Baycloud v Dowling Investments [2005] NSWSC 237

Reported Decision : (2005) NSW ConvR 56-124

New South Wales Supreme Court

CITATION : Baycloud v Dowling Investments [2005] NSWSC 237

HEARING DATE(S) : 17 March 2005

JUDGMENT DATE : 17 March 2005

JURISDICTION : Equity

JUDGMENT OF : Campbell J

DECISION : Initiation of market review in third year is obligatory. Clause providing for percentage increase in subsequent years does not apply if no market review in third year.

CATCHWORDS : LANDLORD AND TENANT - rent review clause - whether lessor obliged to initiate a market rental review each three years - whether, when lessor has not initiated market rental review in the third year, a clause providing for fixed percentage increases in subsequent years applies

LEGISLATION CITED : A New Tax System (Goods and Services Tax) Act 1999

CASES CITED : United Scientific Holdings Limited v Burnley Borough Council [1978] AC 904

Baycloud Pty Limited - Plaintiff PARTIES : Dowling Investments Pty Limited - Defendant

FILE NUMBER(S) : SC 4889/04

I Lawry - Plaintiff COUNSEL : T H Barrett - Defendant

Slater & Elias - Plaintiff SOLICITORS : Gordon Garling Moffitt - Defendant

LOWER COURT JURISDICTION :

