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THE LEASEHOLD REFORM (REASONABLENESS OF SERVICE CHARGES) BILL 09 August 2022

Jonathan Gaunt Q.C., Toby Boncey, Taylor Briggs

The Bill

On 13 July 2022, Baroness Kennedy of Cradley introduced a Private Member’s Bill, the Leasehold Reform (Reasonableness of Service Charges) Bill (“the Bill”), in the House of Lords.

A copy of the Bill in its original form and the Explanatory Notes which accompanied it are attached below. Reference should be made to the Bill, the provisions of which are not fully restated here. Of course, one cannot be certain that the Bill will become law, and even if it does, substantial changes to the Bill may be made by Parliament.

The Bill is designed, according to the Explanatory Notes, to address two “significant gaps in current landlord and tenant law”.

According to the Explanatory Notes, “The first relates to fixed service charges being immune from challenge for reasonableness.” Accordingly, it is said that “Clause 1(2) of the Bill amends section 18 of the Landlord and Tenant Act 1985 to make charges that vary by fixed amounts, by an index, by a percentage or by a period of time, or by any combination of those factors, subject to an assessment for reasonableness.”

The Explanatory Notes explain that “The second relates to charges being made in excess of the cost of providing goods and services… These charges are often concealed by using companies associated with the landlord or managing agent to provide the services. This makes it hard to tell what has actually been done because all leaseholders can see is an invoice from one subsidiary to another.” Thus, “Clause 1(3) of the Bill amends section 19 of the Landlord and Tenant Act 1985 to limit service charges to the amount actually incurred by the landlord or managing agent. Where charges are made by the landlord (or an associate…), the burden of proof is reversed so that it is for the landlord making the charge to show that it is reasonable.”

The Explanatory Notes finally complain that fixed administration charges “often involve the landlord sending out a standard form licence… without significant effort” and in respect of variable administration charges, that “Leaseholders are charged at the highest hourly rates in the market for the services of… in-house surveyors, regardless of the experience of the surveyor, the quality of the service provided, or the time actually spent by the surveyor.” Thus, clause 2 “makes similar changes to those in clause 1(3) to variable administration charges, so that the landlord is required to justify the charge by reference to the costs actually incurred… the burden of proof is reversed so that the landlord has to demonstrate that the charge is reasonable.”

In addition to interesting questions raised by the Bill in relation to regulation of the landlord-tenant relationship and freedom of contract, the timing of the Bill is noteworthy. The Bill has been introduced in the Lords amidst sweeping ground rent reform, such that, if enacted, this Bill, together with the Leasehold Reform (Ground Rent) Act 2022 ("the 2022 Act"), would represent another significant change in the law applicable to long residential leases.

Reasonableness of “fixed” service charges

Service charges are regulated by ss.18-30 of the Landlord and Tenant Act 1985 (“LTA 1985”).

A “service charge” is “an amount payable by a tenant of a dwelling as part of or in addition to the rent – (a) which is payable, directly or indirectly, for services, repairs, maintenance, improvements or insurance or the landlord’s costs of management, and (b) the whole or part of which varies or may vary according to the relevant costs.” (s.18(1) LTA 1985)

The “relevant costs” are “the costs or estimated costs to be incurred or to be incurred by or on behalf of a landlord, or a superior landlord, in connection with the matters for which the service charge is payable”. (s.18(2) LTA 1985)

Thus, service charges are charges which vary or may vary according to the landlord’s costs or estimated costs.

Thus, a fixed annual charge relating to the provision of services or the costs of management is not a service charge.

Nor is a charge which is calculated by reference to the cost of providing services in a particular year, and subsequently varied by reference to some contractual formula or index, but without reference to the costs in later years of providing the services, a service charge (except in that first year): Anchor Trust v Waby [2018] UKUT 370 (LC).

In Anchor Trust v Waby, the Deputy President said:

[46]  … A particularly striking example of the non-availability of statutory protection where a charge varies by reference to a factor other than the amount of the relevant costs is Arnold v Britten [2015] UKSC 36 in which a fixed initial service charge of £90 per annum was to be increased on a compound basis by 10% every three years with the result that the charges soon far outstripped inflation and would reach a level of more than £1 million a year by the end of the term. Sections 18 to 30 have no application to such a provision as it does not provide for the charge to vary according to the relevant costs.

