Scottish Court of Session Decisions

OUTER HOUSE, COURT OF SESSION [2013] CSOH 2
P1013/12	OPINION OF LORD MALCOLM in the Petition of MANCHESTER ASSOCIATED MILLS LIMITED Petitioner; against MITCHELLS & BUTLER RETAIL LIMITED Respondent: in an appeal under the Arbitration (Scotland) Act 2010 ________________

Petitioner: Clark, Solicitor Advocate; Young & Partners LLP

Respondent: Broome; Wright Johnston & Mackenzie LLP

10 January 2013

[1] The petitioner is Manchester Associated Mills Limited, which has a registered office in Salford. It is vested in the landlord's interest in a lease between the City of Aberdeen City Council (landlord's interest) and Drinkray Limited (tenant's interest) dated August 1981. The tenant is now Mitchells & Butler Retail Limited, which has a registered office in Birmingham, and is the respondent in the current appeal.

[2] The lease is a ground lease of subjects at Lewis Road, Aberdeen. A public house, known as "The Three Lums", has been erected on the ground in accordance with the terms of the lease and is presently operated by the tenant. The lease runs from 15 May 1980 for a period of 99 years. The rent provision is to be found at page 4 and is in the following terms:

"...The tenants bind and oblige themselves in the first place to pay to the (landlord) in name of rent seven per centum of the gross annual turnover excluding value added tax of the business to be conducted from the public house to be erected on the ground leased subject to a minimum rental of seventeen thousand five hundred pounds sterling (£17,500) per annum and a maximum rental of thirty thousand pounds sterling (£30,000)..."

The method of determining the "gross annual turnover" is that:

"(the tenants') auditors or accountants shall certify to the (landlord) the gross turnover...of the said business in respect of each year ending on and inclusive of 14 May during the currency of this lease..."

The rent is subject to a review provision, which is set out at clause EIGHTEENTH in the following terms:

"...The (landlord) or the tenants may at their discretion by notice in writing require that the minimum and maximum amounts of rental payable by the tenants in terms thereof, being rent for the ground leased exclusive of any buildings and other structures erected thereon be re-negotiated or, failing agreement, be determined by an arbiter to be mutually chosen or in the event of failure to agree by an arbiter to be appointed by the chairman for the time being of the Scottish branch of the Royal Institution of Chartered Surveyors...Declaring that the proportion of seven per centum per annum of the gross annual turnover of the said business hereinbefore stated to be the standard rate of rental shall not fall to be re-negotiated."

[3] In September 2009 the petitioner gave notice of its intention to seek a review of the minimum and maximum amounts of rent payable by the tenant with effect from Whitsunday 2010. After failed attempts to reach an agreement, an arbitrator was appointed by the chairman of RICS Scotland. After sundry procedure the arbitrator issued an award which determined that:

"...the minimum and maximum rentals payable by the tenant...as at 15 May 2010 are as follows:

1. Minimum rent £33,150 per annum exclusive,

2. Maximum rent £44,850 per annum exclusive."

As more fully explained later, the arbitrator rejected the landlord's contention that the minimum and maximum figures should be referable to 7% of the annual gross turnover of the business. Instead he had regard to market rents for other public house leases in the area, and fixed the levels at +/- 15% of 5% of the annual turnover of the "Three Lums" business. He regarded 5% of turnover as a fair market rent for the ground lease. The arbitration was conducted under the Arbitration (Scotland) Act 2010 and the associated rules.

[4] The petitioner appeals against the award on the grounds of "serious irregularity" (rule 68(1)) and of "legal error" (rule 69(1)). The respondent did not agree to an appeal being entertained, and subsequently Lord Glennie granted the petitioner leave to appeal. The petitioner now seeks an order from the court that the arbitrator should reconsider his award.