IN THE SUPREME COURT OF NEW SOUTH WALES EQUITY DIVISION EQUITY LIST

CAMPBELL J

THURSDAY 17 MARCH 2005

4889/04 BAYCLOUD PTY LIMITED v DOWLING INVESTMENTS PTY LIMITED JUDGMENT – Ex Tempore (Revised 17 March 2005) 1 HIS HONOUR: This dispute concerns the construction of the rent review clause in a lease of hotel premises. The Lease 2 The lease in question is one which was entered into on 25 July 1990 and relates to the premises where the Commercial Hotel at Young is conducted. The term of the lease is expressed to be one for a period of 5 months commencing on 1 August 1990 and terminating on 31 December 1990. 3 The original Lessor under the lease was Austotel Management Pty Ltd. The plaintiff in the present proceedings was the original Lessee. 4 By a deed made 19 September 1991 between the defendant in the present proceedings and the plaintiff, the defendant agreed to observe and perform the covenants and conditions in the lease. The defendant has been the Lessor of the premises since around the time of that deed, I would infer. 5 Although the lease was for only a five-month period, there were recitals in it, as follows: "A. The Lessor is and has over many years been the registered proprietor of numerous hotel properties in New South Wales, B. The Lessor has over many years granted leases of its hotel properties to hoteliers. C. A practice was established pursuant to which a Lessee believed he was entitled to the following rights:- (i) to continue to occupy the Leased Premises following the expiration of the initial term of the lease in return for the Lessee agreeing to pay rent subject to reasonable rent reviews from time to time and not more than annually; … (iii) to be able to sell his interest on the open market notwithstanding the expiration of the initial term of the lease; … D. The Lessor and the Lessee have entered into this lease for the purpose of confirming the practice and rights referred to in the preceding recital, but without prejudice to the right of the parties to vary the terms hereof by written agreement." 6 The lease has a bizarre way of referring to its sub-units. Each separately numbered item in the lease is referred to as a "section", but subdivisions within each "section" are referred to as "clauses". The lease provided, in Clause 4.01, as follows: "The Lessor and the Lessee agree and declare that it is the intention of the parties that the demise hereby granted will continue upon the terms and conditions of this Lease until terminated by the Lessor or the Lessee …" 7 The Lessee's interest in the hotel which is referred to in recital C(iii) is something which is more fully defined in Section 5 of the lease. The relevant provisions of it are: "Section 5 - Interest of the Lessee 5.02 The interest of the Lessee for the purposes of these presents is the right to occupy the Leased Premises on the terms and conditions of this Lease, subject only to the right of the Lessor or the Lessee to terminate the interest of the Lessee pursuant to and in accordance with the provisions of Section 16, 18 and 19 hereof. 5.03 The Lessor and the Lessee agree and declare that for the purposes of rent reviews pursuant to the provisions of Section … 22 hereof, … the value of the interest of the Lessee shall be deemed to be the current market capitalised value of the profitability which might reasonably be expected of the hotel business conducted by the Lessee from the Leased Premises at the time of calculation of the value of the interest of the Lessee if run by a competent and efficient operator with a right to carry on the hotel business from the Leased Premises on the terms and conditions of this Lease at the Yearly Rent and Additional Yearly Rent payable at the time of valuation but subject to review in accordance with the provisions of this Lease." 8 The rental payable under the lease was specified, in Clause 6.01 and the Schedule to the Lease, as being a yearly rent, of $47,746.20, payable by monthly instalments of $3,978.85. There was also provision for the Lessee to pay something called Additional Rent which was connected with the payment of license fees, but that Additional Rent is not the subject of the present dispute. 9 Section 21 of the lease, entitled "Holding over provisions" made provision as follows: "21.01 The Lessee shall be entitled to remain in occupation of the Leased Premises after the expiration of the term hereof and shall continue to hold as a yearly tenant under all the terms and conditions hereof at a Yearly Rent determined as follows: Consumer Price Index Reviews (a) For each year of such holding over period in which there is no market review of rent pursuant to Clause 21.03, the Yearly Rent shall be either:- (i) an amount equal to One hundred and six per centum (106%) of the Yearly Rent payable by the Lessee during the immediately preceding year; or (ii) [an amount which gave a CPI increase] whichever is the greater PROVIDED HOWEVER THAT nothing herein contained shall operate so as to increase the Yearly Rent for such year by more than nine per centum (9%). 21.02 No rent review pursuant to the provisions of clause 21.01(a) shall take place in any year where a market review of rent shall be required to take place pursuant to the provisions of clause 21.03. 21.03 Market Reviews (a) At any time: (i) not earlier than three (3) months prior to the expiry of the second year of the holding over period; and (ii) not earlier than three (3) months prior to and not later than three (3) months following the expiry of each third year thereafter, the Lessor shall notify the Lessee in writing of the amount which at the expiry of such period of years the Lessor claims to be the amount at which the Leased Premises could be leased on the open market on the terms and conditions of this lease to a willing but not anxious lessee on the assumption that a purchase price equivalent to the value of the Lessee's interest as defined in clause 5 hereof had to be paid by any proposed lessee simultaneously with the first payment of rent (the "Market Rent")." 