The Deputy President cited Neill LJ in Coventry City Council v Cole [1994] 1 W.L.R. 398:

"The reasonableness of a fixed charge can be examined at the time when the long lease is being negotiated. Assuming the fixed charge is reasonable the tenant is protected over the whole period of the lease from fluctuating and unpredictable costs. His only exposure to risk is in the risk attendant on a clause which depends on inflation."

The Upper Tribunal therefore concluded that:

[48] It would therefore be wrong for a tribunal to assume jurisdiction to consider the reasonableness of a charge which is fixed, or which varies by reference to an index…

The Upper Tribunal regarded this conclusion as being ‘consistent’ with Neill LJ’s explanation as to ‘why fixed charges made variable by an inflation index are not in need of statutory protection’. The Upper Tribunal explained that:

[54] … The charge in this case became fixed only after the first year, but the charge for the first year was susceptible to challenge under section 19. It may therefore be taken that the base charge was reasonable since, if it was not, it could have been reduced at the leaseholders’ initiative to one which was reasonable. The leaseholders were therefore protected from fluctuating and unpredictable costs except to the extent that such fluctuations were the result of inflation’.

However, this rationale might be criticised on three grounds:

1. Often, leaseholders have taken an assignment, and were never in a position to negotiate the original terms of the long lease. Similarly, the terms of long leases are often offered on a take it or leave it basis (including where leases in the same block or development contain clauses requiring other such leases to be granted on similar terms).
2. Against that, one might say that leaseholders could – and should – take legal advice before entering into a lease or assignment and that they could refuse to take a lease with unsatisfactory service charge provisions (or that they may have a remedy against their solicitor in respect of any negligent advice). However, residential leaseholders are often unsophisticated and may not fully appreciate the effect of lease terms, even if these are drawn to their attention (both mathematically, in terms of how the calculation will work, and legally, in that the original lessee may, prior to the Landlord and Tenant (Covenants) Act 1995, have been taking on a lifelong legal commitment). Prospective lessees may be subject to other pressures which might induce them unwisely to take a lease containing such provisions, such as a shortage of housing stock or increasing costs of borrowing[1]. As Lord Neuberger JSC put it in Arnold v Britton:

“Experience shows that it is by no means unknown for people to enter into arrangements which are ill-advised, even ignoring the benefit of wisdom of hindsight…”

3. Although the first-year charges in an Anchor Trust v Waby-type clause are “service charges” and hence limited to what was reasonable under s.19 LTA 1985, the management charges for the first year might reasonably include the costs associated with dealing with, say, an expensive programme of works, or another isolated event. This means that increasing such charges by reference to a formula or index would enable the landlord to recover sums (so increased) in respect of work which may not be done in subsequent years.

In relation to this element of the Bill, Parliament is faced with a somewhat binary policy choice.  

On the one hand, the view could be taken that the reasonableness of “fixed” service charges should continue to be dealt with by the parties negotiating the terms of leases, and with claims against solicitors offering negligent advice. This approach would respect the parties’ freedom of contract.

On the other hand, one might take the view (as their Lordships did in Arnold v Britton) that the consequences of some “fixed” service charges can be “plainly unattractive, indeed alarming” (per Lord Neuberger) and that cases like Arnold v Britton suggest that there may be a strong case for extending the provisions which protect tenants from unreasonable service charges.

It remains to be seen whether the parts of the Bill addressing “fixed” service charges (or something like it) will gain traction in Parliament.

Reasonableness of (variable) service charges

Section 19 LTA 1985 already applies tests of reasonableness to service charges which vary according to the landlord’s costs or estimated costs:

(1)  Relevant costs shall be taken into account in determining the amount of a service charge payable for a period —

(a)  only to the extent that they are reasonably incurred, and

(b)  where they are incurred on the provision of services or the carrying out of works, only if the services or works are of a reasonable standard;

            and the amount payable shall be limited accordingly.

(2)  Where a service charge is payable before the relevant costs are incurred, no greater amount than is reasonable is so payable, and after the relevant costs have been incurred any necessary adjustment shall be made by repayment, reduction or subsequent charges or otherwise.

A party can apply to the First-tier Tribunal under s.27A LTA 1985 for a determination of whether a service charge is payable, by reference (inter alia) to those tests.

The “gap” identified in the Explanatory Notes appears to be that charges are made in excess of the costs of providing goods or services, and that it is difficult for a tenant to obtain sufficient information to know what has actually been done to enable it to know or demonstrate whether a charge may have been unreasonable.

