The challenge of self-regulation in commercial property leasing: a study of lease codes in the UK

• Author: Cathy Hughes
• Position: School of Real Estate and Planning, University of Reading, Reading, UK

Introduction

Commercial property leasing operates within a wide variety of regulatory regimes across the globe. In the UK it is not heavily regulated and the contracting parties are largely free to decide the term of their lease. There are some statutory limits on certain lease provisions¹, and statute provides and governs the right to renew leases², but, on the whole, the UK law does not directly control the terms that the parties to a commercial lease are able to negotiate. There is not even a statutory or common law requirement for terms to be fair or reasonable.

That does not mean that UK governments have no interest in lease terms. Commercial leases contain provisions defining and affecting key aspects of the occupation of premises ( Crosby et al., 2006a, b ); these can impact on the ability of a business to develop and grow, or even to contract. Consequently, commercial leasing has been linked to government enterprise and productivity agendas. These policies have such enduring importance that successive governments have, especially since the property crash of 1989/1990, been willing to intervene in the commercial leasing market showing a belief that there is market failure which government action could help rectify. However, while the grounds for intervention have largely been linked to economic efficiency, there has been a recent shift to include ethical considerations of fairness.

Burton's (1992) report on retail leases for the Adam Smith Institute was undoubtedly influential: he concluded that severe information asymmetry in the market resulted in tenants being unable to make informed decisions. Furthermore, the rent review process was criticised for not being responsive to market forces; in particular the prevalence of upward only rent review clauses led to a distortion in rents and inefficiency in the market. This distortion of the normal market forces of supply and demand at rent review and a lack of transparency in the market led Burton to advocate government intervention in order to “make the commercial property leasing market work more efficiently according to market principles” (1992, p. 82).

Consequently, the (conservative) government consulted on legislating in the specific areas of upward only rent reviews, confidentiality clauses and rent determination processes at rent review and lease renewal ( DOE, 1993 ). However, the government was apparently persuaded of increasing flexibility in the market ( DOE, 1994 ), deciding not to legislate but encouraging the property industry to develop a system of self-regulation. This led to the first Code of Practice for Commercial Leases ( RICS, 1995 ), developed by a committee of stakeholders in the leasing process including organisations representing landlords, tenants and the land and law professions. Some 15 years later, self-regulation is still the means by which leasing is held in check; the industry is currently operating the third edition of the code ( JWGCL, 2007 ).

It is proving difficult to assess whether self-regulation on leasing has been a “success”, or even to determine how to evaluate the extent to which it can be seen to be a successful system in terms of achieving policy objectives. This is despite research commissioned by the (labour) government from the University of Reading to monitor the operation of the successive codes. These studies found that the first code was poorly disseminated and had virtually no impact on the operation of the market ( DETR, 2000 ). The second code was better disseminated but was not seen to be directly influencing leasing negotiations or practice ( Crosby et al., 2005 ). The results of the dissemination of the third code were no better than the second, if not worse, and it was little used in actual negotiations ( Crosby and Hughes, 2009 ). Wheeler echoed these latter results in her independent survey of solicitors ( Wheeler, 2009 ).

These findings from the University of Reading have prompted various government statements which both exhort and threaten the property industry, as well as a further proposal (not enacted) to legislate ( ODPM, 2004 ). In 2005 the Budget Statement from the Chancellor of the Exchequer included the following statement:

While the Government welcomes the recent trend towards greater market flexibility, it believes much more can be done to strengthen the impact of the code of practice on the market. It will continue to work with the industry on strengthening the code, but remains willing to pursue legislation if further movements towards greater market flexibility are not forthcoming ( HM Treasury (2005) Budget Statement, paragraph 3.119).

The response to findings on the third edition of the code was a ministerial statement ( Austin, 2009 ) which expressed disappointment that small business tenants were not being told about the code and that it was not a “primary tool for the negotiation of new leases” except in the hands of a few large tenants. There has been an increasing focus on small business tenants as the code has developed, to such an extent that it now appears that their awareness and “use of the code” is the primary measure of the response of the market. The minister called on the property industry to respond or face legislation.

However, over the 15 years spanned by the three codes, changes have taken place that would seem to be in line with government ambitions. There is increased diversity of lease lengths, including short leases without rent reviews, increased incidence of break clauses, changes to the approach to repairing liabilities and to subletting that are more subtle but significant. These changes are documented by Crosby et al. (2005) and acknowledged by the various stakeholders in the process, including government. The code monitoring identified that these changes are essentially market driven, although the various incarnations of the code and the associated threats of legislation appear to have played their part in encouraging change ( Crosby et al., 2005 ). Nevertheless, concerns remain regarding lease terms and the processes by which leases are agreed. In launching the third edition of the code, the government minister expressed disquiet about “continuing elements of inflexibility, particularly the predominant use of upward only provisions in rent review clauses and inflexible provisions for tenants exiting property they no longer need” ( Cooper, 2007 ). Asymmetry of information remains an issue; in the 2009 ministerial statement, concern was expressed that small business tenants were not “properly informed about the leasing choices they are making” ( Austin, 2009 ).

Research into the operation of the lease codes so far has not attempted to address the wider issues of the advantages and limitations of using a voluntary solution to achieve policy aims within the commercial leasing market. This paper provides a first step in considering the lease codes in the wider context of industry self-regulation. The aim of the paper is twofold: first to provide a review of literature on industry self-regulation which sets out the key issues and, in particular, suggests key criteria to explain the effectiveness (or ineffectiveness) of self-regulation. Second, to consider the UK commercial lease codes in the light of this literature and criteria, using the existing empirical research carried out by the authors on the operation of these codes. We hope to then have the beginning of a clearer understanding of the role self-regulation can play in commercial leasing, make some preliminary conclusions on the success of these codes and suggest further research.

Self-regulation

Definition and scope

A commonly cited definition of industry self-regulation is:

[…] a regulatory process whereby an industry-level, as opposed to a governmental- or firm-level, organization (such as a trade association or professional society) sets and enforces rules and standards relating to the conduct of firms in the industry ( Gupta and Lad, 1983, p. 417 ).

This definition does not preclude the involvement of government in the process, but places the primary responsibility for setting up and operating the regulatory regime with the industry body. For Hemphill (1992) , key characteristics are that the development of self-regulation is voluntary and that it covers behaviour that is discretionary.

The scope of self-regulation is wide, as it attempts to deal with various aspects of market failure. Gunningham and Rees (1997) make a distinction between economic and social self-regulation, the former being about controlling the market and the latter about externalities, i.e. the unacceptable consequences of business activities for the environment, workforce, customers or clients. Examples of economic self-regulation can be seen in the property industry whereby landlords and their advisers, including letting agents and lawyers, are members of professional bodies and interest groups (such as the Royal Institution of Chartered Surveyors and British Property Federation (BPF)) that are active in setting product and service standards. These initiatives benefit the members of these organisations by, for example, boosting consumer confidence and potentially increasing demand. However, it is social self-regulation that concerns us in the current study as the focus is on the effects on tenants, i.e. the customers or clients of the property industry. In particular the focus is on small businesses, which are sometimes simply individuals, taking leases. For them, leasing is often an infrequent...