Question 1

Service Charges

Accepted Answer

Q: We are a residents’ association, we own the freehold and self manage a block of 27 residential flats. Since acquiring the freehold in 2006 leaseholders have not been required to pay ground rent. An amount equivalent to the ground rent was added to each leaseholder’s service charge payment in 2006. This arrangement has continued to the present time. The company has no sources of income other than service charges paid by leaseholders. The current board of directors (who are all leaseholders & residents) has recently begun a review of the way the company conducts its operations. We are concerned that our lease, as currently worded, may not give us the authority to use leaseholders service charges to pay for all the services that we consider to be necessary for running and maintaining the properties. Particular areas of concern are: 1. Company running/admin costs. Does our lease allow for payment of the following from service charges: (a) Fees for legal and other professional advice. (b) Payment of an honorarium to the Company Secretary. (c) Annual accountancy fees/Companies House fees. 2. Works of improvement. We are keen to undertake projects that would enhance the appearance (and hopefully the value) of the properties. This has been debated with leaseholders/shareholders at recent AGM’s and we have received positive support from them for our views. We are uncertain, however, whether expenditure on works of improvement is allowed by our lease. Are there guidelines as to what constitutes works of improvement as opposed to maintenance? 3. Sinking fund. Any surpluses of income over expenditure that may arise in a particular year are accumulated by the company and held in reserve to pay for major works such as roof renewal. In our 2016 accounts we formally established, for the first time, a sinking fund on the face of our balance sheet. Again we are unsure as to whether or not this is permissible under the terms of our lease. Any advice or guidance that you could give on these matters would be much appreciated FPRA Legal Adviser Nick Roberts replies: A: I am not entirely clear what you mean when you say that the Company discontinued the collection of ground rent when the freehold was acquired in 2006, but that an equivalent sum has been added to the service charge since then. This is all rather illogical, though I can see how the misunderstanding may have arisen. People tend to equate paying ground rent with not owning the freehold, and so, when the freehold is acquired, they expect not to have to pay ground rent any more. But this is not really so. It is the Company that has acquired the (collective) freehold: each leaseholder has not acquired the freehold to his or her individual flat. The lease remains fully in existence. In fact, FPRA recommends that it may often be appropriate for a Residents’ Management Company (RMC) which has acquired its freehold to continue to charge ground rents expressly so that it can cover items of incidental expenditure – chiefly relating to the company itself – which do not form part of the service charge. The specimen lease that I have sight of suggests that – at least in that case – the original 1973 lease was replaced by an extended lease in 2001 and that in turn was replaced by another extended lease in 2016 which was granted pursuant to the Lease Extension provisions of the Leasehold Reform, Housing and Urban Development Act 1993. Such leases MUST be for a peppercorn ground rent: the Act leaves no scope to depart from this. It is not clear to me whether all leaseholders now have extended leases under the LRHUDA 1993, or only some. I have come across cases of RMCs who have acquired their freehold, and – as they have no particular need to charge for extended leases – offer extended leases at a nominal price, provided that certain changes are made to the lease (particularly in respect of what can be included in the service charge). This seems like a good strategy: if leaseholders refuse this deal, and insist on extending under the statutory provisions of the LRHUDA, they could then be charged the same substantial premium for a lease extension that an outside ground landlord would charge. You ask some specific points, and I shall do my best to answer them. I shall answer them all, but the narrative will flow better if I take some out of order: 1. Company running/admin costs (a) fees for legal and other professional advice. The general principle is that, in order to recover expenditure, the ground landlord or RMC must be able to point to a specific provision of the service charge provisions of the lease. Leases tend to be restrictively interpreted here, because a lot of the case law relates to cases where outside ground landlords are trying to claim for items above and beyond what the lease envisaged. I am afraid that I think it is doubtful that these are included, as I do not think they would generally be taken to fall within the scope of ‘the administrative and office and other incidental expenses of the Company in effecting its incorporation and initiating and running its business’ (see clause 4(4)). One could argue that they should, but the words do more naturally seem to refer to something different (see below). (c) Annual accountancy fees / Companies House fees I think these can be included in the service charge, as they clearly do fall within the scope of clause 4(4): ‘the administrative and office and other incidental expenses of the Company in effecting its incorporation and initiating and running its business’. You are in a sense lucky here: if one had a lease with an outside ground landlord and no RMC then company expenses of this kind would not have been included, but here, as you had what is known as a tripartite lease (i.e. a lease with a ground landlord, separate RMC, and a leaseholder) it was seen as necessary from the outset to provide from the RMC’s company expenses. (b) Company Secretary’s Honorarium. I am not sure of this: I would suspect not. As stated above, service charge provisions in a lease tend to be strictly construed. A Company Secretary is an Officer of the Company, but is only an employee (see clause 4(4)) if there is a contract of employment. One could employ someone to be the Company Secretary – it is what most large commercial concerns do – but, although people refer to ‘honorariums’ with different meanings, I think in this context the payment of an honorarium generally means that there is no employment contract as such as the parties wish to avoid the complications that would result from this. 3. Sinking fund Although this is not expressly mentioned in as clear terms as one finds in many leases, I have no doubt that a Court or Tribunal would find that the Company does have power to set up a sinking fund or reserve fund (the two are generally used interchangeably, though some would argue there may be differences). I say this because (1) Clause 1(f) of the 1973 Lease defines ‘Maintenance Expenses’ as ‘monies actually expended or reserved for periodical expenditure’. Further, Clause 2 in the Third Schedule, by referring to the fact that the account of the Maintenance Expenses should ‘distinguish between actual expenditure and reserve for future expenditure’ expressly recognises that the lease intended there to be a reserve fund. 2. Improvements There is a good deal of case law on the distinction between repairs and improvements. The lease does cover the former: see Clause 4(1)(A) and (C) –and other clauses are also relevant. But the latter would not generally be covered. Again, this is because the same law and principles of interpreting leases has broadly to apply whether the landlord is an outside property company, or a company comprised of the leaseholders. Courts and Tribunals have leant over a little to permit improvements, where they seem appropriate. ‘Workarounds’ include:

