, even to the extent that the drafting in the lease was criticised by the justices, it emphasised the possibility of even clearer wording to reduce the risk of dispute in the future. This is particularly important in leases with lengthy contractual terms that may be disputed many years down the line.