Landlord and tenant — Equity sharing headlease — Merger of underlease with headlease — Arrangements contained payment of capital sum — Whether breach of covenant against commutation
By a headlease dated August 12 1985 KWSN
was granted by the appellant landlords a term of 125 years of premises in
consideration of the expense which it incurred in the erection of an office
building; the rent was 13.89% of specified net rents or £50,000 if lower. The
headlease, an equity sharing lease, contained a covenant, at clause 2(22)(f),
that the tenant would not be a party or privy to ‘any agreement or arrangement
for commutation in whole or in part of any annual rent to be reserved and made
payable on any underletting of the premises … in consideration of a lump sum of
money’. On June 30 1988 KWSN granted an underlease to H of substantially the
whole of the building for a term of 25 years at a rent subject to review;
following a review the rent amounted to £972,500 pa. In 1991 the headlease was
assigned to Hypo and in 1993 the underlease was acquired by a company who held
it in trust for the second plaintiff. Because the rent payable under the
underlease, at a rate of about £48 per sq ft, was considerably higher than the
market rental value, of about £18 per sq ft, the group of companies to which
the plaintiffs belonged sought to put in to effect some arrangement to merge
the underlease with the headlease; this would terminate the rental liability
under the underlease and reduce the rent payable under the headlease. By a
series of transactions involving Hypo, the legal title to the headlease vested
in the first plaintiff, which held it in trust for the second plaintiff, and
both the legal and beneficial title in the underlease vested in the second
plaintiff. Under the agreements £11.45m was payable to Hypo on completion with
a retention of £550,000 payable if the arrangement was held not to constitute a
breach of the headlease. The second plaintiff desired to require the first
plaintiff to transfer to it the legal title to the headlease so that the
underlease would come to an end by merger in the headlease, but would only do
this if it could do so without causing the first plaintiff to be in breach of
any covenant under the headlease. In the court below Ferris J made declarations
to the effect that the arrangements would not involve a breach of the covenants
of the headlease. The defendants appealed contending that the arrangements
constituted a commutation of the rent and constituted a breach of clause
22(2)(f) of the headlease.
the overall arrangement, the capital payment of £550,000 is made to bring the
sublease to an end and to extinguish it. Consequently there is no substitution
of a capital payment for a periodic rental payment since the rental payment
automatically disappears on merger. The capital sum of £550,000 was not
consideration for the supposed commutation, but was part of the total
consideration paid to Hypo for the purchase of the headlease. The arrangement was
wider and
there was no breach of the headlease.
The following cases are referred to in
this report.
British Railways Board v Elgar House Ltd
[1969] 2 EG 1313
Freehold & Leasehold Shop Properties
Ltd v
Friends Provident Life Office [1984] 2 EGLR 133; (1984) 271 EG 451
This was an appeal by Master and Wardens
and Brethren and Sisters of the Guild or Fraternity of the Blessed Mary the
Virgin of the Mystery of Drapers in the City of London against the decision of
Ferris J who made declarations on an application by the plaintiffs, Associated
Newspapers Property Ltd and Associated Newspapers Holdings Ltd.
Jonathan Gaunt QC (instructed by Bircham
& Co) appeared for the appellants; Kim Lewison QC (instructed by
Freshfields) represented the respondents.
Giving the first judgment, HIRST LJ
said: This is an appeal against the order of Ferris J dated July 12, whereby on
an originating summons he made certain declarations in favour of the plaintiffs,
Associated Newspapers Property Ltd (Property), and Associated Newspaper
Holdings Ltd (Holdings), in their action against the defendants, Master and
Wardens and Brethren and Sisters of the Guild or Fraternity of the Blessed Mary
the Virgin of the Mystery of Drapers in the City of London (the Drapers
Company).
The question at issue in a nutshell is
whether Holdings are entitled lawfully and without breach of covenant to
surrender the underlease of 180–183 Fleet Street, London EC4, of which the
Drapers Company are the freeholders so as to bring about a merger of the
underlease in the headlease out of which it has been carved. If they can
properly do this, the amount of rent payable under the headlease will be
substantially reduced to the benefit of the plaintiffs, but to the detriment of
the defendants.