There is no presumption for or against the reasonableness of standard or of costs as regards service charges. If a tenant claims that the standard or the costs of the services are unreasonable, then, once the tenant gives evidence establishing a prima facie case, it will be for the landlord to meet those allegations: Yorkbrook Investments v Batten (1986) 52 P&CR 51.

However, tenants often argue that a sum claimed is “too high”, given the work it represents. The FTT will struggle in assessing such claims absent comparative evidence of market rates for the same quality of works.

As to the burden of proof, HHJ Rich QC said in Schilling v Canary Riverside Development Ptd Ltd [2005] EWLands LRX_26_2005:

“If the landlord is seeking a declaration that a service charge is payable he must show not only that the cost was incurred but also that it was reasonably incurred to provide services or works of a reasonable standard, and if the tenant seeks a declaration to the opposite effect, he must show that either the cost or the standard was unreasonable.”

However, the FTT is not obliged to accept the landlord’s case simply because the tenant fails to adduce evidence of reasonableness. In Country Trade Ltd v Noakes [2011] UKUT 407 (LC), the Upper Tribunal explained that the FTT can reject the landlord’s evidence on grounds of credibility, having invited an explanation or observations from the parties:

“The [FTT] is entitled to apply a robust, common sense approach and make appropriate deductions based on the available evidence (such as it is) from the amounts claimed always bearing in mind that it must explain its reasons for doing so. The circumstances in which it may do so will depend on the nature of the issues raised and service charge items in dispute, and will always be a question of fact and degree. In some instances, such as insurance premiums, it will be very difficult for the LVT to disallow the landlord’s claim in the absence of any comparative or market evidence to the contrary. In other cases, such as gardening, cleaning or such like, the position might be different where the nature and complexity of the work is fairly straightforward. It is only where the issue is finely balanced that resort need be had to the burden of proof.”

However, the FTT must still reach decisions based on the evidence before it and must not reach a conclusion on the basis of evidence that has not been exposed to the parties for comment: Arrowdell Ltd v Coniston Court (North) Hove Ltd [2007] RVR 39.

So, the tenant need not always adduce evidence of the market rate of particular works and services in order to succeed. However, lessees will be in a stronger position to challenge the reasonableness of particular items if they are able to adduce comparative market evidence, especially in cases where the burden of proof rests on the tenant (as where the tenant applies under s.27A LTA 1985).

Although tenants can request a summary of relevant costs (s.21 LTA 1985) and request to inspect the landlord’s supporting accounts (s.22 LTA 1985), where a landlord is invoiced by an associate or other third party, this may be all the tenant can see before embarking on a reasonableness challenge. It may accordingly be impossible to know exactly what works or services are comprised in a given item, or to obtain appropriate comparable evidence.  

Placing the burden of proof on the landlord in any given case where reasonableness is in issue and requiring the landlord to justify charges by reference to actual costs appears to be intended to ameliorate the problem of the potential information deficit on the part of the tenant.

One consequence of the proposed reforms may be that landlords will need to collate information from their associates about their direct costs of providing the relevant thing or service in anticipation of the possible need to justify service charges by reference to “out-of-pocket costs”.  This may add a greater administrative burden, the cost of which may, ultimately, be passed on to lessees.

Reasonableness of administration charges

Part 1 of Schedule 11 of the Commonhold and Leasehold Reform Act 2002 (“CLRA 2002”) makes provision in respect of administration charges. These provisions regulate administration charges in a similar – albeit not identical – manner to the regime applicable to service charges. 

Paragraph 1 defines “administration charge” as follows:

‘In this Part of this Schedule “administration charge” means an amount payable by a tenant of a dwelling as part of or in addition to the rent which is payable, directly or indirectly –

(a)        for or in connection with the grant of approvals under his lease, or applications for such approvals,

(b)       for or in connection with the provision of information or documents by or on behalf of the landlord or a person who is a party to his lease otherwise than as landlord or tenant,

(c)        in respect of a failure by the tenant to make a payment by the due date to the landlord or a person who is a party to his lease otherwise than as landlord or tenant, or

(d)       in connection with a breach (or alleged breach) of a covenant or condition in his lease’.

Unlike service charges, administration charges are not necessarily referable to any expenditure incurred or to be incurred by the landlord.