10 Section 21.03 then went on to set out a detailed procedure by which the Market Rent could be ascertained, either by agreement between the Lessor and Lessee or, ultimately, by the determination of a valuer. It continued: "21.03(d)(ix) in making the determination of the Market Rent, any such valuer shall be deemed to be acting as an expert and not as an arbitrator and may have regard to: A. the current Yearly Rent under this Lease; B. the terms and conditions of this Lease; C. the current capital value of the Leased Premises as a going concern valued as a freehold in possession; D. the value of the Lessee's possessional interest as defined in clause 5 hereof; E. the Improvement Works effected by the Lessor to the extent to which such works have increased the potential profitability of the hotel business conducted from the Leased Premises by the Lessee; F. the loss of profits (if any) incurred by the Lessee during the period in which the Improvement Works were being undertaken; and G. rentals paid in respect of comparable leasehold hotels which recognise a possessional interest in the Lessee. … (xi) until a determination is made pursuant to paragraph (ix) the Lessee shall continue to pay the Yearly Rent at the rate which would have applied had this clause not been applied and any variation in the Yearly Rent resulting from a determination in accordance with paragraph (ix) shall take effect from the expiry of such period of years and upon the said determination resulting in an increase in the Yearly Rent, the Lessee shall forthwith pay to the Lessor all outstanding Yearly Rent together with interest thereon calculated on monthly balances at the rate of the aggregate of two percentum (2%) and the Bank Bill Rate provided that such interest will not be payable if the Lessee is not required to pay the costs of the determination pursuant to paragraph (x)(8)." 11 It is common ground between the parties that Clause 21.05 has no bearing upon the present problem. Events Leading to these Proceedings 12 As it happens, no rental increases at all were claimed by the defendant, or paid by the plaintiff, during the whole time that the plaintiff has been in occupation. On 23 September 2003 a letter from the defendant's solicitors to a director of the plaintiff foreshadowed that the defendant would review the rent of the premises. It informed him that the landlord was in the process of obtaining an independent valuation of the current market rent, and would advise him of the valuation when it had been completed. 13 There matters rested, so far as rental increases were concerned, until 1 April 2004. On 1 April 2004 the Lessor made a demand for rental, calculated on the basis that the yearly rent should have increased by 6% on 1 January each year since 1991. On that basis, the landlord asserted that the yearly rent should be $101,839.21. No mention was made of a rent review based on a valuation. That is understandable, as 2004 was the fourteenth year of the holding over period, and the lease did not allow for a market review in the fourteenth year. 14 The plaintiff's solicitor did not accept that the defendant was entitled to increase the rent in this fashion. There was some correspondence between solicitors where each side sought to explain its contentions to the other, but neither succeeded in persuading the other, and these proceedings were commenced. Rent During the First Two years of the Holding Over Period 15 It is common ground between the parties that the consumer price index has at all times been less than 6% during the period which is relevant to this litigation. Hence, it is clause 21.01(a)(i) which governs the situation in each year in which there is no market rental review pursuant to Clause 21.03. 16 The contention of the plaintiff is that during the first year of any holding over period, Clause 21.01(a) operates, and hence the rental payable is 106% of what it previously was. The plaintiff says that, in the second year of any holding over period, the rental is, pursuant to Clause 21.01(a)(i) 106% of 106% of the rental during the last year of the term. 17 The defendant accepts the plaintiff's argument so far. Rent During the Third Year of the Holding Over Period 18 It is at the third year of the holding over period that the contentions of the plaintiff and the defendant diverge. Both parties agree that, if there is a market review in the third year of a holding over period, the provisions of Clause 21.03 will operate to fix a rent for that third year. The difference between them concerns the situation which in fact applied in relation to this lease, where there is no market review initiated in the third year of the holding over period. 19 It is the plaintiff's contention that there is an obligation on the Lessor under Clause 21.03(a) to initiate the rent review process in that year. The plaintiff points to various factors in support of that. It points to the fact that the clause contains the expression "shall notify", which is one commonly used to express an obligation to notify. It points to Clause 21.02, which refers to a year "where a market review of rent shall be required to take place pursuant to the provisions of clause 21.03", which states, even more clearly than the phrase "shall notify" in Clause 23.03, an obligation. It points, as well, to recital C(i), which expresses a common understanding of the parties that the Lessee will have a right to continue to occupy the premises in return for paying rent "subject to reasonable rent reviews from time to time and not more than annually." 20 As well, it points to the way that the lease is one which is obviously intended to have the capacity to govern the relations of the parties over a period of many years, and that it would not be expected that the parties would agree to a rental clause which was not brought back in line with market rentals periodically. 21 The defendant submits that, rather, Clause 21.03(a) confers an option on the Lessor to initiate a market rent review each third year, but that there is no obligation on the Lessor to do so. It points in particular to the opening words "At any time." The defendant submits that the opening words "at any time" relate to the words "the Lessor shall notify the Lessee in writing ...". In that way, the Lessor submits, the clause is conditional, and means, in effect, that if the Lessor shall notify the Lessee of an amount which it says is the market rent, the rent review process is initiated. It is implicit in the Lessor's submission that the expression "shall notify" in Clause 21.03 is not an expression which indicates an obligation, but is merely a use of the future tense. The existence of the word "required" in Clause 21.02 is adequately explained by taking it to mean "required by the Lessor, if the Lessor so chooses". 