Under the headlease dated August 12 1985,
the original tenant, King William Street Nominees (KWSN), was granted a term of
125 years from November 1 1984 in consideration of the expense which it agreed
to incur in the erection of an office building on the site which is at the
corner of Fetter Lane. This is often described as an equity sharing lease. The
amount of rent payable under the headlease is 13.89% of a sum described as net
rents (ie the gross income derived from sublettings of the property less
certain prescribed expenses) or £50,000, whichever is the greater, subject to
rent reviews in 1999 and at 15-year intervals thereafter. On June 30 1988 KWSN
entered into an underlease with Huntsmoor Nominees (Fleet Street) Ltd
(Huntsmoor), of substantially the whole of the building for a term of 25 years
from November 1 1984 at an initial rent subject to five-year upwards-only
reviews. Consequent upon a review a total rent of £972,500 pa was fixed, the
equivalent of over £48 per sq ft, with the result that the rent payable to the
Drapers Company under the headlease, after taking into account also receipts
from a small section of the premises sublet to another party, was £146,693.40
pa, ie over £96,000 in excess of the minimum rent payable under the formula.
As is normal in leases where the rent
payable is to be calculated on a formula of this kind, the headlease contains
numerous supplemental provisions aimed to ensure that the rent cannot be
artificially reduced. First, if the tenant under the headlease itself occupies
the demised premises or some part thereof, the gross income derived from the
property is to be deemed to include an amount equivalent to the fair market
rent of the premises of the part so occupied. Second, there is a detailed set
of provisions relating to assignment, subletting or parting with possession,
which are the subject of tenants’ covenants contained in clause 2(22) of the
headlease, and which provides as follows, summarising all but paras (d) and
(f), the latter of which is the key covenant in the present proceedings.
Para (a) prohibits dealings other than by
an assignment or underletting authorised by another paragraph of clause 2(22).
Para (b) prohibits assignments of part of the premises only. Para (c) prohibits
assignments or underlettings of the whole without the consent in writing of the
Drapers Company.
Para (d) provides:
Not to underlet the premises or any part
thereof at any time in consideration or in part-consideration of a fine or premium
or otherwise than at the best annual rack rent reasonably obtainable therefor
in the open market from time to time.
Para (e) requires underlettings of parts
of the premises above the ground floor to be of complete floors or of minimum
parts of complete floors.
Para (f) provides as follows:
Not to be party or privy to any agreement
or arrangement for commutation in whole or in part of any annual rent to be
reserved and made payable on any underletting of the premises or any part
thereof in consideration of a lump sum of money.
I refer to this stipulation hereinafter
as ‘the subclause’.
Para (g) requires certain provisions,
including a provision equivalent to the subclause to be included in every
underlease. Para (h) requires the tenant to procure that every assignee enters
into a direct covenant with the Drapers Company to perform the covenants
contained in the headlease.
On May 31 1991 the headlease was assigned
by KWSN to a company whose name is now Hypo Property Investments Ltd (Hypo).
Huntsmoor was the service company of a
firm of solicitors, Taylor Joynson Garrett, who occupied the property demised
by the underlease as their offices. However, in 1992 or 1993 Huntsmoor entered
into negotiations with a company in the Associated Newspapers Group to take a
lease of new offices in the latter’s development known as Carmelite. These
negotiations culminated in an agreement under which, inter alia, the
underlease was to be taken over by Harmsworth Properties Ltd (Harmsworth)
pursuant to which an assignment was entered into dated April 6 1993 between
Huntsmoor and Harmsworth for an assignment thereof. Huntsmoor then vacated the
premises and Harmsworth, as assignees, became liable to pay the rent to Hypo.
On November 24 1993 Harmsworth entered into a deed of trust declaring that it
held the underlease on trust for Holdings.