(a) the cost of replacing 1930s single glazed metal windows with modern double-glazed sealed units has been allowed where the cost was only a few percentage points higher; (b) similar leeway was granted where a flat roof was replaced with a pitched roof (and it was possible there to argue that the long term repair costs would thereby be reduced); (c) it is likely that the cost of an improvement would be covered if, because of modern building regulations (which may include requirements for fire safety, or better insulation) it would be impossible to carry out repairs which simply replaced like for like.

Unfortunately if the improvements go beyond these rather limited workarounds, passing a resolution at an AGM does not entitle the Directors to go beyond the scope of the lease. Either you would be looking to vary your leases (the FPRA office has a booklet originally prepared by me which offers some guidance on this) or, if there is unanimity, you could fund improvements by a voluntary levy from all leaseholders, only proceeding with the work once everyone had paid. (If you have near unanimity you could even consider proceeding on the strength of the contributions that you can get, on the basis that it is cheaper and more convenient if everyone pays a bit more than to get around the problem in any other way). I hope that this substantially answers your queries. [Submitted October 2017]

Question 2

Service Charges

Accepted Answer

Q: We are a residents’ association, we own the freehold and self manage a block of 27 residential flats. Since acquiring the freehold in 2006 leaseholders have not been required to pay ground rent. An amount equivalent to the ground rent was added to each leaseholder’s service charge payment in 2006. This arrangement has continued to the present time. The company has no sources of income other than service charges paid by leaseholders. The current board of directors (who are all leaseholders & residents) has recently begun a review of the way the company conducts its operations. We are concerned that our lease, as currently worded, may not give us the authority to use leaseholders service charges to pay for all the services that we consider to be necessary for running and maintaining the properties. Particular areas of concern are: 1. Company running/admin costs. Does our lease allow for payment of the following from service charges: (a) Fees for legal and other professional advice. (b) Payment of an honorarium to the Company Secretary. (c) Annual accountancy fees/Companies House fees. 2. Works of improvement. We are keen to undertake projects that would enhance the appearance (and hopefully the value) of the properties. This has been debated with leaseholders/shareholders at recent AGM’s and we have received positive support from them for our views. We are uncertain, however, whether expenditure on works of improvement is allowed by our lease. Are there guidelines as to what constitutes works of improvement as opposed to maintenance? 3. Sinking fund. Any surpluses of income over expenditure that may arise in a particular year are accumulated by the company and held in reserve to pay for major works such as roof renewal. In our 2016 accounts we formally established, for the first time, a sinking fund on the face of our balance sheet. Again we are unsure as to whether or not this is permissible under the terms of our lease. Any advice or guidance that you could give on these matters would be much appreciated FPRA Legal Adviser Nick Roberts replies: A: I am not entirely clear what you mean when you say that the Company discontinued the collection of ground rent when the freehold was acquired in 2006, but that an equivalent sum has been added to the service charge since then. This is all rather illogical, though I can see how the misunderstanding may have arisen. People tend to equate paying ground rent with not owning the freehold, and so, when the freehold is acquired, they expect not to have to pay ground rent any more. But this is not really so. It is the Company that has acquired the (collective) freehold: each leaseholder has not acquired the freehold to his or her individual flat. The lease remains fully in existence. In fact, FPRA recommends that it may often be appropriate for a Residents’ Management Company (RMC) which has acquired its freehold to continue to charge ground rents expressly so that it can cover items of incidental expenditure – chiefly relating to the company itself – which do not form part of the service charge. The specimen lease that I have sight of suggests that – at least in that case – the original 1973 lease was replaced by an extended lease in 2001 and that in turn was replaced by another extended lease in 2016 which was granted pursuant to the Lease Extension provisions of the Leasehold Reform, Housing and Urban Development Act 1993. Such leases MUST be for a peppercorn ground rent: the Act leaves no scope to depart from this. It is not clear to me whether all leaseholders now have extended leases under the LRHUDA 1993, or only some. I have come across cases of RMCs who have acquired their freehold, and – as they have no particular need to charge for extended leases – offer extended leases at a nominal price, provided that certain changes are made to the lease (particularly in respect of what can be included in the service charge). This seems