Evidence of trading accounts on rent reviews

Jonathan Karas QC

The "profits" method of valuation involves a valuer trying to estimate the profit which would be likely to be earned by a tenant who operate a business at premises and then attributes a part of that profit to the rent which such a tenant would be willing to pay. This method of valuation is common in the leisure industry and properties such as car parks where the "comparable" method of valuation is considered unreliable - indeed, it may be impossible to find true comparables.

Plainly, if one were advising a tenant occupying premises what he ought to pay for them, one would have regard to the profits which he has earned as a guide to what he might earn in the future and what rent he should pay.

Unfortunately, most modern rent review clauses (even relating to premises where a profits method of valuation is most appropriate) do not assess the rent by reference to what the actual tenant ought to pay having regard to what he has actually earned and might earn. Rather, most leases still provide for rent to be reviewed to an open market rent with hypotheses by reference to which the valuation must be conducted. This is done using various words but the gist is that the hypothetical transaction by reference to which the valuation is to be conducted is

(1) to take place in the actual open market but

(2) to be on the hypotheses

(a) that there is vacant possession

(b) that the tenant is not in occupation and

(c) that any goodwill created by the actual tenant is to be disregarded.

In the case of Cornwall Coast Country Club v Cardgrange Ltd [1987] 1 EGLR 146 one of the issues on an "open market" rent review was whether the tenant should give discovery of documents relating to the profits earned by its gaming business. Scott J held that there was no doubt that the arbitrator was entitled to take into account the income-earning capacity of the premises but went on to hold (in essence) that unless the evidence would have been available in the market to prospective lessees it was not admissible since it would not have influenced the deal which would have been struck between the hypothetical parties.

In the case of Electricity Supply Nominees Ltd v London Clubs Ltd [1988] 2 EGLR 152 Hoffman J took a similar approach. At 152-153, Hoffman J said (emphasis supplied) he said

In the Cardgrange case, which also concerned the accounts of a casino, Scott J followed the principle laid down by the House of Lords in Lynall v Inland Revenue Commissioners [1972] AC 680 and held that the only admissible evidence of the profit-earning capacity of the casino was evidence available to a prospective lessee in the open market. In this appeal, Mr Neuberger has submitted that the learned judge was wrong. He said that evidence of actual earnings, even if not available in the open market, was admissible to test the value of expert estimates of what the profit-earning capacity would have been. If it showed, as appeared here to be the case, that actual profits were nothing like what the expert said the market would have assumed, the arbitrator would be entitled to take that into account in assessing the value of the expert's evidence. In my judgment, this submission is based upon a false assumption about the issue before the arbitrator. He is concerned not with the actual earning capacity but with how the market would have assessed earning capacity. The open market may be a false market in the sense that it is based upon false assumptions, but it is still the open market. I do not see how information about profitability which the market did not know can be relevant to the question of what the market would have thought.

The cases in which post-review-date transactions are admissible seem to me to stand on quite a different basis. An open market transaction at a later date may, by applying the presumption of continuity, afford a legitimate basis for an inference that a transaction on similar terms would have taken place at an earlier date. Of course the presumption may be rebutted by showing that the market, at the later date, was possessed of information not previously available. But there is no reason in principle why relevant inferences cannot be drawn from subsequent events. But this is not the kind of reasoning upon which the tenants in this case want to rely. I am therefore not persuaded that Scott J was wrong and I propose to follow his decision.

Subsequently, Browne-Wilkinson V-C in Urban Small Spaces Ltd v Burford Investments Co Ltd [1990] 2 EGLR 120 confirmed that these cases represent the law. He plainly considered that he was bound to assume the Electricity Supply Nominees and Cardgrange cases about the admissibility of evidence. In that case an arbitrator made an order for discover of documents relating to rents received by the tenant from licensees occupying parts of the premises. He held that the fact that documents might be inadmissible in evidence was not in itself a reason for refusing disclosure and he refused to overturn the arbitrator's decision. The Vice-Chancellor said (emphasis supplied):

Assuming, as I must for present purposes, that the decisions of Scott J in Cornwall Coast Country Club v Cardgrange Ltd and Hoffmann J in Electricity Supply Nominees Ltd v London Clubs Ltd are correct as to the admissibility of such evidence for the purpose of fixing the rent, the question of what is a discoverable document is not limited to documents admissible in evidence: all information and documents which may be used either in making the parties' case or in destroying the other parties' case must be discovered."

