A reserve fund held by the landlord or management company on behalf of the leaseholders can provide a distinct benefit in covering the cost of major works or other significant items of expenditure.
With considerable and ongoing attention surrounding the apportionment of costs for remedial building safety works, such funds can, in some instances, mitigate the potential need to increase service charges to meet important and urgent requirements. The presence of a healthy reserve or sinking fund can also be attractive to potential buyers, providing peace of mind that there is a contingency in place to meet future needs.
Lease Provision for Reserve Funds
A lease will usually state if there is an obligation to set up and maintain a reserve fund and the method for collecting contributions to this fund. The lease may allow contributions to be collected as part of the annual service charge, which must be reasonable in amount in order to satisfy the necessary statutory requirements under the Landlord and Tenant Act 1985 (“LTA 1985”).
Demands for monies destined for the reserve or sinking fund will, in addition to complying with the terms of the lease itself, have to satisfy the test set out in LTA 1985 s.19(2), which provides: “Where a service charge is payable before the relevant costs are incurred, no greater amount than is reasonable is so payable, and after the relevant costs have been incurred any necessary adjustment shall be made by repayment, reduction or subsequent charges or otherwise.”
Of equal significance, Section 42 of the Landlord and Tenant Act (LTA 1987) also states that a reserve fund which contains service charge monies, must be held on trust, in a designated account at a relevant financial institution. The premise of this is to prevent the types of risk which might result in the monies not being available to spend on the purpose intended or to provide protection for lessees if the landlord or management company enter an insolvency regime.
In the case of business leases, which would fall outside this scope, it may be that there is an implied term that any contribution to the reserve or sinking fund demanded will be reasonable.
In the absence of a clause permitting, directly or indirectly, the establishment of such a sinking/reserve fund in a lease, there may not be the entitlement to demand contributions in order to establish one. Given this point, along with the procedural requirements set out above, the case law highlighted below illustrates the issues of interpretation and contention that can arise.
Cases in Point
In the absence of a provision in the lease expressly providing for the establishment of a reserve or sinking fund (whether or not referred to as such), on a proper construction of the lease the landlord may be entitled to establish such a fund. In St Mary’s Mansions Ltd v Limegate Investment Co Ltd, the terms of the lease provided that the amount of service charge due from a given tenant was to be ascertained and certified by a certificate signed by the landlord’s auditor.
A further sub-clause provided that the certificate should contain a summary of the expenses and outgoings incurred by the landlord. An additional sub-clause defined “the expenses and outgoings incurred by the lessor” as including not only those expenses actually disbursed or incurred in the year in question, but also: “Such a reasonable part of all such expenses, outgoings and other expenditure hereinbefore described which are of a periodically recurring nature … including a sum or sums of money by way of reasonable provision for anticipated expenditure … as the lessor or its accountants or managing agents may in their discretion allocate to the year in question as being fair and reasonable …”
The landlord established a reserve fund and a substantial sum was accumulated in it. In those circumstances, the court appears to have thought it clear that the landlord was entitled to establish and maintain a reserve fund, subject to complying with the procedural requirements imposed by the lease relating to certification and because the statutory trust implied by the Landlord and Tenant Act 1987 s.42 applied to the lease in question. Where there is express reference in the service charge provisions of the lease to payment of sums towards the cost of provision for future expenditure, it may not be clear whether such provisions give rise to a reserve or sinking fund.
In Secretary of State for the Environment v Possfund (North West) Ltd, it was held that, on the proper construction of the relevant term in the lease, the monies paid by the tenant were merely an indemnity against the cost actually and irreversibly incurred by the landlord during each year by virtue of the depreciation of its plant, i.e. a “depreciation allowance”. However, the judgment noted that where payments made in respect of the cost of making provision against future expenditure by way of a “depreciation allowance” are proved to exceed that which was necessary, the landlord would ordinarily be expected, at least, to give credit to the tenant for the excess against future depreciation payments.
Summary
Where the lease makes specific provision for the establishment of a reserve or sinking fund, it may do so in general or specific terms. Not infrequently the service charge clause in a lease will simply provide for service charges to include an amount towards “future anticipated expenditure”, or some such very general form of words, but sometimes it will be more specific than this and identify the subject matter of the future anticipated expenditure, for example, “plant and machinery”.
In such cases, the fund can be used only for the specified purposes. Where the terms of the lease are more general, it will be a matter of construction in each case. It is clear that a reserve fund can have benefits for both landlords and tenants, and it is worth noting that where the lease does not provide for such a fund to be established, either seeking agreement from the tenants to vary their leases or to making an application, in respect of residential property, to a tribunal for a variation of the lease can be mutually beneficial.
Should you wish to discuss service charges and the operation of service charges and sinking funds further, please contact us: [email protected] / [email protected].