[5] The landlord notes that the lease provides that the rent for the property should be paid at a rate of 7% of the gross annual turnover. However the arbitrator has set the maximum rental figure well below 7% of the turnover in the years immediately preceding the review date. The landlord states that the purpose of a review of the minimum and maximum levels of rental is to protect the landlord from the effect of an unusually poor period of trading and to safeguard the tenant from an unduly high rent caused by an exceptionally good period of trading. It does not open up the "standard rate of rental" for a wider reconsideration in accordance with general market conditions, as argued for by the tenant. The maximum and minimum levels should be fixed in relation to the standard rent, above and below the same.

[6] The position of the tenant before the arbitrator was that the 7% provision is out of line with rents for similar premises in the area. The arbitrator was invited to review the minimum and maximum levels of rental so as to produce a rent which more accurately reflects current market rentals. Cash purchasers are aware of their buying power in the current economic conditions, often making negotiations on price difficult from the seller's perspective. The smoking ban has reduced the number of buyers in the market for traditional public houses, with a negative impact on demand and therefore values. A maximum limit of £38,000 per annum (equating to 4.78% of the 2010 turnover) was presented as a fair solution, as it would allow the rent payable under the lease to keep pace with the market, which has declined for traditional public house property, whilst still affording the landlord the protection of a minimum level of income.

[7] It was submitted that the tenant is a highly efficient operator of the business, resulting in turnover for the year end of over £795,000. This was a higher level of turnover than would be expected from a typical tenant for a property of this type and location. The tenant should not be penalised by paying a higher than market level rent. The maximum limit should be kept low since turnover does not equal profit. It was only through the purchasing power of a company of the size of the tenant that it was possible to achieve commercially acceptable profit margins.

The arbitrator's determination

[8] The arbitrator resolved the dispute as to the correct approach in favour of the tenant. He stated:

"The parties adopted opposing views as to the interpretation of (the review clause) in the lease. On the one hand the landlord's agent is of the view that the rental valuation parameters under consideration are to be viewed in the context of values above and below a level of rent, as brought out by a lease rent formula of 7% of turnover, the upper and lower limits to be re-negotiated each five years. On the opposing hand, the tenant's agent's view is that the market for the type of subject should be considered when determining the minimum and maximum rents which are to be paid in terms of clause EIGHTEENTH of the lease. It is evident that this dispute hinges on the meaning to be attributed to the clause regarding re-negotiation of minimum and maximum rents, namely clause EIGHTEENTH."

The arbitrator then referred to legal opinions which had been obtained on behalf of the parties. He set out his conclusions as follows:

"Clause EIGHTEENTH does not state that the minimum and maximum figures are to be above and below 7% of turnover. I am persuaded on the balance of the arguments put to me, that this determination is to be made in terms of the market. I find it persuasive in a situation involving a re-negotiation of rental levels, including maximum and minimum levels such as are contained within this contract, to take into account the reality of the market unless the terms of the lease specifically direct not so to do; I find no such direction in the contract with which we are currently concerned and accordingly it is, I consider, reasonable to give due consideration to evidence of value."

The arbitrator then considered the market information presented to him. He summarised it as follows:

"1 Comparisons provided evidence of rent being charged on the basis of figures between 6.75% and 8% of turnover where a developed site was in consideration.

2. Comparisons provided evidence of rent being charged on the basis of ground rents at around 5% of average turnover."

His assessment of rental value was in the following terms:

"I have given careful consideration to the submissions and counter-submissions presented to me, to the market information and relevant evidence presented to me in various ways, partly from my enquiries (and submitted to parties for their comments) and the legal opinions (where relevant) provided by parties and I am persuaded that the correct procedure to adopt in determining the maximum and minimum rents under this clause is to apply the market evidence for ground lease public house premises as has emerged from these many exchanges. I conclude that 5% of average turnover is a reasonable basis for measuring fair market rent for the ground in question, at the relevant date.

Accordingly:

Certified turnover as at May 2010 - £795,741.35

Certified turnover as at May 2009 - £760,554.09

I consider it reasonable to adopt these two years for the purposes of identifying a maintainable level of turnover; I average these trading years as:

£778,147.70 x 5% = £38,907.38, say £39,000 fair market rent.

