Lessee-owned Blocks: Moving Towards Commonhold

1.  Introduction

These notes are intended to show how the law constituting lessee-owned blocks of flats is not ideally fit for purpose, to introduce the idea of conversion to commonhold, while setting out some of the problems which that poses, and to give a summary of how commonhold works.

These notes are written by James Brenan, a solicitor of many years experience in advising landlords and tenants, as general guidance to potential clients.  They are not a substitute for proper advice on the specific facts of any situation - and no responsibility is accepted for any decisions or action taken without obtaining specific advice from retained solicitors.  

Throughout these notes the terms “tenant” and “lessee” are used interchangeably and the abbreviation "LMC" is used to refer to a leaseholders' management company, whether owing the freehold (or reversion) or not.  

2.  The Decline of Investor-Landlords

In a significant percentage of all blocks of flats lessees now own the right to manage and in most of these cases they also own the reversion to their leases.  This trend is growing as more groups of lessees (and potentially Rent Act tenants as well) take advantage of the right of first refusal under the Landlord and Tenant Act 1987 ("the 1987 Act"), and as more groups of lessees utilise the right of collective enfranchisement under the Leasehold Reform, etc Act 1993 ("the 1993 Act") and the recent no-fault right to manage.  There is also the fault-dependent right under the 1987 Act to apply to a leasehold valuation tribunal ("LVT") for the appointment of an independent manager, which is a precursor to lessees later obtaining an acquisition order to acquire their block's reversion or freehold.

The typical vehicle for such collective ownership was until 2003 the private company limited by share capital.  Following the Commonhold and Leasehold Reform Act 2002 ("the 2002 Act"), this familiar type of legal entity has been joined by the Right to Manage ("RTM") company.  That Act and its regulations have also given recognition to a fact known by a good many practitioners: that companies limited by guarantee are more effective and efficient vehicles to use for these non-profit-seeking purposes.

In practice there are a variety of types of persons or entities owning the freeholds or reversions of blocks of flats on behalf groups of tenants, as follows:-

-    up to 4 tenants owning in their own names and, one hopes, as parties to a deed of trust and co-ownership agreement (and this invokes the law of trusts as the legal background, which has differences to company law that may become significant in the event of any dispute);

-    a company limited by shares owned by a group of tenants, often but not necessarily comprising all of the tenants; and

-    a company limited by guarantee, owned as above.

It is also relevant to take into account the following who may simply manage the block:-

-    an independent manager, appointed by an LVT under the 1987 Act - which has a unique advantage: after 2 years the tenants can obtain the freehold under an acquisition order without having to pay anything for marriage value; and

-    an RTM company owning only the right to manage.

3.  The Self-Destructive Potential of Lessees Management Companies

What happens if a lessee in an LMC-owned blocks goes to a LVT and enforces the principle whereby service charges must only be in respect of expenses lawfully incurred by the lessor under the terms of the lease?  Or if that lessee enforces the rule that such expenses must be no more than reasonable in their amount?  There will be a service charge reduction and this may have effect throughout the block because the complainant's case will in effect have become a representative action in behalf of all the lessees.  In consequence the expenditure of that lessee's own company will exceed its service charge income by the amount of those irrecoverable expenses and also no doubt by its litigation costs paid and thrown away.  Indeed, the complainant may seek an order pursuant to Section 20C of the Landlord and Tenant Act 1985 prohibiting these costs from being paid for with service charge funds.  A similar loss to the LMC would also arise if it incurs a liability to pay damages to a lessee, for example by allowing a roof to leak into a flat, because leases typically do not allow a lessor to recoup damages payments via service charges.

The LMC will have to find this shortfall of funds by some other means or else it will become insolvent.  It is most unlikely to be able to raise an ad hoc levy against its members.  Under Section 16 of the Companies Act 1985, such a power would have to be present in a company's memorandum and articles from its incorporation - which is not unlikely - and is normally exercised by issuing partly paid-up shares.  RTM companies are required to be limited by guarantee and so they will not have any ability to raise money by issuing shares.  

Commonhold associations, in contrast, have the power to levy annual "assessments" against unit owners to meet their expenses and they will have far less exposure to litigation in respect of management decisions. An executive summary of the features of commonhold ownership appears below.

4.  The Excessive Bureaucracy and Legalism of Leasehold Structures

Leases have represented the legal constitution of one of the most potentially mistrustful relationships that our society and legal system have created: that of landlord and tenant.  Landlords have traditionally advanced their rights in the most catch-all and aggressive language that their lawyers could imagine - you only need to read a forfeiture clause to see this - and tenants have drawn some well respected boundaries to defend themselves. Parliament and the courts have weighed into the conflict on countless occasions, no doubt with the best of intentions, but leaving the law encrusted with rigid and arcane rules and procedures that only complicate and add to the expense of management.  The outcome for LMCs is that they are bound by numerous unnecessary and restrictive duties, each potentially enforceable by a single disaffected lessee within any block.

One example of this strictness is Section 42 of the 1987 Act, whereby service charge funds and sinking funds must be held by the lessor in separate trust accounts - where incidentally they become taxable as if they were discretionary trust funds.  Breach of this duty is a criminal offence.  