Administration charges may be either variable or fixed. Paragraph 1(3) defines a “variable administration charge” to mean an administration charge payable by the tenant which is neither specified in his lease nor calculated in accordance with a formula calculated in his lease.

Paragraph 2 provides that “a variable administration charge is payable only to the extent that the amount of the charge is reasonable”.

Clause 2 of the Bill adds new subparagraphs to paragraph 2 of Schedule 11. New paragraph 2(2) provides that, for the purposes of paragraph 2, an administration charge is only reasonable if it reflects the out-of-pocket cost to the landlord (or person providing the service for or on behalf of the landlord), taking into account various specified matters. New paragraph 2(3) provides that it is for the landlord seeking to enforce any administration charge to provide evidence of its out-of-pocket costs and to show that the administration charge is reasonable by reference to that evidence.

Issues in the drafting of the Bill

It is possible to identify certain wrinkles in the drafting of the Bill in its current form (which, should the Bill gain traction, may well be wrinkles which Parliament can iron out in due course):

1. The Bill does not amend the definition of service charges to cover fixed costs of management etc., but only to cover those costs which vary otherwise than by reference to the landlord’s costs. It remains to be seen whether this was a deliberate policy choice (the Bill being intended to be focused only on addressing Arnold v Britton-type clauses).
2. Clause 1(2) would insert a new s.18(1)(b)(i), which does not appear to fit grammatically with the rest of the section. Presumably, the insertion of a comma was intended following “costs” in s.18(1)(b), not the insertion of a new subparagraph.
3. On the face of it, the new s.19(7) only places the burden of proof on the landlord when they are “seeking to retain service charges” or “to use service charges to pay an associate”. The use of the word ‘retain’ suggests that this provision is directed at the situation where, having paid the relevant charge, the tenant seeks the return of part on the basis that it was unreasonably incurred or unreasonable in amount. This subsection does not appear to make provision for the incidence of the burden of proof in circumstances where the tenant withholds payment of the service charge, whether in whole or part. By contrast, in relation to administration charges, the Bill employs different language, making provision for the situation in which the landlord is ‘seeking to enforce any administration charge’.
4. In many cases, the narrow definition of “associate” in s.1260 of the Companies Act 2006 adopted in the Bill would not include independent managing agents. Presumably, this is because, as agents of the landlord, they are intended to be included within the word “landlord”. Otherwise, this drafting would raise the prospect of landlords being permitted to pass on the cost of unconnected managing agents (including that agent’s profit) to lessees through service charge, but not being permitted to recharge a similar profit element in respect of internal management or management provided by “associates”. It is unclear why managers who happen to be landlords or associates of landlords should be treated differently to independent managing agents and this is presumably not intended.
5. Clause 1(3) of the Bill provides for the insertion of a new s.19(6) which states that “A charge is not reasonably incurred, and a service is not of a reasonable standard, if it does not reflect the out-of-pocket cost incurred by the landlord (or an associate of the landlord)”. The term “out-of-pocket” is defined by reference to the “direct cost” of providing the relevant thing or service. However:

 

1. It is not wholly clear whether “reflect” is intended to be construed narrowly, so as to limit the landlord’s recovery to the direct cost incurred, or whether it is to be construed more broadly, so that the landlord merely has to justify the costs as reasonable by reference (but not necessarily exclusively) to those direct costs. The language of new s.19(7) may suggest that the broader construction is more likely to be appropriate.
2. The Bill does not offer any guidance as to when a cost can be said to be “direct”. Is this intended to include only costs paid out to third parties in respect of particular works or matters, or also to include internal management costs (such as an apportioned part of the salaries and overheads of the landlord’s staff arranging particular works)?
3. If the former, this may cause difficulties in respect of leases which do not provide other means of recovering these internal costs and may therefore discourage landlords from providing services internally.
4. If the latter, difficult practical questions may nevertheless arise in respect of the apportionment of salaries and overheads to particular service charge items. Further, it seems likely that landlords and/or managing agents would be required to keep more detailed records of the work done in respect of each flat and/or block. This may well result in time and costs being incurred which are disproportionate to the value of a given service charge item.  These costs could potentially be passed on to lessees if the terms of a given lease permit.
5. A further difficulty relates to comparables. Where a third party invoices the landlord in respect of work done or a service provided (including management services), that price will probably include a profit element. This will presumably be a “direct” cost to the landlord and hence recoverable, subject to the test of reasonableness. In assessing reasonableness, the price in the market will almost invariably incorporate a similar profit element. By contrast, where the landlord provides services internally, the wording of the Bill, and its emphasis on a landlord’s costs being “out-of-pocket” and direct, suggests that the landlord will be proscribed from recovering a profit element. Rather than stripping out the profit element and thereby reducing costs for leaseholders, this may only further disincentivise landlords from providing services in-house. 