By 1993 there had been a substantial
slump in the London office premises market, with the result that the open
market rent obtainable for the premises demised by the underlease, assuming
that a subtenant could be found, had fallen very substantially below the £48
per sq ft payable under the lease to a figure of about £18 per sq ft.
Furthermore, the restrictions upon letting parts of a complete floor meant that
subletting could only take place in a more restricted market than might
otherwise have been the case. Consequently, as is common ground, the underlease
had become an onerous one from the point of view of the underlessee, and a
beneficial one from the point of view of the Drapers Company for as long as it
remained on foot and so long as the property market remained depressed.
Discussions within the Associated
Newspaper Group as to the appropriate strategy to be adopted are contained in a
number of minutes which are in evidence. This material was summarised by the
judge as follows:
Minutes of meetings of those concerned to
deal with the transaction within the Associated Newspaper Group show that a
number of problems were recognised, including the following:
(a) The restriction on the manner of
subletting which is contained in the underlease made it very difficult to find
subtenants willing to take a subtenancy conforming to the terms of the underlease.
Moreover Hypo was unhelpful about negotiating a relaxation of this restriction.
(b) The rent payable under the underlease
was very high and there was no reasonable prospect of recouping it to anything
like a complete extent from underlettings. If underlettings could be achieved a
rent of not more than about half the rate per square foot implicit in the rent
payable under the underlease appeared to be the best that could be obtained,
and even that might require the acceptance of a significant rent free period.
(c) Some doubt was felt whether the net
burden of the rent payable under the underlease, after allowing for whatever
was received from subletting,
Associated Newspaper group.
In the light of these considerations it
was decided to try to ameliorate the position by acquiring the headlease from
Hypo and merging the underlease in the newly acquired headlease, so
extinguishing the underlease. It was hoped that by this means: (i) the severe
restrictions on subletting contained in the underlease would be avoided,
although the less severe restriction contained in the headlease would remain;
(ii) the requirement to pay rent under the underlease would be extinguished;
(iii) the interest on the money borrowed to finance the purchase of the
headlease would indisputably be deductible for tax purposes; and (iv) the rent
payable under the headlease would be reduced to the minimum rent of £50,000 pa
in place of more than £146,000 pa.
Negotiations ensued with Hypo leading to
a tentative agreement for the purchase of the headlease from Hypo at a price of
£12m. However, the Drapers Company objected and made it known through their
solicitors that it would regard a merger of the underlease in the headlease in
these circumstances as a breach of the subclause.
Having regard to this objection, the
transaction with Hypo was restructured so as to obviate an immediate merger of
the underlease in the headlease by an agreement dated September 22 1994 between
Hypo and Property. Under this agreement Hypo agreed to sell the headlease to
Property at the price of £12m, of which the sum of £11,450,000 was payable on
completion and the balance of £550,000 is constituted as a retention remaining
in the hands of Property. Property agreed to commence proceedings in order to
obtain a court order to the effect that the merger of the underlease would not
constitute a breach of covenant under the headlease. There are elaborate
provisions, which I need not recite in detail, under which Property covenants
to use all reasonable endeavours to obtain a favourable order, and under which
the mode of conduct of the proceedings and of the pursuit of any appeal are
regulated. It is provided that if a favourable order is obtained within
prescribed time-limits, the retention is to be paid over to Hypo, but that if
the order is refused then the retention is to be kept by Property.
Consequently, by a transfer of the same
date, Hypo transferred the headlease to Property whose obligations were
guaranteed by Holdings, and Property and Harmsworth executed a declaration of
trust in which Property acknowledged that the £12m required for the purchase
from Hypo had been provided by Harmsworth, and declared that Property held the
underlease in trust for Harmsworth.
The purpose of these various instruments
executed on September 22 1994 was to put the beneficial ownership of both the
headlease and the underlease into the same hands, while leaving the legal title
in separate entities, to avoid any merger taking place before the court had
given a ruling as to whether such a merger would be in breach of covenant.