Another example is the elaborate infrastructure of rules requiring landlords to submit to management audits and give transparency of information regarding expenditure and budgeting for significant works and any long term service agreements.  You might be forgiven for assuming that in situations where the body of tenants appoints the directors of a non-profit-making freeholder company and can hold those officers to account through company law mechanisms it would be unnecessary to comply with rules designed to rein in external landlords - but this commonsense approach is nowhere recognised by the law.  LMCs are treated as if they were investor-landlords whose interests and intentions conflict with the tenants'.  (In fairness, investor-landlords have a legitimate interest in the management of their estates which naturally and often will not match the views of lessees.)

Similarly LMCs are constrained in the same way as any investor-landlord not to utilise service charge funds for making any pure improvements or additions of new amenities to their blocks.  Thus, it will contravene the typical wording of any lease for, say, a tarmacced area to be turned into a landscaped garden, for a children's' play area to be built  in the common grounds, or even for new security measures such as a CCTV system to be put in place.  (Notwithstanding this legal position, some LMCs have been known to take their chances and transgress these strictures - but it is always risky for them.)

5.  Development of Retained Space

Aside from the fund-raising considerations, some LMCs are at liberty to develop retained space around or above their blocks while others are not - depending on the wordings of their leases.  The issue of development of retained space tends to generate strong feelings among an LMC's members.  Some see it as an ideal way of generating money for refurbishing and improving their block while others dislike the idea intensely.  Many leases are not immediately clear on this point and so they have to be read as a whole and considered against their factual background in order to give their meaning on it.  The judgment in Hannon v. 169 Queens Gate Ltd [2000] 1 EGLR 40 acknowledged that ownership of a block's reversion by an LMC is a proper matter to take into account when interpreting an ambiguous lease on this question - in favour of finding this development right to exist.  (It may be of interest that such ownership, by an LMC, is also a relevant factor in giving a wider than normal interpretation to a service charges clause in a lease regarding the recovery of management expenses.) Commonhold law approaches this issue in a different way, as will be seen below.

This example illustrates how haphazardly leasehold laws will constitute relationships and the potential for lease-based conflicts to spill over into litigation.  Arguments over standards and costs of communal services and charges often fester in the same way under leasehold laws.

6.  The Alternative of Commonhold

Taken together with the irrelevance and inconvenience of their leases having finite terms of years and requiring payment of ground rents that will now be arbitrary in amount as well as taxable income in their hands, the above disadvantages of leasehold are likely to cause many tenants that own their lease reversions through the vehicle of an LMC to consider changing over to commonhold.  

Commonhold represents an attempt to move away from the vagaries and hostilities that are inherent to the leasehold system by unifying property law rules with corporate governance rules and by including some less drastic methods for dispute avoidance and resolution and excluding the threat of forfeiture.
Commonhold schemes will all have a statutory core of standardised documentation - albeit with options and spaces for customised additions, known as "local rules".

Commonhold associations' memoranda and articles of association and community statements will contain measures to protect unit owners against over-assertive majorities - covering such issues as the right to be or to elect directors, special majorities for particular major decisions and disclosure of management documents.  

There will be no trust in favour of members in respect of annual assessment money collected by the association.  However, Section 39 of the 2002 Act and its regulations provide for separate funds to be held for the repair and maintenance for the common parts and the commonhold units. Reserve funds covering future years' expenditure are to be voluntary. Income that arises on any reserve fund will be liable to corporation tax - as will any incidental profit generated by the association.  Money held in a reserve fund is not available to pay to any judgment creditor of the association except in relation to a reserve fund activity.  
The above development of retained space  (or Hannon) question is left by the 2002 Act to be dealt with as a matter for local rules in commonhold community statements - which depend initially on the full agreement of the founding owners, can contain entrenched (unalterable) provisions and otherwise are alterable by majority vote of unit owners.
Directors of commonhold associations will be bound by compulsory provisions in all commonhold community statements to follow a detailed procedure each year for estimating expenditure and reserve fund needs and notifying these amounts to unit owners.  Owners must be told how they can object and that there is a one month time limit for objections.  The directors are bound to consider objections received.  They must then give a further formal notice to owners requiring payments.  (There is a shorter procedure for cases of emergency expenditure.)  Interest automatically accrues on late payments.
As there is no statutory duty of reasonableness for such assessments there will be less scope for challenging them in court, compared to the ability of tenants to challenge the amounts of service changes.  We do not yet know the courts' attitude to intervening in commonhold associations' decisions but the indications are that they will do so only very sparingly.
In the first year after registration of a scheme the directors must consider whether to commission a reserve study by a professional person, and they must commission such a study at least once in every 10 years.

