by David Neuberger
The subject of real property options is normally perceived as being bedevilled by technical, archaic and arcane rules. This paper is restricted to consideration of options in leases, because they raise most of the problems encountered in other property options and many more besides.
Options in favour of tenants are normally of three types:
(1) An option to break the current lease;
(2) An option to acquire a new lease on the expiration of the current lease;
(3) An option to acquire the freehold.
Leases sometimes contain options in favour of the landlord. An option to break (especially in the event of the landlord’s wishing to redevelop) is by far the most common. An option to require the tenant to purchase the freehold is rare; an option to compel the tenant to take a further lease is very rate indeed.
The principles applicable to the exercise of an option, be it a landlord’s option or a tenant’s option, are the same. I shall concentrate substantially on tenants’ options, although much of what is said can be applied, with appropriate modifications, to landlords’ options.
Virtually any option will contain stipulated preconditions for its exercise. The general rule is that such preconditions must be strictly complied with. Except for cases where the landlord may somehow have misled the tenant, or where similar special circumstances exist, the failure on the part of the tenant to comply with any precondition will invalidate the exercise of the option. Clearly, what the preconditions are, and when they have to be satisfied, depends upon the construction of the particular option agreement. In practice, the date upon which the preconditions have to be satisfied (which I shall call “the satisfaction date”) will almost invariably either be the date upon which the purported exercise of the option occurs or be the date upon which the purported exercise takes effect.
Time-limits
An option will almost always identify the time within which the option can be exercised. A well-drafted option will provide for the earliest date and the latest date within which the option may be exercised.
In accordance with the principle already mentioned, a notice served outside those time-limits will be irredeemably bad (Hare v Nicoll [6] 2 QB 130 at p 136). Of course, if the option specifically provides that the time-limits are not of the essence, a failure to comply with the time-limits would not defeat the exercise, but I have never seen such a provision in an option agreement.
The law relating to time-limits in options is therefore diametrically opposite to the law relating to time-limits in rent review clauses: prima facie, the time-limits are absolutely strict in the former case, whereas in the latter case they are not.
That this is the state of the law is clear from authority. However, the logic behind it appears somewhat questionable. Lord Diplock has explained (in United Scientific Instruments v Burnley Borough Council [8] AC 904) that time-limits should not be treated as being of the essence in rent review clauses because the right to increase the rent was the quid pro quo which the landlord obtained for granting the tenant a longer lease. However, it could equally be said, in relation to an option in favour of the tenant in the lease, that the tenant would not have been prepared to enter into the lease on the particular terms contained in it without the benefit of the option: accordingly, why are the time-limits in a rent review clause elastic whereas the time-limits of an option are strict? It is fair to say that the right to review the rent is, as it were, an integral part of the lease, whereas an option (at least if it is to acquire a new lease or to acquire the freehold, but perhaps not if it is a right to break) is a collateral arrangement rather than an integral part of the current lease itself: Green v Low (No 1) (1856) 22 Beav 625.
A curious point arose in Biondi v Kirklington & Piccadilly Estates Ltd [7] 2 All ER 59, where a tenant had a 35-year lease with a right to renew by giving notice “six months before the expiration of the term”. A notice served 10 days after the term began was held invalid: although it was served six months before the expiration, the court concluded that it was served earlier than either party must have envisaged a valid notice being served.
An option will almost always provide for its exercise to be by notice in writing. If it does not so provide, the law implies that the notice must be served in accordance with section 196 of the Law of Property Act 1925: New hart Builders Ltd v Brindley [5] Ch 342. However, unlike the prescribed time-limits within which the option must be exercised, it would seem that the law does not require that the manner of the exercise be strictly in accordance with the terms of the option. Thus, if service of the notice exercising the option is to be by recorded delivery, a notice in fact served on the landlord is validly served even if it were sent by ordinary post: Yates Building Co v RJ Pulleyn & Sons (York) (1975) 237 EG 183. (In Holwell Securities Ltd v Hughes [1974] 1 WLR 155 the letter went astray in the post: option held not exercised.) However, where it is clear from the terms of the option that the notice exercising it is to be in writing, it would appear that an oral notice would not suffice: New Hart Builders Ltd v Brindley cited above, but see the conflict of views in Dean & Chapter of Chichester Cathedral v Lennards Ltd (1978) 35 P&CR 309.