However, the declaration of trust between Harmsworth and Holdings dated
November 25 1993, referred to above, had been overlooked, with the result that
on September 22 1994 Harmsworth not Holdings was treated as beneficial owner of
the headlease. Following the discovery of this mistake, by an assignment dated
September 30, Harmsworth assigned the beneficial interest in the headlease to
Holdings, and on October 19 1994 Harmsworth transferred the underlease to
Holdings.
The result of all these rather complex
dispositions is that the legal title to the headlease is vested in Property,
which holds it in trust for Holdings. Both the legal and beneficial title to
the underlease is vested in Holdings. Holdings desire to require Property to
transfer to Holdings the legal title to the headlease so that it can cause the
underlease to come to an end by merger in the headlease, but would only do this
if it could do so without causing Property to be in breach of any covenant
under the headlease.
The originating summons was issued on
October 20 1994 to seek the ruling of the court on whether there would be such
a breach of covenant, which ruling of course would also determine the
destination of the retention sum of £550,000 held under the agreement between
Hypo and Property. The case was heard by Ferris J in April 1995, and on July 12
1995 he made declarations substantially in the form sought by the plaintiffs as
follows:
The
Court Declares
(1) that the Second Plaintiff may call
for a conveyance of the Lease dated 12th August 1985 between the Defendants (1)
and King William Street Nominees (2) (the ‘Lease’) without thereby committing
any breach of the covenants contained in the Lease.
(2) that the merger of the Underlease
consequent on the transfer of the Lease would not constitute a breach of any
covenant contained in the lease.
The judge’s conclusions may be summarised
as follows:
1. That the composite transaction
comprised in the purchase of the headlease by Property from Hypo and the
ensuing dealings with the beneficial interest in the headlease was capable of
being an arrangement within the meaning of the word ‘agreement or arrangement’
in the subclause.
2. That commutation could only be said to
take place where some new right or payment (normally a capital sum) is obtained
in exchange for the right or payment which is given up, where the relevant
underlease continues in being despite the change involved. However, in the
present case, under the transaction proposed, no obligation of any kind would
be substituted for the present obligation to pay rent at the high rate, since
by operation of law that obligation would simply disappear, the underlease
having been annihilated with nothing being substituted for it. As a result,
there was nothing which could be treated as a commutation of rent.
He cited the concise Oxford English
Dictionary definition of ‘commute’ as follows:
interchange (two things); buy off (one obligation)
by (for, into) another; change (punishment into another less severe); change
(one kind of payment into, for another) …
With regard to the effect of a merger he
cited Blackstone’s Commentaries as follows:
Whenever a greater estate and a less
coincide and meet in one and the same person, without any intermediate estate,
the less is immediately annihilated; or, in the law phrase, is said to be
merged, that is, sunk or drowned, in the greater. Thus if there be tenant for
years, and the reversion in fee simple descends to or is purchased by him, the
term of years is merged in the inheritance, and shall never exist any more.
On behalf of the appellants, Mr Jonathan
Gaunt QC submits that the subclause is a very widely drawn stipulation,
particularly having regard to the words ‘agreements or arrangements’ and the
words ‘party or privy’, and that, in his words, it casts its net as wide as
possible to embrace any arrangement where the purpose is to achieve a
commutation or any other arrangement which has the same effect. He recognises
that at the heart of the appeal there lies the meaning of the word
‘commutation’ in its context, but he submits that ‘commutation’ is not a legal
term of art and that in construing the word here, it is, contrary to the
judge’s view, irrelevant whether or not the existing lease continues and that
the proper approach is to construe the word as also covering any arrangement
which does away with the rent in exchange for a lump sum. In consequence, he
submits, the present arrangement, looked at in the round, comes within the
ambit of the word ‘commutation’, seeing that one contractual package is
substituted for another, one ingredient of the new package being the
disappearance of the rent in exchange for a capital sum, namely the £550,000
retention which is only payable if the merger is successful.