7.  Establishing a Commonhold Scheme from Leasehold

Section 3 of the 2002 Act prevents any land from being registered as commonhold unless every lessee whose term was granted for 21 years or more joins with the freeholder in applying. Mortgagees of those leases must also give consent. Such agreement can be made subject to conditions, such as that the lessee concerned receives a commonhold unit according to a particular constitution or receives compensation. Unanimity will usually be unobtainable from any large or disparate group, or it may be too daunting to attempt to get this. Regulations allow a dispensing power of the Court, on application where the non-consenting party cannot be identified or traced or if they simply refuse to respond.
Once a government fully recognises the deficiencies of leasehold law for LMCs and decides to promote commonhold more vigorously we might see new regulations fixing an overridable proportion of non-consenting lessees. (Section 37 of the 1987 Act could be a useful template for Parliament to adopt if and when that happens: it facilitates all the leases in a block to be amended by an order of an LVT, subject to certain safeguards for the dissenting owners, where 75% of owners in the block actively support the proposal and less than 10% of owners actively oppose it.)

In order for a commonhold scheme to be attractive to all lessees of a block the service charge liability shares and any ground rents would first have to be proportionate among them and their lease term periods would have to be equal, or else the conversion process would have to provide for compensation payments.  (It is quite known for developers of blocks to retain a  flat for their own enjoyment and to award that flat an unfairly light share of the service charge liabilities; purchasers of flats have often missed this trick because their advisers have failed to scrutinise  the sizes of flats in comparison to service charge shares.)  It may assist in this regard that the LVT's power to vary leases will probably be extended by regulations pursuant to Section 162 of the 2002 Act - enlarging the grounds under Section 35 of the 1987 Act for variation where a lease "fails to make satisfactory provision" - and of the 1987 Act already provides for compensation in these cases.  Altering a lease's term period, however, is more than a mere variation: it is a termination and regrant.

8.  Executive Summary of Commonhold

In further outline, commonhold schemes have the following features: 

    -  schemes must be grounded, not flying
    - schemes can cover multiple sites, i.e. which comprise separate and non-contiguous lands
    - separate titles for each commonhold unit and the common areas
    - standard form memorandum and articles of association (individual owners can sue to bring these into line with the law if they do not comply) with some scope for local variations
    - company incorporated by guarantee
    - limit of £1 to all members liability in the event of liquidation
    - names to always end with "...Commonhold Association Limited"
    - association cannot be a member of itself
    - association can own individual units within its scheme
    - there can only be one member per unit (first-named in case of joint owners)
    - only unit-holders and in certain circumstances a developer can be members (once the first unit sold)
    - limits on rights of developers to exercise continuing control
    - community statement lays down the delineations of units and common parts and the scheme's rules and regulations, with limited scope for local variations
    - no "licence to assign" system exists in the standard documents
    - anyone becoming entitled to be a member must give formal notice to the association within 14 days
    - leases of residential units are not allowed to exceed 7 years or be granted for a premium
    - for residential units, only the unit holder can pay sums due to the association - so their liability cannot be passed on
    - tenant must have been given copy of community statement, plans and a prescribed notice
    - notice of any tenancy must be given to association within 14 days in prescribed form
    - further notice rules govern assignments of residential tenancies
    - rights of Rent Act 1977 protected and statutory tenants would carry on in respect of such an encumbered flat in case it were to become a commonhold unit
    - assured tenancies (and assured shorthold tenancies) under the Housing Act 1988 are extinguished in case a flat becomes a commonhold unit
    - existing commercial tenancies, including any under the Landlord and Tenant Act 1954, come to an end on conversation
    - compensation is automatically payable to any tenant whose tenancy comes to an end on conversation if the owner's consent was not required
    - contrary to the position under leasehold law, an incoming unit owner assumes liability for any arrears of payments due form the outgoing one (and acquires a right of subrogation)
    - there is presently no scope for shared ownership leases in commonhold blocks
    - there is no scope for different groups of units to be maintained under different funds - the only adjustment between units can be made via their percentage shares
    - voting rights can be weighted in relation to the sizes and values of individual units
    - the limitation period for issuing a legal claim in respect of any breach of commonhold duties is 6 years
    - forfeiture has gone and cannot be imposed indirectly via provision in the community statement
    - community statements can be amended by a majority vote of members if so allowed by a local rule
    - amendments cannot redefine the extent of any unit without the owner's consent or a court order dispensing with such consent
    - the general law as to neighbouring land owners' rights (e.g. easements, party walls, covenants and nuisance) continues to exist alongside commonhold rules
    - subject to safeguards for protecting members against significantly disproportionate alterations, members' (and units') proportionate rights to vote and liabilities to pay communal assessments can be varied by special (75%) resolution
    - community statements will promote the use of mediation and conciliation for settling any disputes, but the legal process is always available for money claims
    - there should become available an Ombudsman to assist in resolving internal disputes.

The above is merely a summary of the rules affecting the governance of commonhold schemes and is necessarily incomplete.  For example, no coverage is attempted here as to the rules concerning the insolvency of commonhold associations and their winding up.  One thing to note in particular is the unusually detailed regulation of directors' duties, in addition to their usual company law duties.  Any one contemplating becoming a director of a commonhold has a lot of preparation to do - first in learning the rules and then in following them at regular stages throughout the accounting year. Professional managing agents will in practice be necessary.

This article was written by James Brenan.