Matthew Farrell, Stephen Goldie and Joseph Madden reveal how two recent cases indicate a change in approach by the Scottish courts
“Diminution in value doesn’t apply in Scotland; it is an English concept.” This has long been the approach of those involved in terminal dilapidations north of the border.
For almost 90 years, terminal dilapidation claims have been measured only by the cost of the works necessary to restore the premises to the condition required by the lease.
Over the past three or four years, however, that approach has started to change. Tenants are now arguing that the landlord’s true loss should be assessed using an alternative measure: the reduction in the capital value of the premises caused by their breaches.
Without clear judicial support, those arguments would often fall on deaf ears, but two recent decisions in Scotland would appear to have made landlords sit up and take notice, by putting it beyond doubt that diminution in value is an available measure of a landlord’s loss in terminal dilapidations disputes.
Scotland’s approach to terminal dilapidations seems to have changed for good. Practitioners in England and Wales may want to take note.
The Scottish approach
In 1926, the Inner House of the Court of Session (the equivalent of the Court of Appeal in England), in Duke of Portland v Wood’s Trustees [1926] SC 640, had to decide if Scotland would follow England’s approach to terminal dilapidations.
At that point, the courts’ approach in England was to award a landlord damages for terminal dilapidations based on the cost of the works necessary to put the premises into the condition required by the lease (Joyner v Weeks [1891] 2 QB 31). This was the sole measure of a landlord’s loss, irrespective of the landlord’s intentions, because, it was argued, cost of works was a simpler and more certain means of measuring loss.
The Inner House chose to take a different approach to that followed in England. After making it clear that the means of measuring loss was not to be confused with the loss itself, it decided that the true loss suffered by a landlord could only be determined by using a number of legitimate means of measuring loss and comparing the results they produced.
A landlord could measure its loss by cost of works and a tenant could measure it by some other way. If the measures produced different results, the parties would then have to persuade a court why their measure of loss should be preferred as the one that represented the landlord’s true loss.
This should have been a eureka moment for tenants in Scotland, but, for whatever reason, landlords and tenants continued to deal with terminal dilapidations based only on the cost of works.
What has changed?
When the economic downturn struck in 2008, suddenly new tenants were few and far between. Landlords that had leases coming to an end were facing lengthy void periods. Many landlords turned to dilapidations to generate income.
Sometimes the money recovered from the outgoing tenant for dilapidations would be spent on the premises to make them more attractive to prospective tenants. Often, however, the landlord would simply keep the money and market the premises at a reduced rent.
This could have the effect of creating a windfall for the landlord by compensating it for a loss that had not been suffered; precisely the sort of situation the Landlord and Tenant Act 1927 was designed to prevent.
In response to this issue, tenants finally woke up to Duke of Portland and the possibility that diminution in value could be the true measure of the landlord’s loss, especially when it could be shown that the landlord did not intend to carry out the works listed in its schedule.
Quite understandably, this change in approach to terminal dilapidations has not been readily accepted by landlords and their advisers. Two recent court decisions have, however, made it harder for them to maintain that resistance.
New law
In Grove Investments Ltd v Cape Building Products Ltd [2014] CSIH 43; [2014] PLSCS 250, the parties were in dispute over whether or not the lease contained a payment obligation for terminal dilapidations.
If it did, the tenant would be precluded from arguing that the landlord’s true loss should be measured by diminution in value and would have to pay the value of the terminal schedule, irrespective of the landlord’s intentions for the building.
Following the decision in Rainy Sky SA v Kookmin Bank [2011] UKSC 50, the Inner House held that the alleged payment obligation was capable of two constructions, in which case, the meaning that accorded with commercial common sense should be adopted. Commercial common sense, according to the court, would seek to provide a landlord with a remedy that is unlikely either to over- or under-compensate it for its true loss.
The court therefore decided that the most commercially sensible construction was that the lease did not contain a payment obligation.