In support of his argument, he cited two
authorities which, he submitted, showed the court’s disposition to pay close
regard to the commercial purpose in equity sharing leases, which, he contends,
is the protection of the landlord’s interest to prevent the tenant artificially
reducing the rent, which he contends is the paramount commercial purpose. These
two cases were British Railways Board v Elgar House Ltd [1969] 2
EG 1313 (Stamp J) and Freehold & Leasehold Shop Properties Ltd v Friends
Provident Life Office [1984] 2 EGLR 133 (CA) (Oliver, Griffiths and Fox
LJJ). In both cases the court was construing ill-drawn clauses in equity
sharing leases and, in doing so, naturally paid regard to the commercial
implications of the rival constructions, and was able to hold that the
commercially sensible construction fell within the terms of the lease so
drafted. There was no
lease.
Ably though these arguments were
addressed, I am unable to accept them. The starting point is the judge’s
conclusion in the appellants’ favour as to the wide ambit of the words
‘agreement or arrangement’. This is criticised by Mr Kim Lewison QC, on behalf
of the respondents, in his skeleton argument, but since he had no opportunity
to advance his argument because we did not call on him, I propose to assume,
without deciding, that the judge was right in this respect.
Where, however, in my judgment, Mr Gaunt’s
argument founders, is on his construction of the word ‘commutation’ in the
context of the subclause. This provides for commutation of any annual rent to
be reserved and made payable on any underletting of the premises. It is common
ground that the preposition ‘on’ is to be interpreted as equivalent to under,
ie we are dealing with rent payable under any underletting. Rent payable under
a lease is essentially a periodic payment by the tenant for his right to remain
in possession of the premises for the term of the lease. Consequently,
commutation in this context connotes an exchange between the tenant and the
subtenant of a capital payment for the previous obligation to make the
periodical rental payment, with the tenant remaining in possession under the
new arrangement for the remainder of the term. It is the counterpart of para
(d) of clause 22(2) which I quoted above. Here, by contrast, under the terms of
the overall arrangements, the capital payment is made to bring the sublease to
an end and to extinguish it. Consequently, there is no substitution of a
capital payment for a periodic rental payment since the rental obligation
automatically disappears on merger together with the subtenant’s right to
continue to occupy the premises qua subtenant, since the sublease itself
has disappeared.
Equally, in my judgment, it is wrong to
treat the £550,000 retention as consideration for the supposed commutation. On
a proper construction of the agreement between Hypo and Property, the £550,000
forms part of the total consideration of £12m for the purchase of the
headlease, though only payable if the outcome of the contemplated legal
proceedings is successful.
At the end of the day, it seems to me
that the appellants are making a valiant but vain attempt to squeeze into a
straightforward landlord and tenant commutation clause, a very much wider and
more complex transaction which the draftsman never envisaged.
For these reasons, similar to those
advanced by the judge, I would dismiss the appeal.
Agreeing, MILLETT LJ said: The
question in this appeal is whether a merger of the underlease in the leasehold
reversion will bring about a commutation of the yearly rent payable under the
underlease.
A legal liability is said to be commuted
when another and different liability is substituted for it. It is conceded that
no such substitution occurred when the headlease was acquired. That is
obviously right. The underlease continued to subsist and the rent continued to
be payable thereunder as before.
Nor, in my judgment, will any such
substitution take place if, and when, the underlease is surrendered or merged
in the headlease. The rent reserved by the underlease will, of course, cease to
be payable, for the liability to pay it is coterminous with the underlease. But
it will not be replaced by any other liability. In particular, it will not be
replaced by an obligation to pay a capital sum. The only obligation to pay a
capital sum was incurred in consideration for the acquisition of the headlease,
not for the determination of the underlease, which it facilitated but did not
effect; nor was it incurred in substitution for the liability to pay the rent
under the underlease, since unless and until the underlease is brought to an
end both liabilities will continue to be enforceable in full.
I agree that the appeal should be
dismissed.
HUTCHISON LJ agreed and did not add anything.
Appeal dismissed.