Commercial property: break clauses
Breaking with convention
31 January 2014
Duncan Freeman looks at the possible implications of a high-profile judgment on break clauses and rent repayments to tenants
Logically, at least, it makes sense: if a tenant pays a full quarter's rent on a quarter day but the lease comes to an end before the end of that quarter, the tenant should expect a refund from its landlord for the period after the lease expires. If the lease comes to an end following the exercise of a break option, in most cases that logic is turned on its head.
The recent decision of Mr Justice Morgan in the case of Marks and Spencer plc (M&S) v BNP Paribas Security Services Trust Company (Jersey) Ltd  EWHC 1279 (Ch) (which has been appealed) provides helpful guidance on the topic and the rare circumstances in which a tenant should expect a refund.
The decision has attracted much commentary because it involved a novel argument for a term to be implied into the lease that where M&S operated the break option successfully, the parties agreed that it be entitled to a refund of the rents related to the remainder of the quarter after the break date.
The facts of this case are straightforward:
- from 25 January 2006, M&S had been the tenant (under four separate contracted out leases in substantially like form, although only the lease of the third floor was considered in this case) of an office building in Paddington
- rent was payable quarterly in advance on the usual quarter days
- the lease contained a break option allowing M&S to terminate the lease on 24 January 2012 (the break date)
- the break option was conditional on service of a valid break notice; there being no arrears of rent or VAT at the break date; and the payment by M&S of an entire year’s rent (£919,800 + VAT) on or before the break date
- on 7 July 2011 M&S served notice exercising the option to end the lease
- M&S paid the full quarter's rent on 25 December 2011
- on or around 18 January 2012, M&S paid to the landlord £919,800 + VAT
- the lease came to an end on 24 January 2012
- with the lease at an end, M&S sought repayment of those rents and other sums for the period after the break date (namely, 25 January-24 March 2012).
M&S argued that the rent and other sums for the period after the break date should be refunded to it because:
- the lease provided expressly for the return of the rents and other sums; ('Express term' argument)
- a term should be implied into the lease entitling it to repayment of those sums; ('Implied term' argument)
- there was a total failure of consideration for the period following the break date ('Failure of consideration' argument).
Former tenants who have paid a premium in order to operate a break option may well advance claims for repayment of overpayments based on the M&S’s implied term argument
The express term argument
M&S failed on this argument that the lease only required that it paid rent for the duration of the lease, not for any period after the lease had ended. However, on the December 2012 quarter day it was not certain that the term would expire because it had not yet paid the break premium. His Lordship's reasoning followed that of Smith J in PCE Investors v Cancer Research  EWHC 884 (Ch). In that case (which did not involve the obligation to pay a premium or penalty) Smith J ruled that the tenant had failed to meet the pre-conditions for the operation of the break because it had failed to comply with the tenant covenant to pay the rents. At the quarter day before the break date it was by no means certain that the lease would determine, in which case the entire quarter’s rent was due and payable by the tenant to the landlord. The tenant only paid an apportioned amount up to the break date and consequently the term was not broken.
Conversely, where on the last quarter day before the end of the lease, the end of the lease is certain to occur during the quarter, the tenant is only required to pay an apportioned sum up to the date the lease expires. It makes no difference if the expiry is by effluxion of time or the operation of a break option. The key is whether the lease is certain to expire when the last rental payment is due.
The implied term argument
M&S submitted that a reasonable party to the lease would understand that M&S would 'end up' paying rent for the period from 25 December 2011 to 24 January 2012. Although not spelt out expressly, what the lease meant was that if M&S had paid a full quarter's rent on 25 December 2011, it would be entitled (in the event of the lease terminating on 24 January 2012) to recover a part of the quarter's rent in relation to the period after 24 January. Morgan J agreed.
The fact that the break option could only be operated effectively where M&S paid to the landlord a sum equivalent to one year's rent was clearly relevant. It showed that the parties had applied their minds to the compensation the landlord should receive in consideration for receiving vacant possession. His Lordship considered it unlikely that the parties intended that the landlord would be entitled to retain the full amount of the quarter’s rent paid on the quarter day before the breakdate in addition to the lump sum equivalent to the annual rent.
Failure of consideration argument
This argument was dismissed on the basis that there had not been a total failure of consideration and followed the decision in Ellis v Rowbottom  1 QB 740. That case considered the effect off the Apportionments Act 1970 and whether it applied to rents payable in advance and it was argued that where the lease was forfeit mid-way through a quarter, there had been a partial failure of consideration, which entitled the tenant to a refund of the rents falling due after forfeiture. That argument failed on the grounds that rents payable in advance do not accrue from day to day but on the date they are due.
What does the decision mean?
Break options are construed strictly (practitioners will recall the 2011 decision of Morgan J in Avocet Industrial Estates LLP v Merol Ltd where an underpayment of £130 in default interest scuppered the operation of the tenant's break option) and commentators have referred to Morgan J's 'sidestepping' of previous authority by allowing the implied term argument. It remains to be seen whether the distinguishing feature of this case (the implication of a term based on the requirement to pay a break premium as consideration for the operation of the break) is successful on appeal.
As for tenants looking to exercise a break option in the future, it is doubtful that they will risk the successful operation of the break by not paying enough rent
However, the decision does not disturb well-established principles, which can be summarised as follows:
- a covenant requiring the payment of the rents for the year 'and any proportion thereof' does not entitle the tenant to a refund where the term is determined (other than by effluxion) mid-way through the quarter
- if at the quarter date preceding the termination date, it is certain that the lease will come to an end on a date falling between two quarter days, the tenant is only obliged to pay a rent apportioned up to that date. This principle also applies where the tenant exercises a break option
- if the lease comes to an end mid-way through a quarter by forfeiture or the operation of a break option, the tenant is not entitled to a refund of the rents referable to the period after the term date on the basis of a failure of consideration.
Morgan J's decision was handed down on 16 May 2013 and it remains to be seen whether (as some have predicted) the floodgates have been opened to claims for the refund of rental overpayments by former tenants.
It is expected that some former tenants may review those situations where rents were paid to former landlords prior to the operation of a break option to consider whether it could be said with certainty at the preceding quarter day before the break date that the term would determine. If the answer to that question is yes, a former tenant may well seek to recover the overpayment.
In addition, former tenants who have paid a premium in order to operate a break option may well advance claims for repayment of overpayments based on M&S's implied term argument.
As for tenants looking to exercise a break option in the future, it is doubtful that they will risk the successful operation of the break by not paying enough rent even where it has satisfied the pre-conditions required in order to operate the break option successfully. What is more likely is that practitioners may look to neutralise the issue by including specific rent apportionment provisions in the event that the option is exercised.
Duncan Freeman was a Senior Associate at Dundas & Wilson LLP
Related competencies include: T048