I consider it reasonable to adopt +/- 15% of fair market rent as the maximum and minimum amounts of rental payable by the tenants, being the rent for the ground leased exclusive of any buildings or other structures erected thereon, in terms of clause EIGHTEENTH of the lease, and accordingly these I determine at £44,850 and £33,150 respectively."

In summary the arbitrator considered that he was entitled to determine the maximum and minimum levels of rental by reference to market conditions. The information before him suggested that, for a public house ground lease, 5% of average turnover is a reasonable basis for identifying a fair market rent for the ground in question at the relevant date. He then took an average of the turnover for the immediately preceding two years, applied 5% thereof as a fair market rent, and fixed the maximum and minimum levels by reference to a +/- 15% calculation.

In essence the landlord's complaint is that the terms of the lease required the arbitrator to have regard to the 7% of turnover provision in the lease, and therefore apply any +/- calculation to 7% of the average turnover figure, which would result in a baseline of about £54,500. 15% of that is £8,175, giving rise, on this approach, to a maximum figure of £62,675, and a minimum of £46,325. The arbitrator's maximum figure for rent falls well below 7% of the average turnover figure used. This is the nub of the landlord's concern as to the consequences of the outcome of the arbitration.

Submissions for the landlord

[9] Mr Clark submitted that the legal error appeal is supported by the following six points:

1. The arbitrator ignored or gave insufficient weight to the terms of the rent provisions.

2. The arbitrator ignored or gave insufficient weight to the terms of clause EIGHTEENTH.

3. The arbitrator erred in law by making the determination "in terms of the market".

4. The arbitrator erred by stating that his determination is a "re-negotiation of rental levels".

5. The arbitrator erred by stating that he would "apply the market evidence".

6. The arbitrator erred by concluding that "5% of average turnover is a reasonable basis for measuring fair market rent."

[10] Mr Clark stressed that the primary obligation is for the tenant to pay 7% of the gross annual turnover of the business conducted from the public house. That primary obligation is qualified by the upper and lower limits on the amount of the rental. The tenant is to pay 7% of the gross annual turnover "subject to" the upper and lower amounts. Accordingly the upper and lower bounds are to be determined by reference to a figure which represents 7% of turnover. The turnover provision is excluded from the rent review clause, which in terms describes the 7% proportion as the "standard rate of rental." In proceeding upon the basis of the market the arbitrator departed from the explicit terms of the lease. It is not open to the arbitrator to conclude that 5% of average turnover is "a reasonable basis for measuring fair market rent for the ground in question". In effect the arbitrator reviewed "the standard rate of rental". He applied his own assessment of a fair market rent as the basis for determining the minimum and maximum amounts of rental.

[11] Mr Clark also mounted a challenge in terms of a serious irregularity under rule 68(1). Mr Clark relied upon rule 47 which provides:

"(1) The tribunal must decide the dispute in accordance with -

(a) the law chosen by the parties as applicable to the substance of the dispute...

(2) Accordingly, the tribunal must not decide the dispute on the basis of general considerations of justice, fairness or equity unless -

(a) they form part of the law concerned, or

(b) the parties otherwise agree."

In agreement with the tenant's submission on this, in my view there is no substance in the proposition that the arbitrator was in breach of the terms of this rule. If he correctly interpreted the relevant terms of the lease, he was entitled to proceed as he did. He was not setting aside the relevant law, nor embarking upon some unjustified frolic of his own, based upon subjective notions of justice and fairness. He considered that the parties' contract allowed him to proceed as he did. The question arising in this appeal is whether that conclusion was correct. In other words, did he err in law?