22 In my view, the plaintiff's way of reading Clause 21.03 is to be preferred. The proper way of reading the opening words of Clause 21.03, "At any time", is to read them with paras (i) and (ii) which follow, so that the resulting expression is one which sets a period during which the Lessor is required to act. The proper construction of the clause, in my view, is that the Lessor has an obligation to notify the Lessee in writing of an amount it claims to be Market Rental, and that obligation is one which the Lessor can perform at any time which fits within paras (i) or (ii). The role the defendant seeks to give to the words "At any time", involving treating them as meaning "If" or "when", has the effect that Clause 21.03(a) is an incomplete proposition – it has the form "if (or when) a particular event happens", without going on to say what is the consequence of that event happening. It is implausible that that is what the parties intended. 23 While the defendant's argument about the explanation for the word "required" in Clause 21.02 would have persuasive force if the defendant's construction of Clause 21.03 were right, it cannot be accepted when the defendant's construction of Clause 21.03 is wrong. 24 As well, I place weight on the usual commercial function of rent review clauses, as being, in long leases, to keep the rental in line, roughly, with market conditions: United Scientific Holdings Limited v Burnley Borough Council [1978] AC 904 at 948,958-9. 25 It follows from this, in my view, that Clause 21.02 has the effect that, during the third year of any holding over period, and in relation to any other part of a holding over period when the Lessor must initiate a rent review pursuant to Clause 21.03, the provision for 6% or CPI increases in Clause 21.01(a) does not operate. 26 I accept the submission put by Mr Barrett for the Lessor that in the opening line of Clause 21.01(a) the expression "each year of such holding over period in which there is no market review..." refers to years in which there is in fact no market review. 27 Accepting that construction, however, Clause 21.02 then operates as an exception to the situation which would otherwise arise. By that I mean that, if Clause 21.02 were not there, and the Lessor had chosen to not have a market review under Clause 21.03, the effect of Clause 21.01(a) would be that there would be a 6% or CPI increase. What Clause 21.02 does is to say that that situation will not apply during a year when there is a market rent review required, without reference to whether that market rent review is in fact performed. 28 I give only slight weight to the recital C(i) in deciding what the rent should be in the third year of holding over. I accept that it is open to argue that a "reasonable rent review" could be one which arose from a 6% or CPI increase, and indeed in those years between market rent reviews under Clause 21.03 the parties obviously regarded Clause 21.01(a) as providing one of the reasonable rent reviews that they had agreed to. However, that does not enable the express words of Clause 21.02 to be overcome. 29 The plaintiff accepts that during the third year of the holding over period, if its contention that Clause 21.03(a) creates an obligation on the Lessor is correct, there would be an obligation on it to continue to pay rent at the same rate as it had paid during the second year of the holding over period. The plaintiff is right in taking that view. If, in relation to any year, there is no provision in section 21 which results in the rental increasing, then it must remain the same as it was immediately before that year. Rent During Fourth Year of Holding Over Period 30 Concerning the fourth year of the holding over period, the plaintiff accepts that if the literal words of Clause 21.01(a) apply, the result would be that there would be a rental payable which was 106% of that payable in the third year. However, the plaintiff submits that it would not be correct to adopt a literal construction of Clause 21.01(a) in the fourth year of the holding over period if the Lessor had not triggered the market review provisions in the third year. The basis for this is, the plaintiff contends, to be derived from the structure and purpose of the lease. 31 The plaintiff points out that the lease is one for a particular variety of commercial premises, namely a hotel. It points out that the lease is one which could endure for many years under the holding over provisions, and that under the express terms of the lease, it is only the Lessor who can initiate a rent review. It accepts that it might be open to the Lessee to obtain an order for specific performance of the Lessor's obligation under Clause 21.03 to notify the amount the Lessor claims to be the market rental, but says that the lease ought be construed on the basis that the parties are expecting it to be performed, and not that they would need to go to Court to require it to be performed. The plaintiff points out that there is no ratchet provision in the rental review mechanism, so that there is no prohibition on the rental going down following a market review. As well, the factors which are required to be taken into account by a valuer under Clause 21.03(d)(ix) are ones which show that the rental determined in a market review would be capable of reflecting a decrease in the profitability of the hotel as a going concern, by going down. Even though the price of things might usually go up, the plaintiff says that it was readily foreseeable at the commencement of the lease that the profitability of the hotel might go down, as the trading of a hotel in a country town is always open to being affected by competition, changes in the popularity of particular drinking places, and the vagaries of the rural economy. It says that it would not be commercially reasonable to construe Clause 21.01 as applying, in the fourth year of a holding over period, regardless of whether there has been a market review in the third year, because that way of construing it could give the Lessor a rental which was well above a market rental. The lease, as so construed, would ensure that the Lessor received steady increases in rentals, no matter how unprofitable the hotel trading might become. 