Top tips (and traps for the unwary)
Adam Bernstein speaks to David Manda of Walker Morris LLP, who provides practical lease-break advice and options for businesses considering, for whatever reason, relinquishing surplus property.
In times of economic decline or uncertainty, many businesses look to rid themselves of surplus property to reduce rental commitment and liabilities. The pandemic, and the consequential surge in home and flexible working, has also demonstrated that many businesses can operate effectively with much less rented commercial space.
Context and key case law
While the cost savings involved in a rationalisation exercise can be significant, so too can the risks. Once the decision has been made to bring a commercial lease to an end, the failure to serve a valid break notice can have drastic consequences. The business may lose the opportunity to break the lease and may, therefore, remain liable and tied into the property with long-term, unwanted commitments.
And the point was well made in the leading case on the subject, Mannai Investment v Eagle Star in 1997. In the ruling, Lord Hoffmann famously said: “if the [termination] clause had said that the notice had to be on blue paper, it would have been no good serving a notice on pink paper, however clear it might have been that the tenant wanted to terminate.” In doing so, he vividly explained that strict compliance, with both contractual break conditions and any particular service provisions, is required for lease breaks to be effective.
As a result, very careful consideration must always be given to the exercise of any break. The starting point when serving a break notice must always be to examine the lease and the contractual provisions that set out the options; any conditions that must be complied with, and any particular requirements for service (including when notice must be given, how notice must be served and on whom, and by whom, it must be served).
The question of when a break notice can be served is very important, especially if the option is a one-off or “once and for all” break (as opposed to a “rolling break”). There are then three dates to determine: the break date, the date by which notice must be served (that is, when the notice must be received by the other party), and, working back, the date by which the notice must actually be issued. If any of these are calculated incorrectly then there is a real risk that the break notice will not be validly drafted or served, and the lease will continue.
It is essential to check whether the break clause contains a specific process for serving notice or whether the lease contains general “service of notices” provisions elsewhere. Service must be made according to any contractually specified provision. For example, the lease may specify that service must be by fax or email at a particular address, by first class or registered post, on an agent as well as, or instead of, on the party, or even that notice must be written on pink paper!
As indicated earlier, it must be understood exactly who must give the notice and on whom the notice must be served. However, determining the correct party(ies) is often more difficult than first imagined. In most cases the landlord and tenant are no longer the original contracting parties, the land or tenancy may be unregistered, the landlord/tenant may not be based in the UK, and/or the lease may specify that the notice must be served on an agent.
What? Conditional break options
Conditional break options should be approached with real caution. If the lease requires absolute compliance with one or more conditions then failure to do so, no matter how trivial, will render the break ineffective. For example, if a break option was conditional on making payment of all lease sums and just a penny remained outstanding at the break date or other prescribed time, that penny would make the whole break invalid.
The most common condition is the payment of all rent due as at the break date. On the face of it, that seems straightforward and fair enough. However, is rent defined within the lease and does it include service charge and/or insurance rent? If it does, can these be properly calculated or established? Does rent (and potentially other sums) simply need to have fallen due under the lease, or do sums have to have been demanded? If sums need to have been demanded, can the tenant guarantee the landlord will have demanded sums in time for the tenant to make payment?
Another common condition is for a tenant to comply with its repairing obligations – that is, putting the property back in the state it was when the lease started. However, a landlord is generally under no obligation to confirm exactly what work it expects to be carried out, nor to provide any certainty prior to the break date that any works carried out are satisfactory to discharge the tenant’s obligations.
If conditions in a break option are not absolute, they are often drafted to say that the tenant must materially, substantially or reasonably comply with certain conditions. This is to try to protect the tenant from rendering the break invalid through minor and inconsequential breaches. The problem here is that each of these terms can have a slightly different meaning and no guarantees can be given to provide absolute certainty of compliance. In these circumstances, a tenant may be well-advised to undertake the fullest possible compliance. Apart from the risk of a break being ineffective, a party will always face the risk of a damages claim for breach of covenant either during or after the end of a lease in any event. The fullest possible compliance has the dual effect of mitigating those risks.
A related point– terminal dilapidations
As an aside, whenever any commercial lease comes to an end – whether by exercise of a break option or otherwise – the issue of terminal dilapidations is likely to arise.
“Terminal dilapidations” is the phrase used to cover breaches of tenant covenants relating to the physical state of the premises that are present at the end of the lease. Terminal dilapidations can, therefore, encompass breaches of repair covenant, decoration, the obligation to comply with statute (which, itself, can cover planning matters, health and safety, environmental matters, and the like), “yielding-up” or “vacant possession” obligations; requirements to reinstate any alterations that have been made to the premises; and so on.
Terminal dilapidations, and, in particular, the extent of a tenant’s liability for them and the means by which such liability can be dealt with (for example, by the carrying out of works and/or by the payment of a financial sum), is a hugely complex area, and a very common source of landlord and tenant dispute. The position with terminal dilapidations will differ on a case-by-case basis as liability, and an appropriate remedial or compensation strategy will depend on the terms of the individual lease (and any other related documents, such as licences for alterations, deeds of variation, schedules of condition, and so on); the actual state of the premises at the date of lease termination; the use to which the landlord intends to put the premises in future; and myriad other factors.
Even where a tenant is not exercising a break option that is reliant upon compliance with conditions regarding the physical state of the premises at lease end, misunderstandings or mistakes as regards dilapidations liability can prove costly. Specialist legal advice, as well as advice from specialist building and valuation surveyors, will generally be required and should form part of a tenant’s overall exit strategy on any commercial lease termination.
There is, at any time, a considerable amount of risk and time involved in serving a break notice and complying with the relevant conditions. In the current climate, where many businesses are feeling financial pressure and where pandemic-related restrictions or staffing issues may have a practical impact on a tenant’s ability to quickly and comprehensively comply with break conditions, it is perhaps even more important than ever for tenants to carefully consider their ability to exercise any break options and, in particular, the time and strategy needed to put in place an efficient and effective exit.
Tenants that act without a good understanding of their position risk not making the break they intend or costs that they hadn’t planned for.
David Manda is a director in the Real Estate Litigation Team at law firm Walker Morris LLP.