In reaching its decision, the court expressly recognised that cost of works would not always represent the landlord’s true loss if it planned to do something else with the building that might supersede the repair works; or if aspects of the building, even if repaired, would be “technologically obsolete”.
The second of the decisions is @SIPP (Pension Trustees) Ltd v Insight Travel Services Ltd [2014] CSOH 137; [2014] PLSCS 251, which involved the same issue: did the lease contain a payment obligation? The court – the Outer House of the Court of Session, the equivalent to the High Court in England – followed the decision in Grove and decided that the lease did not contain a payment obligation.
However, the court went one step further than Grove, and stated that in certain circumstances the proper measure of a landlord’s loss in a terminal dilapidations claim could be the diminution in capital value of the premises caused by the tenant’s breaches of the lease.
These decisions mean that there can no longer be any doubt that a tenant in Scotland can argue in certain circumstances that diminution in value is the correct measure of the landlord’s true loss.
What those circumstances are remains to be seen once these cases – and other similar ones that are making their way through the Scottish courts – reach their final determinations after evidence has been heard.
The future
For the moment, tenants facing terminal dilapidations claims should consider with their advisers whether diminution in value might apply to them.
If acting for a landlord, the starting point for a claim is normally going to be based on cost of works. Similarly, when acting for a tenant, irrespective of the chosen defence (diminution in value, supersession and such like), it is likely that cost of works will continue to be relevant – in fact it is difficult to understand how a client could be properly advised without having an up-to-date cost of works assessment.
In that case, how will building surveyors’ advice change in Scotland as a result of these recent decisions? Building surveyors are often the first point of contact for clients, or their legal or management surveyor advisers – and quite rightly so, given their combined technical, legal
and commercial experience and understanding.
To properly advise clients on liability, strategy and risk, particularly with changing case law, a building surveyor has to be fully aware of matters such as: market conditions and property value; the changes in the law relevant to dilapidations; and when it is appropriate to recommend the involvement of other surveyors specialising in areas such as lettings, investment and valuation.
Building surveyors should be adopting a detailed, flexible approach to advising their clients – a defence strategy is likely to be multi-faceted, including advising concurrently on: cost of works; the effect of that cost on other defences including diminution in value and supersession; and on various potential outcomes based on a risk assessment, sometimes item by item.
In today’s market, dilapidations advice from building surveyors is highly specialised. It is important that clients and fellow surveyors are aware that diminution in value is a credible and, in certain circumstances, correct option, while recognising that cost of works will often remain the correct method of measuring a landlord’s loss.
Comparison with the English approach
In Scotland, a landlord is only entitled to recover his true loss from the tenant. His true loss will be determined by what constitutes a reasonable loss in the circumstances.
If the cost of works would materially exceed the increase in value of the premises that they would generate, no reasonable landlord is likely to carry them out. The cost of works in such circumstances is therefore unlikely to be the landlord’s true loss.
However, one can imagine a situation where the landlord would still wish to carry them out for his own perfectly legitimate reasons. In that situation, in Scotland, a judge can listen to those reasons and decide, despite the advice that the diminution in value is materially less than the cost of works, that the landlord intends to carry out the works and it is not unreasonable for him to do so, meaning that his true loss is the cost of those works. The likelihood of this happening could, admittedly, be remote, but it is possible.
Unfortunately, if the premises were in England and Wales, the same landlord’s recovery would be limited by section 18 of the 1927 Act to the diminution in value of the premises. He would not, as a result, be compensated for his, arguably, true loss caused by the tenant’s breaches of the lease. Until section 18 is changed or repealed, that will always be the case.
Matthew Farrell is a partner in, and Stephen Goldie head of, real estate litigation at Brodies LLP. Joseph Madden is a lead director at PMP Building Consultancy. Brodies acted for the tenants in both Grove and @Sipp, and PMP Building Consultancy was the surveyor instructed by the tenant in @Sipp.
