That sinking feeling

In the preface to the most recently published practitioners' work on service charges (Service Charges and Management: Law and Practice by Tanfield Chambers (2006) published by Sweet & Maxwell), the authors make two most cogent points. The first is that the common law and the terms of the lease should always be the starting point for the analysis of any service charge problem. The second is that in the case of service charges arising under commercial leases, the common law is the end point as well as the starting point.There is no statutory overlay. The consequent need for careful drafting is emphasised in the two cases considered below, which focused respectively on sinking and reserve funds.

Background

The terms 'sinking fund' and 'reserve fund' are not usually seen as synonymous. The purpose of a sinking fund is generally regarded as being to provide for expenditure which may be occurred no more than once or twice during the lifetime of a lengthy lease on specific items such as lifts, central heating boilers, air conditioning plant and roofs. In that sense it is essentially a replacement fund. A reserve fund, on the other hand, tends to be established to meet recurring expenditure, such as external decoration costs, in such a way that fluctuations in the annual amounts of service charge are avoided. It is essentially an equalisation fund.

Sinking funds especially offer some very obvious advantages. The landlord will have money available before incurring major expenditure, and the tenant will not be faced with a disproportionately high service charge bill in any one year. Against that, of course, there are some equally obvious disadvantages. The tax treatment may be adverse, management and administration can be complex, and unless the fund is held on trust, the tenant may become an unsecured creditor of an insolvent landlord.

Furthermore, in the case of both sinking and reserve funds, the tenant may be required to contribute to future expenditure from which it will derive no benefit if the lease expires before the work is carried out. The following cases illustrate this particular problem for tenants.

Possfund

In Secretary of State for the Environment v Possfund (North West) Limited [1997] 2 EGLR 179 the tenant, as part of the service charge, had made quarterly payments to the landlord that were set aside in a separate fund earmarked for the air-conditioning plant serving the premises. On the expiry of the lease almost 20 years later, the money had not been spent. (At the date of the hearing the fund was worth £1m). The tenant claimed that it was entitled to recover the money.

Rimer J held that once the payments were made they became the absolute property of the landlord. They had not been made on account of future expenditure. Their purpose was to indemnify the landlord against the cost incurred by virtue of depreciation each year of the plant. In that sense they were a depreciation allowance. (One factor against the tenant's contention was an absence in the lease of any machinery for repayment.)

Southwark Diocesan

The quarterly on account service charge payments in Brown's Operating System Services Ltd v Southwark Roman Catholic Diocesan Corporation [2007] EWCA Civ 164; [2007] PLSCS 44 had produced a large surplus. The tenant requested a service charge 'holiday'. The landlord refused, and so the tenant gave six months' notice to quit pursuant to a break right in the lease. It refused to make service charge payments for that period on the basis that the landlord had sufficient funds in hand. The landlord sued for those payments, contending that the lease provisions entitled it to create a reserve fund and that fund was not repayable to the tenant, even if it had not been expended at the expiry of the lease.

The Court of Appeal held that the lease did not provide for the creation of a reserve fund, albeit that it did entitle the landlord to include in the annual service charge reasonable provision for expenditure likely to be incurred in the future. However, that was restricted to expenditure likely to be incurred during the currency of the lease. Sums remaining unspent thereafter belonged to the tenant.

RICS code of practice

In June 2006, the RICS launched Service Charges in Commercial Property: RICS Code of Practice. This has now come into effect 'for service charges commencing on 1 April 2007 or any date thereafter'. Unlike the publication that it has superseded, it has been accorded the status of an RICS guidance note. However, compliance with the Code is an entirely voluntary matter. Somewhat surprisingly, none of its 80 or more recommendations touches on the issues arising out of these two cases.

If a tenant is to avoid problems of this kind, the lease will need to make it clear whether or not the landlord is entitled to create a sinking or reserve fund, the specific use to which any permitted fund may be put and what is to happen to any sums remaining unspent on the expiry or earlier determination of the lease. Additionally, of course '“ as the Code makes clear '“ the fund should be held in a separate interest bearing account and in trust for the tenant or tenants.