Compliance with covenants
The most common form of tenant’s option (particularly if it is a right to break or a right to a new lease) will contain a provision that the tenant must have observed its obligations under the covenant in the lease up to the satisfaction date. Such a provision has to be interpreted strictly. Thus, if the covenants have to be observed up to the term date of the lease, and the tenant is under an obligation to decorate the whole of the interior with three coats of paint in the last year of the term, the landlord could defeat the exercise of the option if he could establish that, in the last year, the tenant decorated the whole of the interior with three coats of paint except one ceiling of one room which he had decorated with only two coats of paint: West Country Cleaners (Falmouth) Ltd v Saly [6] 1 WLR 1485.
The strict approach of the court is also shown by the decision in Hollies Stores Ltd v Timmis [1] 2 Ch 202. The lease was to a company with three guarantors and contained an option in favour of the company to renew with the condition that all three guarantors joined in the new lease. By the time the option came to be exercised, one of the guarantors had died. Despite the offer by the company of an undoubtedly suitable alternative guarantor, and of security, the option to renew was held to be unenforceable because the terms effectively required the three original guarantors to be parties.
While the harshness of this approach can be, and has been, criticised, it at least has the merit of certainty. Either the tenant has observed his obligations or he has not. There is no room, unless the terms of the option otherwise provide, for implying the concept of “substantial compliance” or “reasonable compliance”.
However, even in the context of such a strict clause, a tenant who has been in breach will not have lost the right to exercise the option if the breach is put right by the satisfaction date. Thus, if the tenant failed to pay the rent when it fell due, and even allowed substantial arrears to accrue, it would seem that he would not lose the right to exercise the option on that ground, provided that the rent was all up to date by the satisfaction date. In practice, the law would treat the past breaches of covenant of failure to pay rent as “spent”.
What is meant by “spent” was considered in Bass Holdings Ltd v Morton Music Ltd [7] 3 WLR 543. The terms of the option required the tenant to have complied with his covenants up to the satisfaction date. Prior to that date, in breach of covenant, the tenant had applied for planning permission without the landlord’s consent, and the landlord had issued forfeiture proceedings which had eventually been compromised on terms that the tenant obtained relief from forfeiture. At first instance, it was held that the tenant’s attempt to exercise the option failed on the grounds that the breach of a negative obligation, namely not to apply for planning permission, was one which could not be put right and accordingly irrevocably prevented him from exercising the option. The Court of Appeal disagreed, holding, in effect, that the parties could not have intended such an uncommercial result: a breach which had caused no harm to the landlord and had in any event been effectively sorted out would not, therefore, defeat the exercise of the option.
The Court of Appeal appears to have left open the question of whether they would have arrived at the same result if the breach, although committed well before the satisfaction date, had only been discovered by the landlord following the satisfaction date. While the decision in that case wrought obvious justice between the parties, it could be said that the decision at first instance at least had the merit of laying down a clear, if somewhat draconian, principle.
The difficulty with a more flexible form of option is shown by a case such as Bassett v Whiteley (1983) 45 P&CR 87, where the tenant was required to have “reasonably performed and observed” his obligations up to the satisfaction date as a condition of the exercise of the option (my emphasis). The Court of Appeal appears to have taken the view that the inclusion of the word “reasonably” gave the court a sort of roving commission enabling it to consider the overall conduct of the tenant, including the history of any breaches and the reasons therefor and to conclude whether or not the tenant was entitled to exercise the option. As was pointed out in the Bass Holdings case (see at p 549 the discussion of Bassett v Whiteley) this represents a very different approach from that of the courts in relation to the more normal, and stricter, form of option, which rarely involves consideration of the tenant’s conduct before the satisfaction date but requires one to concentrate, if not exclusively, on the position as at the satisfaction date.