"Such evidence" mentioned by the Vice-Chancellor (as he then was) was information "which would not be available to the public at large in negotiating the hypothetical rent" (not simply trading account evidence). The Vice-Chancellor plainly considered that Scott J and Hoffman J had held that such evidence was inadmissible.

This is the state of the law. It is fair to say that many surveyors do not like it. It prevents them having regard to the most obvious and reliable evidence as to what the premises are actually worth. Are there ways around this?

First, it has been suggested that the provision of the Arbitration Act 1996 which came into force after these cases were decided provides a way around the authorities. Under Arbitration Act 1996 s. 34(2)(f), "subject to the right of the parties to agree any matter" (under s.34(1)), the arbitrator has a discretion whether or not to apply "strict rules of evidence (or any other rules) as to the admissibility, relevance or weight of any material". It is highly doubtful whether this suggestion is correct.

(1) It is axiomatic that a decision which takes into account immaterial matters is unlawful: this is a well established principle see e.g. Hollington v F. Herthorn & Co [1943] 1 KB 587; Associated Provincial Picture Houses v Wednesbury Corpn [1948] 1 KB 223. If Cardgrange and the subsequent cases are correct, then it is inherent in the exercise of ascertaining an "open market rent" in accordance with the formula agreed that only matters known to the open market are material. To have regard to such matters would be unlawful and an arbitrator cannot exercise his power under Arbitration Act 1996 s.34 to render material that which is immaterial.

(2) To have regard to such matters would go behind what the parties have agreed (if Cardgrange is correct) as an inherent part of the formula. The arbitrator's power is expressly subject to the right of the parties to agree any matter. The power under section 34 cannot be used to re-write what the parties have agreed in the rent review clause.

Secondly, is it open to the parties to argue that Cardgrange and the subsequent cases were wrongly decided. The rules of precedent probably mean that it is not now open to a first instance tribunal (including an arbitrator) to hold that the cases were wrong: Colchester Estates (Cardiff) Ltd v Carlton Industries plc [1986] Ch 80. It is, however, possible that if the matter were to reach the Court of Appeal a different conclusion could be reached. It has been suggested by John Male and Michael Barnes (L & T Review 1999 3(3), 69-73) that the Judge in Cardgrange was correct in noting that what the arbitrator must do is assess how parties would behave without access to trading accounts (which would have been unknown to the market) but "fails  ... to address the exact function of a judge or arbitrator. That function is to reach a conclusion on the result of the hypothetical negotiations and on the stance which the two negotiating parties would take. If those parties would proceed by way of a profits method valuation the court (or arbitrator) will have to consider what estimate they would make of the components in the valuation exercise, for instance an estimate of the bedroom rents of a hotel. The court must therefore estimate what estimate the parties would have made. In doing so the court can only proceed on expert evidence put before it of what that estimate would be. Expert evidence may differ; it very often does. If there is a difference the court should grasp every tool which will enable it to decide which expert evidence to accept. Where a difference in the expert evidence adduced is in the views of the experts on what the hypothetical parties would have estimated as the bedroom rents for a particular hotel it seems illogical that the court must deliberately shut its eyes to the actual bedroom rents achieved which may be a valuable guide as to which expert view is to be accepted."

The difficulty with this argument, however, is that there may be good reasons why the hypothetical tenant might come to a different assessment of the potential for trade when making his bid from the actual trading position which can be established from the trading accounts (to which he does not have access and which are unknown in the market). Indeed, it is highly unlikely in fact that a hypothetical tenant without access to the actual trading accounts would make such assessment which coincided with the actual trading accounts. The actual situation would be unknown to the hypothetical tenant: he might, having regard to prevailing market conditions, be more or less optimistic than he would be if he had had access to the actual trading accounts. Even as a "check" for what is within the realms of possibility it is difficult to see what probative value the actual trading accounts for the subject premises would have since ex hypothesi one is dealing with how parties might behave who did not have access to these accounts and who did not know the true position.

While the state of the law precludes surveyors and arbitrators from having regard to the most obvious and reliable evidence as to what the premises are actually worth, it seems to me that this is not a fault is not in the logic in Cardgrange and the subsequent cases. The fault is in the use of "open market" rent review clauses in leases of premises which by their nature proceed on the basis that assessing the deal that would be struck between parties who have no knowledge of the actual trading accounts. If parties and their professional advisers conclude that it makes far more sense to value premises by reference to the trade achieved and achievable by the actual tenant, they should use agree rent review formulae other than the usual "open market" formulae. On the other hand, if the parties choose to adopt "open market" rent review clauses which assess the rent by reference to a transaction in which the actual trading accounts are not available, then the parties should be free to do so.