The Court of Appeal (CoA) has delivered a landmark ruling, one which establishes that a landlord’s contractual obligation to a third party does not act as an automatic shield against the statutory requirement that service charges must be reasonably incurred.

Facts:

The appellants are leaseholders of various properties in a development at St. David’s Square. In July 2000, the developer entered into long-term “rental and maintenance” contracts with a company called Countryside Communications (CC). The contracts covered vital communal systems, including video door entry (intercoms), TV/satellite distribution, car park gates, and leisure centre CCTV.

In 2014, F.I.T. Nominee Ltd. purchased the freehold and continued to pay CC, passing 100% of those costs to the leaseholders via service charges. This appeal relates to the amounts charged under the CC contracts for the years 2018 to 2020, totalling £590,541.44. The charges for the door entry system alone amounted to £398,440.73. The tenants, led by Mr. Spender, provided evidence that a brand-new, modern door entry system could be bought outright for about £268,000. This meant the tenants were being asked to pay more in “rent” for an ageing 20-year-old system over two years than it would cost to buy and install a new, state-of-the-art system.

The landlords had the right to terminate the contracts in July 2020. However, due to “inadvertence” (i.e., misplacing the paperwork), they failed to give notice. The contracts automatically rolled over, and the landlords continued to charge the tenants the full rental price until they eventually negotiated a 50% reduction in 2022.

The tenants started proceedings, with the First-instance Tribunal (FTT) upholding some of the tenants’ claims. The landlords appealed to the Upper Tribunal (UT), which allowed the appeal and set the FTT’s decision aside. The tenants appealed.

Decision:

The CoA ruled in favour of the tenants and remitted the case to the FTT to determine whether the costs were reasonably incurred. The Court focused on preventing Section 19 of the Landlord and Tenant Act (LTA) 1985 from becoming a “dead letter”. Lord Justice Zacaroli emphasised that the validity of the phrase “reasonably incurred” involves two distinct tests. While the process (i.e., how the landlord reached the decision) matters, the outcome (i.e., the actual price being charged) is equally important. The Court ruled that, even if a landlord is legally forced to pay a bill because of a contract they signed years ago, that cost is not “reasonably incurred” if the amount is objectively unreasonable when compared to the market.

It was for the tenants to provide a prima facie case that the costs were unreasonable. Once such a case is made, the burden shifts to the landlord, who must prove that the costs were indeed reasonable. F.I.T. Nominee failed here because they could not explain why the rental element of the 2000 contract was still a fair charge in 2020.

Implications:

This case has significant implications, as it fundamentally shifts the power dynamic between landlords and tenants regarding long-term service contracts. Previously, many landlords believed that if they were contractually bound to pay a third party (e.g., a 20-year equipment lease), that cost was automatically “reasonably incurred” under Section 19 of the 1985 Act because the landlord had no choice but to pay the bill. However, the CoA clarified that a legal obligation to pay a third party does not equal a right to recover that cost from tenants. Landlords can no longer use “bad deals” or “inherited contracts” as an absolute defence. If the outcome (i.e., the price) is objectively unreasonable compared to the market, the Court can slash the service charge, regardless of the underlying contract.

Once the tenant raises this doubt, the burden then shifts to the landlord to prove that the costs were reasonable at the time they were entered into. The CoA has ruled that management mistakes are not a “reasonable” cost. If a landlord misses a deadline to cancel a bad contract, then the landlord, and not the tenant, must absorb the price difference.