Exercising the option
So far as the exercise of the option is concerned, the contents of the notice should be carefully drafted and considered in the light of the terms of the option agreement. Thus, in a case decided about 45 years ago a landlord’s option to determine a lease was held to be invalidly exercised when it mistakenly referred to the date of determination as being three days earlier than that stipulated in the lease, although the notice expressly referred to the relevant provision in the lease: Hankey v Clavering [2] 2 KB 326, but note the more recent approach in Germax Securities v Spiegal (1979) 37 P&CR 204. There must be considerable doubt whether the Hankey decision, although a unanimous one of the Court of Appeal, would be followed in the present climate of judicial authority.
In relation to options to acquire the freehold, particular care should be given to the formula by which the price is to be assessed. The most frequently encountered problem is whether the landlord’s interest is to be valued on the assumption of vacant possession or whether it is to be valued subject to the tenant’s right under the lease (together with any statutory right). There are a number of decisions on this point which are somewhat difficult to reconcile: see the discussion in Re Nagel’s Lease [4] 1 WLR 1077.
The practical question for many business tenants holding under a lease with an option to renew is whether they would do better to exercise the option or to rely upon their rights under Part II of the Landlord and Tenant Act 1954. Once a tenant validly exercises his option to renew, he loses his right under Part II of the 1954 Act under his current lease — see section 28. While I have heard it argued that the tenant who purports to exercise the option to renew, but in fact has not validly done so, loses his right to a new tenancy under the 1954 Act, it seems to me that that cannot be right: if he has not validly exercised the option, he has no agreement for a new lease, and consequently the provisions of section 28 cannot apply.
The advantage to the tenant of exercising the option to renew rather than falling back on his rights under the 1954 Act are twofold. First, if he validly exercises the option to renew, the landlord has no grounds upon which to oppose the grant of a new lease.
Second, almost all options to renew provide that the new lease is to be on the same terms as the current lease: the effect of this is that the landlord has no power to require any variation from the terms of the current lease, however reasonable his seeking to do so might be. Under the 1954 Act, while there is normally a fairly heavy burden on a landlord who wishes the terms of the new lease to differ from the terms of the current lease (O’May v City of London Real Property Co Ltd [3] 2 AC 726), the court undoubtedly has power to effect such a variation. This is of particular relevance if the current lease is for a term of more than seven years and has no provision for review: in that event, and the option is for a new lease on the same terms as the current lease, the landlord almost certainly is not entitled to insist upon the new lease containing any provision for rent review (National Westminster Bank Ltd v BSC Footwear Ltd (1981) 42 P&CR 90) whereas the position is very different under the 1954 Act — see section 34(3). Furthermore, a landlord could reasonably hope to include a redevelopment break clause in a lease granted pursuant to the 1954 Act (Adams v Green (1978) 247 EG 49), which would not be the case if the new lease were obtained pursuant to an option to renew unless the previous lease had such a clause.
Another point in relation to options to renew is whether the new lease itself also contains an option to renew. If the option provides that the new lease is to be “on the same terms as this lease”, it could be said with some force that as the option to renew is one of the “terms of this lease” it should be included in the new lease. That would render the lease perpetually renewable. Whether an option renders a lease perpetually renewable depends upon the terms of the particular option. While the court tends to lean against a construction which renders a lease perpetually renewable, certain other old-fashioned expressions have been interpreted so as to render a lease perpetually renewable, a construction which is often commercially insensible: so that it has been said that “the law has become the prisoner of the machinery”: per Sachs LJ in Re Hopkins Lease [2] 1 WLR 372. A perpetually renewable lease now takes effect as a lease of 2,000 years determinable by the tenant only, on 10 days’ written notice: paras 5 and 10 of Schedule 15 to the Law of Property Act 1922.