Submissions for the tenant

[12] Mr Broome pointed out that there are no express terms in the lease as to the criteria to be applied in reviewing the maximum and minimum levels of rent. In the three years prior to the arbitrator's determination, 7% of turnover was above the then maximum rental of £46,000. Accordingly the respondent had been paying an amount which was less than 7% of turnover in the majority of the five years governed by the preceding rent review process. Mr Broome suggested that the various points relied upon by Mr Clark all came down to one basic proposition, namely that the arbitrator misconstrued the relevant terms of the lease. The commercially sensible construction of the lease is that, when determining the maximum and minimum levels of rent, one should apply the market evidence of fair or open market rent for ground leased public house premises. The lease was entered into in 1980 and is to last for 99 years. The five yearly rent review pattern is fairly standard. Most modern commercial leases provide that, after each of the planned review dates, the rent shall be the open market rent or, if higher, the existing rent, with that rent, if not agreed by the parties, being determined by an independent third party. An open market rent approach requires a consideration of rents paid for comparable properties adjusted to circumstances. This was the procedure adopted by the arbitrator when assessing the minimum and maximum levels of rent. It is against this general commercial property background that the parties' choice of a rent with a turnover element, subject to reviewable minimum and maximum levels, falls to be considered.

[13] Mr Broome observed that pure turnover rents, by which the rent is exclusively a percentage of the tenant's turnover, do exist in the UK, particularly for premises in shopping centres. They are also common for rented retail premises in airports. In the present case the rent is not a pure turnover rent. It is subject to maximum and minimum rental levels. Under reference to passages in various textbooks and journal articles, Mr Broome observed that it is common for rents with a turnover element to be subject to a base rent. The purpose is to give the landlord comfort that an adequate level of guaranteed income will be achieved, and thus make the property a commercially attractive investment. Accordingly, the valuation of the base rent must be construed against that commercial purpose. Linking the base rent directly to the turnover of the tenant subverts its commercial purpose by making the rent entirely dependent upon the performance of the business. That makes no commercial sense. Such an outcome could have been achieved by providing a turnover rent with no minimum rental level.

[14] Mr Broome submitted that the arbitrator adopted a commercially sound construction by using the market level of rent. To construe this lease otherwise would be to hold that the original parties intended their rent review clause to give rise to maximum and minimum rental figures moving up and down directly in accordance with, and only in accordance with, the vagaries of turnover over 99 years.

Discussion and decision
[15] The court's task is to decide whether the arbitrator's decision amounts to an error in law, in that he failed to follow the intention of the parties as expressed in the lease. The starting point must be the words used in the lease, construed in the context of a 99 year ground lease of a public house business. The original tenants bound themselves to pay an annual rent at 7% of gross annual turnover, subject to a minimum of £17,500 and a maximum of £30,000, with the minimum and maximum figures subject to review every five years. There was to be no change in respect of the 7% of turnover rental provision throughout the term of the lease. There is no indication in the lease as to the basis upon which the original minimum and maximum figures were calculated. This is the first time that a review has been remitted to arbitration. Previously the parties agreed to fix the levels by reference to 7% of the turnover in the period immediately before the relevant date.

[16] It may be helpful to try to understand why the rent clause was framed as it was. It is not a straightforward percentage of turnover rental provision. It is not a percentage of turnover, subject to a base amount. It has both a minimum and maximum, or "collar and cap" as sometimes described. As to the content and structure of the clause, there are at least two possible explanations. The relatively wide range may have been fixed by reference to an anticipated band of rentals within which it was thought that 7% of likely gross turnover would fall in the five year period. If correct, this would support the landlord's argument. Another possibility is that the range was set by reference to a band of fair or market rents anticipated to be appropriate for the ground lease over the five year period, with the precise rent to be fixed each year by reference to the 7% of gross turnover provision in combination with the minimum and maximum levels. If this is correct, it would provide support for the tenant's position and the arbitrator's decision. One problem with this latter explanation is that it is more difficult to reconcile with the clear reference to the rental being 7% of turnover, and that this is to remain unreviewed throughout the whole term of the lease.

[17] The arbitrator has adopted a comparator or market rental approach to the fixing of the minimum and maximum figures. He said that he did this because the lease does not instruct him otherwise. The landlord contends that the instruction, though not express, is to be implied or inferred from what is said in the lease - and in particular the reference to 7% of turnover as "the standard rate of rental". Mr Broome submitted that this part of clause EIGHTEENTH should receive little weight because it says 7% of turnover "hereinbefore stated to be the standard rate of rental", and in fact the lease does not make any earlier mention of a standard rate of rental. Bearing in mind that, if possible, content should be given to every part of a deed, I interpret this part of clause EIGHTEENTH as simply a reference back to the first part of the rental clause, which provides that the tenants will "in the first place" pay a rent of 7% of turnover. Granted this was "subject to" the minimum and maximum figures, but it seems reasonable to approach the 7% as the agreed primary or "standard" rate of rent.