 

6. There is an apparent inconsistency between new ss.19(6) and (8). While subsection (6) refers to ‘an out-of-pocket cost incurred by the landlord (or an associate of the landlord)’, the definition of ‘out-of-pocket’ in subsection (8) is narrower still, referring only to ‘the direct cost to the landlord of providing the thing or service in question’ (emphasis added). There is a similar discrepancy between the new paragraphs 2(2) and 2(4) inserted by clause 2 into CLRA 2002 Schedule 11.
7. Clause 2 of the Bill introduces a new paragraph 2(3) into Schedule 11 CLRA 2002. That paragraph, on its face, would require a landlord seeking to enforce “any” administration charge, which would on the face of it include non-variable administration charges, to show that the charge is reasonable by reference to evidence of out-of-pocket costs. It is not clear whether this was intentional.

This would impose, for the first time, a reasonableness requirement in respect of non-variable administration charges. But, unlike service charges (which, by definition, vary, even in respect of those described as “fixed” in the Explanatory Note), non-variable administration charges may include fixed sums which bear no relation to any cost to the landlord (for example, interest charged on overdue payments). Either new paragraph 2(3) would make such charges effectively irrecoverable (which seems unlikely to have been intended) or it would be difficult to see how its requirements could be sensibly applied to such charges.

8. By contrast, other administration charges may be more easily linked to some cost or expenditure on the part of the landlord. For example, the charge may relate to some task or step which is undertaken by or on the behalf of the landlord, such as the preparation of a section 146 notice. However, where this step is routine in nature, the work may be easily replicated, with the result that the costs are “front-loaded”: although the work may have a relatively high up-front cost, the cost rapidly tapers off thereafter.

At present, a landlord may elect to charge a flat fee to each tenant, thereby spreading the up-front cost between them in a rough and ready but proportionate manner. However, it seems that such a practice would not be permissible under the regime envisaged by the Bill. This engenders the possibility of differential treatment of lessees.

Consider the following example: a landlord lets flats in a block on identical leases. Under each of the leases, the landlord is entitled to charge £250 for the provision of certain information to the tenant. Pursuant to the lease, a tenant (T1) requests this information from the landlord. However, as this information has never been collated before, it takes the landlord’s solicitor several hours to perform the task. Even though the cost to the landlord of this work exceeds £250, the contractual sum operates as a cap. Assuming that this sum is otherwise reasonable, the landlord is limited to charging T1 £250. Another tenant (T2) then requests the same information. As the work has already been done, the “out-of-pocket” costs of providing this information to T2 are either nil or negligible. The landlord cannot recover the administration charge from T2. Although their leases are identical, T1 is worse off than T2, and the landlord may be unable to recover the total cost of providing the information.

9. Unlike the 2022 Act (which is prospective in effect), the Bill contains no such temporal limitation. Being retrospective in nature, its effect would be to override provisions of extant leases, representing a more significant interference with freedom of contract.

Comment

It remains to be seen whether Parliament will adopt the Bill, or some variation of it, now or in the future.

The Bill identifies and seeks to address scenarios in which the current statutory regime regulating service and administration charges has the scope to lead to unfair results. How, if at all, it may be appropriate to deal with the “gaps” identified by Baroness Kennedy in her Explanatory Note is a policy decision for Parliament.

Thought could perhaps usefully be given by Parliament to the extent to which existing (or amended) statutory mechanisms for varying leases might also be deployed to address these problems. Presently, an application can be made (albeit on limited grounds) to vary leases which do not make satisfactory provision in respect of (inter alia) service charges under Part IV of the Landlord and Tenant Act 1987. And in respect of administration charges (including non-variable administration charges), an application may be made under paragraph 3 Schedule 11 CLRA 2002 to vary a lease on the grounds (inter alia) that any administration charge specified in the lease is unreasonable or any formula specified in the lease in accordance with which any administration charge is calculated is unreasonable.

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• Jonathan Gaunt KC
• Toby Boncey

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