An option to renew can be contrasted with an option to determine. Is a business tenant better off with a long tenancy with a right to determine every so often or a short tenancy with a right to renew for a specified number of occasions? The choice might be between a 20-year term with a right to break at the end of every fifth year on the one hand or, on the other hand, a five-year term with a right to renew for three further consecutive terms of five years.
It seems to me that, at least in property terms, a tenant is generally better off with the second alternative. In the case of the 20-year lease, if he wants to exercise the right to break and fails to do so, then he is “stuck” with an unwanted lease for at lease the next five years. On the other hand, if he has a five-year lease and fails for some reason to exercise his option to renew, he still has his rights under Part II of the 1954 Act. Of course, as already discussed, that may not be so satisfactory, particularly as any lease granted pursuant to the 1954 Act will almost certainly not contain any option to renew: Kirkwood v Johnson (1980) 38 P&CR 392. Owing to federal accountancy laws, many US corporations prefer the alternative of a shorter lease with a right to renew.
In relation to options to determine, it should be borne in mind by any tenant of business premises that, if he validly exercises an option to determine, he loses his current right to claim a new tenancy under the 1954 Act: section 28 of the Landlord and Tenant Act 1954.
A well-drafted option will make it clear whether the benefit of the option is assignable and, if so, whether it is assignable separately from the term of the lease, whether it is personal to the original tenant, or whether it is exercisable only by the person who, at the time of exercise, is the tenant in possession.
It would appear, not for the first time in relation to options, that the law is somewhat inconsistent. An option entitling the tenant to acquire the reversion is not automatically assigned by the tenant when he assigns the lease: Woodall v Clifton [5] 2 Ch 257.
However, an option to renew the lease is apparently automatically assigned by the tenant even if the contract to assign and the assignment are totally silent on the question: Griffith v Pelton [8] Ch 205.
The reasoning behind this is hard to understand, as the Court of Appeal have recently observed in Kumar v Dunning [7] 3 WLR 1167.
In the absence of any indication to the contrary, it is probable that an option to acquire the freehold or an option to renew is freely assignable: Re Button’s Lease [4] Ch 263. However, it is important that if the benefit of the option is assigned, notification of the assignment is given to the landlord, as until that date an assignment at law will not have taken place: section 136(1) of the Law of Property Act 1925. It is important that such notification is given, not because the option lapses if it is not given, but that, until notice has been given, the option in law remains vested in the assignor, and consequently a purported exercise of the option by the assignee would not be effective (Warner Bros Records Inc v Rollgreen Ltd [1976] QB 430): in a field where time-limits are so important, overlooking that point could accordingly deprive a tenant of the benefit of the option.
Registration of options
The final topic I would like to mention is the registration of options. In the case of unregistered land, a tenant’s option (whether to acquire the reversion or to renew) would not be binding on a successor in title of the landlord if it is not registered: section 2(4) and section 4(6) of the Land Charges Act 1972. In relation to registered land, the position is the same unless it can be established that the option is within one of the categories of overriding interest: section 70(1) of the Land Registration Act 1925. Some options specifically provide that, if the option is not registered against the landlord’s interest within a specified period, the option will lapse. Bearing in mind particularly the requirements of strict compliance with the terms of an option, it is my view that failure to register the option within that stipulated period means that the option is irretrievably lost, even if registration is effected outside the time-limit and before the landlord has actually disposed of his interest.
Conclusion
As demonstrated by this discussion, the practical gap between what a landlord and a tenant (or their respective surveyors) think they may have agreed and what their solicitors actually ensure they agree is even greater in relation to options in leases than it is when one turns to other provisions in leases. However, while it is easy to say that parties to a commercial lease cannot normally intend that a valuable option to renew or to break should not be exercised, for instance because of a trivial breach of covenant existing at the satisfaction date, it is hard to suggest a satisfactory formula which, while it may take away some of the harshness of the present law, would not replace it with the equally undesirable concept quality of uncertainty.