32 Concerning this construction, the plaintiff returns to recital C(i). It says that, to construe Clause 21.01(a) as applying in the fourth or a subsequent year of a holding over period, when there had not been market review of the rent in the third year, is something which could result in there being an unreasonable rental review, in that the rent would, by that mechanism, come to be out of line with market conditions. It is one thing, the plaintiff says, to accept that it is reasonable to increase the rental by the greater of 6% or CPI when there has been a market rental review within the previous three years, but quite another to accept that the application of the greater of 6% of CPI increases will result in a reasonable rental if there has not been a comparatively recent corrective of the rental to a market rental. 33 As well, the plaintiff places reliance on recital C(iii). It says that, if the hotel were to be subjected to a rental, by the operation of Clause 21.01(a) in the fourth or subsequent year of a holding over period which was significantly more than a current market rental for the property, that would provide a significant impediment to the ability of the Lessee to sell its interest in the hotel on the open market. 34 In light of the way that the Lessee's interest in the lease is defined in Section 5 of the lease, I accept the submission that, if the rental were to become significantly more than market rental, that could provide an inhibition on the Lessee's ability to sell his interest in the hotel on the open market. 35 The plaintiff accepts that the matters of structure and purpose to which it points depend heavily upon the possibility that the rental might go down on a market rent review. It says that this possibility is an appropriate one to look to, however, given that the Lessor has every opportunity under the lease to protect himself in a rising market by initiating the rent review process under Clause 21.03. That the Lessor has not initiated market rent reviews in the past will not prevent it from doing so in the future. 36 Further, the plaintiff says that, if the rentals were ones which would continue to increase in non-rent review years by 6%, and the Lessor were to continue, in the sixth, ninth, and so on, years, to not initiate a rent review, the Lessee would be subjected to rents which became increasingly out of line with market conditions. This would be so even though the effect of this happening was that, averaging over all the years of the lease, the net effect was roughly that of a 4% increase each year. 37 If this approach of the plaintiff were not to be adopted, the effect would be that (ignoring for the moment the possibility of a CPI increase under Clause 21.01(a)(ii)) the rental in the third year would be the same as in the second year, but that the rental in the fourth year would be the same as in the second year plus 6%, and in the fifth year would be a 6% increase on the rental in the fourth year. 38 The defendant points to the fact that, at the time the lease was entered, in 1990, the parties contemplated as a possibility that inflation might exceed 9%, and hence made provision for capping a CPI increase at 9%. It also points to the generally inflationary conditions which had existed around that time and in the years immediately before. 39 In my view, the plaintiff's contentions concerning this matter are to be preferred. The lease proceeds on a basis that there will be regular rent reviews, and the express terms of the lease proceed in the framework of that assumption. If that assumption is a misplaced one, the express words of Clause 21.01(a) ought not be given their literal meaning. It is very common when commercial agreements are negotiated, for provisions to be included on the basis of an assumption which the parties share. The wording of provisions needs to be construed bearing in mind that framework of assumptions. Another way of putting this is that the literal words of a contract do not apply to a situation which is outside the four corners of the contract. 40 Here the parties made express one of the assumptions which they shared, namely that there would be a rental review every third year, which would bring the rental back to market levels. When that assumption has been falsified, and has been falsified by the Lessor's failure to adhere to its obligation to make that assumption good, giving effect to the purpose of the agreement, that there shall be reasonable rent reviews, does not enable Clause 21.01(a) to apply. Rather, the situation is the same as in years when a rent review is called for, namely that the rental which was payable during the immediately preceding year continues to be the rental which is payable. That is so because there is no applicable clause of the lease which can alter the rental. 41 The arguments about the rent payable in the fourth and fifth years of the holding over period, when there has not been a market review in the third year, apply also to the rents payable in the seventh and eighth years of the holding over period, when there has not been a market review in the sixth year. 42 I make the declaration in paragraph 1(i) of the amended summons. I declare that upon the proper construction of the lease dated 25 July 1990 in the third and subsequent years of the holding over period and until such time as the Lessor initiates a rent review under Clause 21.03 and that rent review is completed, the plaintiff has been and will be obliged to pay rental to the defendant at the same rate as applied during the second year of holding over, namely $53,647.63 per annum, together with such tax as is payable under A New Tax System (Goods and Services Tax) Act 1999. 43 I order the defendant to pay the plaintiff's costs. **********