[18] The arbitrator has made use of the gross annual turnover of the business in his calculation of the minimum and maximum levels. He took an average of the turnover for the two years before the review date. He then set the maximum and minimum levels at +/- 15% of 5% of that figure. He did this because the evidence indicated that, at the time of the review, 5% of annual turnover was generally treated as a fair rental for a lease of ground upon which a public house business is conducted. The question is - is this consistent with the agreement set out in the lease?

[19] It does seem remarkable that, notwithstanding the terms of the rental clause, and the inviolability of the 7% of turnover provision, the maximum and minimum levels have been fixed without any reference whatsoever to 7% of the turnover in the period prior to the relevant date. For whatever reason, the original parties fixed upon 7% of gross turnover as the measure of the rental, subject to the base and cap figures. The arbitrator's award has set the maximum figure for the next five years well below 7% of average gross annual turnover for the period leading up to the review. Is he entitled to do that? The terms of the lease do not provide any express guidance. As I said earlier, there are at least two possible explanations for the rental provisions, one favouring the landlord's argument, the other that of the tenant. Mr Broome insists that his approach is the more commercially sensible, relying upon now well-trodden ground in recent case law. The difficulty is that often one party's commercial good sense is another's prejudicial unfairness.

[20] If it is helpful to try to imagine what the original landlord and tenant might have regarded as commercial good sense, I see no reason why they should not have decided to fix upon 7% of gross annual turnover as the rental, and then set minimum and maximum figures on the basis of certain assumptions as to what the 7% rental might be in the first five years of the tenancy. They could envisage repetition of this exercise every five years in the light of changing circumstances, for example in respect of inflation and trading conditions. In what way does this fail to make commercial good sense? It reflects the decision to settle upon 7% of gross annual turnover as the main measure of the rental payment. If it were to turn out that the assumptions as to turnover were wrong in either direction, the minimum and maximum figures would provide protection to respectively the landlord and the tenant. It is striking that the initial range was so large - £17,500 to £30,000. This suggests that the parties were trying to cater for likely movements over the five year period.

[21] During the hearing Mr Clark was at pains to emphasise that his submission was that 7% of the gross turnover should be "the starting point" for the exercise of fixing the minimum and maximum levels. As I understood it, this recognised that there might be exceptional circumstances which require to be taken into account, for example that the turnover for one year was exceptionally high or particularly low because of special circumstances, such as the business was closed for lengthy refurbishment, road closures, etc. If it was apparent that due to circumstances personal to the tenant at the time, the turnover was abnormally low - or high - then this could be taken into account when fixing appropriate minimum and maximum levels. However the essential point was that, in the absence of unusual factors, the arbitrator could not simply ignore 7% of the gross annual turnover when making his determination. He should not proceed solely by reference to rental levels in respect of other properties which are leased on very different rental terms. None of the "comparators" provided for turnover rents.

[22] The wording of the rental clause at page 4 of the lease (quoted earlier at paragraph 2) suggests to me that the parties intended that there would be a link between the 7% of turnover rental provision and the minimum and maximum amounts. In addition the lease specifies that the 7% will remain in place for the whole of the lease, and that only the minimum and maximum figures will be subject to change every five years. Again this suggests a link between 7% of turnover and the minimum and maximum levels. So, for example, if, as appears to be the case here, during a five year period 7% of turnover increases well beyond the applicable range, the review will allow the maximum figure to catch up with the improved performance of the business. As it is, the effect of the arbitrator's decision is that 7% has been replaced by 5%. Rather than fix the upper and lower limits in such a way as to allow the rental payments to match the growth in turnover, the arbitrator has thwarted what I would take to be part of the purpose of the review. In my view the arbitrator's approach does less than justice to the full terms of the rental provisions in the lease. It is not consistent with the original parties' agreement. In short, the arbitrator erred by fixing the figures solely by reference to general market conditions.

