What do proposed Law Commission reforms mean for commercial leasehold?

Having proposed four different models to reform the Landlord and Tenant Act 1954 in its first consultation paper, the Law Commission has now confirmed in an interim statement that the contracting-out model is here to stay. This means that security of tenure will remain the default position, subject to a right to opt out. 

The Law Commission has also indicated that it will not extend the exemptions to the Act, so it will therefore continue to apply to most commercial properties. However, there are plans to extend the duration threshold for leases to fall outside the Act.

Currently, leases of less than six months are excluded from the Act, but the second consultation paper is expected to suggest widening the exclusion to leases of under two years.

It is not yet clear whether the current cumulative provisions, which mean that a succession of six-month leases will be brought within the Act, will be included in any changes to impose an upper limit for successive two-year leases.

The current process, involving service of a contracting-out notice and receipt of a signed statutory declaration from the tenant before the lease is entered into, is seen as unduly cumbersome.

The Law Commission may propose an endorsement on the face of the lease, or go further and suggest that as these provisions have been in place for more than 70 years, the effects of contracting out are now widely known without the need for any express notice.

We will have to wait for the second consultation paper to understand their proposed direction of travel.

Proposed changes are also likely to focus on the interaction between the 1954 Act and energy efficiency, both in terms of modernising lease terms and widening grounds for opposing renewal to include circumstances where landlords wish to carry out energy improvement works.

It has announced a particular review of two statutory provisions: the Landlord and Tenant (Covenants) Act 1995 and rights of first refusal under the Landlord and Tenant Act 1987, as well as a wider scoping project dealing with dilapidations, service charges and the interaction between environmental frameworks and commercial leasehold law.

The Act also limits the extent to which former guarantors can guarantee subsequent tenants following assignment of the lease. This has created unintended consequences for intra-group transfers.

Under the Act, where one group company wants to assign its lease to another company within the group, but the parent company guaranteed the original lease, the first group company will be unable to repeat that guarantee on assignment. This can often block intra-group transfers or add unnecessary cost by requiring a bank guarantee.

The Law Commission has indicated that it will consider recommending changes to these provisions to avoid preventing commercially sound transactions. This could be by allowing the guarantor to repeat its guarantee in favour of a group company assignee, provided that certain criteria are met.

This gives tenants the right to buy that interest before the landlord can make the disposal.

There is confusion, however, over which disposals are subject to rights of first refusal under the Act, as there is no specific exclusion for the grant of commercial leases.

It is therefore unclear whether qualifying residential tenants in mixed-use buildings should be given a right of first refusal before the lease of a commercial unit can be granted.

Given the cost burden of the notice process, and the uncertainty that can taint subsequent sales if not done correctly, a simple change to clarify that the grant of a commercial lease is not a disposal subject to the right of first refusal process would make a huge difference to landlords or tenants.

This includes the law relating to dilapidations, service charges and the interaction between environmental frameworks and commercial leasehold law.

It is not yet clear which areas will be targeted for reform, but the focus on environmental frameworks could mean a fresh look at:

• reinstatement clauses 
• the tension between an obligation on tenants to remove alterations under the lease and the environmental impact of doing so.

The Law Commission could propose an obligation on landlords to consider retaining alterations that remain useful, with a requirement to compensate the outgoing tenant for any increase in the value of the building as a result.

Any changes would require detailed valuation evidence for each party, and could potentially have a substantial impact on RICS surveyors practising in the dilapidations area.

This focus on environmental frameworks could also be geared towards allowing the inclusion of green lease clauses in renewal leases under the 1954 Act as reasonable updating.

As alluded to above, this could also tie into the Law Commission's second consultation paper on the 1954 Act.

Under section 35 of the 1954 Act, if the parties cannot agree the terms of a lease, the courts have a wide discretion to determine them having regard to the terms of the current tenancy and all relevant circumstances.

O'May v City of London Real Property Co Limited ([1983] 2 AC 726) confirms the burden is on the party proposing the change to convince the court it is fair and reasonable.

Reasonable modernisation, such as updating the terms of a lease to reflect a change in legislation, is usually uncontroversial.

However, the fact that something has become market standard is just one of many factors the courts will consider in making a change.

There have been several cases where the parties have argued over new green leases clauses in renewal leases on the basis that these are market standard, including Clipper Logistics Plc v Scottish Equitable Plc.

The Law Commission could consider including specific provisions on how green lease clauses should be treated, and whether they amount to reasonable modernisation.

Environmental issues could also impact service charges, and the allocation of the cost of environmental updates between landlord and tenant.

Any changes will be highly relevant to RICS surveyors involved in the administration of service charges.