like a good strategy: if leaseholders refuse this deal, and insist on extending under the statutory provisions of the LRHUDA, they could then be charged the same substantial premium for a lease extension that an outside ground landlord would charge. You ask some specific points, and I shall do my best to answer them. I shall answer them all, but the narrative will flow better if I take some out of order: 1. Company running/admin costs (a) fees for legal and other professional advice. The general principle is that, in order to recover expenditure, the ground landlord or RMC must be able to point to a specific provision of the service charge provisions of the lease. Leases tend to be restrictively interpreted here, because a lot of the case law relates to cases where outside ground landlords are trying to claim for items above and beyond what the lease envisaged. I am afraid that I think it is doubtful that these are included, as I do not think they would generally be taken to fall within the scope of ‘the administrative and office and other incidental expenses of the Company in effecting its incorporation and initiating and running its business’ (see clause 4(4)). One could argue that they should, but the words do more naturally seem to refer to something different (see below). (c) Annual accountancy fees / Companies House fees I think these can be included in the service charge, as they clearly do fall within the scope of clause 4(4): ‘the administrative and office and other incidental expenses of the Company in effecting its incorporation and initiating and running its business’. You are in a sense lucky here: if one had a lease with an outside ground landlord and no RMC then company expenses of this kind would not have been included, but here, as you had what is known as a tripartite lease (i.e. a lease with a ground landlord, separate RMC, and a leaseholder) it was seen as necessary from the outset to provide from the RMC’s company expenses. (b) Company Secretary’s Honorarium. I am not sure of this: I would suspect not. As stated above, service charge provisions in a lease tend to be strictly construed. A Company Secretary is an Officer of the Company, but is only an employee (see clause 4(4)) if there is a contract of employment. One could employ someone to be the Company Secretary – it is what most large commercial concerns do – but, although people refer to ‘honorariums’ with different meanings, I think in this context the payment of an honorarium generally means that there is no employment contract as such as the parties wish to avoid the complications that would result from this. 3. Sinking fund Although this is not expressly mentioned in as clear terms as one finds in many leases, I have no doubt that a Court or Tribunal would find that the Company does have power to set up a sinking fund or reserve fund (the two are generally used interchangeably, though some would argue there may be differences). I say this because (1) Clause 1(f) of the 1973 Lease defines ‘Maintenance Expenses’ as ‘monies actually expended or reserved for periodical expenditure’. Further, Clause 2 in the Third Schedule, by referring to the fact that the account of the Maintenance Expenses should ‘distinguish between actual expenditure and reserve for future expenditure’ expressly recognises that the lease intended there to be a reserve fund. 2. Improvements There is a good deal of case law on the distinction between repairs and improvements. The lease does cover the former: see Clause 4(1)(A) and (C) –and other clauses are also relevant. But the latter would not generally be covered. Again, this is because the same law and principles of interpreting leases has broadly to apply whether the landlord is an outside property company, or a company comprised of the leaseholders. Courts and Tribunals have leant over a little to permit improvements, where they seem appropriate. ‘Workarounds’ include:

(a) the cost of replacing 1930s single glazed metal windows with modern double-glazed sealed units has been allowed where the cost was only a few percentage points higher; (b) similar leeway was granted where a flat roof was replaced with a pitched roof (and it was possible there to argue that the long term repair costs would thereby be reduced); (c) it is likely that the cost of an improvement would be covered if, because of modern building regulations (which may include requirements for fire safety, or better insulation) it would be impossible to carry out repairs which simply replaced like for like.

Unfortunately if the improvements go beyond these rather limited workarounds, passing a resolution at an AGM does not entitle the Directors to go beyond the scope of the lease. Either you would be looking to vary your leases (the FPRA office has a booklet originally prepared by me which offers some guidance on this) or, if there is unanimity, you could fund improvements by a voluntary levy from all leaseholders, only proceeding with the work once everyone had paid. (If you have near unanimity you could even consider proceeding on the strength of the contributions that you can get, on the basis that it is cheaper and more convenient if everyone pays a bit more than to get around the problem in any other way). I hope that this substantially answers your queries. [Submitted October 2017]

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