[23] This still leaves room for the exercise of discretion or judgment by the arbitrator, who, as Mr Broome pointed out, will be a chartered surveyor with expertise in this area of work. For example, he may wish to consider whether there are any relevant special circumstances relating to the recent gross turnover which require to be taken into account. He is setting the figures for the next five years, so he might ponder upon inflation forecasts and likely trends in the trade. He must decide upon the figures themselves, including whether he wishes to set the minimum figure in the region of current turnover, or materially below it. He must determine the maximum figure. He may wish to apply his mind to a range which is likely to be appropriate for a five year period. In the present case, with reference to the 5% figure, the arbitrator chose +/- 15%. He did not explain the reasoning behind this, but no doubt, if the appropriate reference to 7% of turnover had been adopted, this kind of decision would fall within the area of his reasonable discretion.

[24] In general a landlord will be reluctant, especially over 99 years, to tie the rent exclusively to a percentage of turnover, a figure which may fluctuate for a wide variety of reasons. Necessarily the landlord's income would be uncertain and valuation would be a difficult exercise. The landlord will be concerned as to the investment value of his property. In support of his submissions, Mr Broome placed emphasis upon such concerns. However, in my view the minimum and maximum figures and the review provisions in this lease can provide some protection to the landlord in this regard, for example if a tenant is persistently neglecting the business and thereby depressing the turnover well below any normal expectations. One would expect an arbitrator, in an appropriate case, to have this in mind when fixing the minimum figure. This is not a pure percentage of turnover lease. The arbitrator is not absolutely tied to 7% of turnover no matter how low (or high) that figure may be. That said, my view is that, special circumstances aside, the exercise should be carried out under reference to a rental of 7% of gross annual turnover. Instead the arbitrator relied solely upon market rental evidence based on other tenanted public houses in the area. Whatever else, this is not an open market rental lease, though, in effect, the arbitrator has treated it as such. The lease makes no mention of open market levels; but there is specific agreement as to a rental based on 7% of turnover, albeit subject to the collar and cap.

[25] I have reviewed the case law, textbook passages and contributed articles relied upon by Mr Broome. However I find nothing in them which persuades me that the opinion which I have reached is removed from commercial reality. Throughout the lease, the commercial purpose was to maintain a link between the rental payments and 7% of the gross annual turnover of the public house business. There may be advantages/disadvantages in this to one or both parties, but this does not render the bargain unreal or absurd.

[26] Mr Broome placed weight upon the decision in City of Aberdeen Council v Clark 1999 SLT 613, but it is of no real assistance to the proper interpretation of the very different terms of the current lease. In that case the court proceeded upon the basis that, absent anything in the lease suggesting the contrary, the rent review should be conducted on the basis of assessing a fair and reasonable rent, which no doubt would generally involve evidence as to open market rentals in respect of comparable leases. Any other result would have had the absurd result that the rent would be unchanged for 99 years, notwithstanding the review clause. I agree that, in general, rent review provisions are designed to reflect changes in the value of money and real increases (or decreases) in the value of property. Nonetheless the fact remains that the current review must take place within the framework of the specific bargain struck by the original parties to this lease.

[27] In GREA Real Property Investments Limited v Williams [1979] 1 EGLR 121 Forbes J (at page 123) said:

"The only principle of law which I think it necessary to enunciate is thus the simple one that any method of valuation must properly reflect the intention of the parties as expressed in the lease..."

In my view, and for the reasons given above, the valuation approach adopted by the arbitrator did not properly reflect the intention of the parties as expressed in the lease. I therefore uphold the legal error appeal, quash the arbitrator's determination dated 1 August 2012, and remit the whole matter to him for reconsideration. It will be for him to determine the appropriate minimum and maximum levels, though I hope that he will gain some assistance from the terms of this opinion.