High Court finds clause allowing landlord to terminate side letter and insist on payment of higher rent in lease falls foul of rule on penalties

In a recent decision, the High Court has held that a clause in a side letter, which allowed a landlord to terminate the side letter and insist on payment of the higher rent set out in the lease, was a penalty and therefore unenforceable: Vivienne Westwood Limited v Conduit Street Development Limited [2017] EWHC 350 (Ch).

This is one of the few decisions to have struck down a clause as penal since the Supreme Court substantially rewrote the law on penalties in its decision in Cavendish v Makdessi [2015] UKSC 67 (see our blog post on that decision here and our contract disputes practical guide which considers liquidated damages here). That decision replaced the traditional test of whether a clause is (or is not) a “genuine pre-estimate of loss” with a test of whether it is out of all proportion to the innocent party's legitimate interest in enforcing the counterparty's obligations.

The latest decision is of particular interest for its discussion of whether a clause is in substance a secondary obligation which takes effect on breach of a primary obligation, so that the rule on penalties is engaged, or whether it is a conditional primary obligation and therefore falls outside the rule. In Makdessi itself, a number of the Justices found that a clause depriving the seller of a business of deferred consideration in circumstances where he breached a non-compete provision was, in reality, a price adjustment clause – ie a primary rather than a secondary provision, which was not susceptible to the rule on penalties. (In any event, the Supreme Court found that the clause was not out of proportion to the seller's legitimate interest in enforcing the non-compete provisions, and was therefore enforceable.)

The present decision gives a further illustration that the distinction between a conditional primary obligation and a secondary obligation is a rather fine one. The practical message is that, whenever a clause takes effect on breach, it would be prudent to assume that the rule on penalties may be engaged. The question of whether it is enforceable will then come down to whether the clause is out of all proportion to the innocent party's legitimate interest in performance of the contract.

The decision also suggests that the question of whether a clause provides for the same consequences irrespective of whether a breach is minor or serious, which the judge said had long been a hallmark of a penalty clause, remains an important consideration post-Makdessi.

The case is also of interest for its discussion of the meaning of a clause allowing termination for "any breach" of contract. In a number of cases, such a clause has been interpreted as requiring a breach that is repudiatory at common law, on the basis that a broader interpretation would flout business common sense (see our contract disputes practical guide on termination here). Here, however, the judge was not prepared to imply even a term requiring a "material" breach, commenting that the test of materiality is "fraught with conceptual uncertainty" – which may come as a surprise to many, given the frequency with which commercial parties agree provisions allowing termination for "material" breach.

David Nitek and Maura McIntosh, a partner and professional support consultant in the disputes team, consider the decision further below.

Background

The claimant and defendant were, respectively, tenant and landlord of retail shop premises (the defendant having acquired the landlord's interest some time after the grant of the lease). The lease provided for a term of 15 years from 18 November 2009 at an initial yearly rent of £110,000 (payable quarterly in advance) subject to "upwards only" rent reviews to the open market rent in 2014 and 2019.

At the same time as entering into the lease, the claimant and the original landlord also entered into a side letter by which the landlord agreed to accept yearly rent at a lower rate from the claimant, stepped from £90,000 in year 1 up to £100,000 in year 5 and then capped at £125,000 for the next 5 years if the open market rent was higher. The agreement to accept a lower rent was expressed to be personal to the claimant and not by way of variation of the lease. The side letter provided a right for the landlord to terminate the agreement contained in the side letter with immediate effect if the claimant breached any of the terms and conditions in the side letter or any term of the lease. In the event of termination, it provided that "the rents will be immediately payable in the manner set out in the lease as if this agreement had never existed".

After the claimant missed a payment of rent in June 2015, the defendant wrote to the claimant asserting a breach of the terms of the lease and gave notice terminating the agreement in the side letter with immediate effect. The claimant then paid the rent arrears in full, which the defendant accepted as part payment only pending the first rent review which remained outstanding. Ultimately the rent review was determined at a yearly rent of £232,500, and both parties agreed that this would be the amount payable if the side letter had been validly terminated.

The principal question the court had to determine was whether the right for the landlord to terminate the side letter on any breach by the claimant, so that the full rent reserved by the lease became payable, was an unenforceable penalty.

Decision

The High Court (Timothy Fancourt QC sitting as a deputy judge) held that the right to terminate was penal and therefore unenforceable.

The judge referred to the Supreme Court's comprehensive review of the law of penalties in Makdessi, commenting that although the judgments of the different Justices revealed differences of approach on the application of the principles to the facts of that case, the main principles were clearly restated. He summarised them as follows:

1. Whether or not a contractual provision is a penalty is a question of interpretation of the contract, and the real question is whether it is penal or punitive in nature (paras 9, 31, 243).
2. In English law, a penalty clause can only exist where a secondary obligation is imposed upon a breach of a primary obligation owed by one party to the other. It is to be distinguished from a conditional primary obligation, which depends on events that are not breaches of contract (paras 14, 32, 258).
3. Whether a clause imposes a secondary liability upon a breach of contract is a question of substance and not of form (para 15)
4. A provision that in substance imposes a secondary liability for breach of a primary obligation is penal if it imposes on the party in default a detriment out of all proportion to any legitimate interest of the innocent party in the performance of the primary obligation (para 32), or (using traditional language) which is exorbitant, extravagant or unconscionable in comparison with the value of that legitimate interest (paras 152,255).
5. The onus lies on the party alleging that a clause is a penalty to show that the secondary liability is exorbitant, extravagant or unconscionable (para 143)
6. Since the penalty rule is an interference with freedom of contract, it is not lightly to be concluded that a term in a contract negotiated by properly advised parties of comparable bargaining power is a penalty (paras 33, 35).

Threshold test

The first question that had to be determined, therefore, was what the judge referred to as the "threshold test" of whether the obligation to pay rent at the higher level reserved by the lease was a secondary obligation engaged upon breach of a primary obligation. Only then would the law of penalties be engaged.

The claimant (tenant) argued that in substance the primary obligation was to pay rent at the lower level specified in the side letter (as well as performing the other obligation in the lease). On breach of any of those primary obligations, the claimant was obliged to comply with a secondary obligation, namely to pay rent at the higher level.

The defendant (landlord) argued, to the contrary, that the primary obligation was to pay rent at the higher level set out in the lease, and the side letter gave the claimant a right to a discount which was conditional on the claimant's prompt performance of its obligations under the lease and side letter.

The judge concluded that the claimant's argument was to be preferred. The true bargain was that, in return for having a tenant of the claimant's reputation, the landlord would accept a reduced level of rent. The claimant's obligations under the lease and the side letter together were to pay the lower amount of rent and otherwise comply with all the obligations of the lease. Given the terms of the side letter, there was no primary obligation to pay rent at the higher rate reserved by the lease. The primary obligation was to pay rent at the lower rate, and the obligation to pay at the higher rate was a secondary obligation engaged on breach. The threshold test was therefore satisfied and the law of penalties was engaged.

The judge acknowledged that the defendant's argument had some support from the conclusions of Lords Neuberger, Sumption and Carnwath in Makdessi that the loss of a valuable right to money as a result of a breach of contract would not engage the law of penalties because it was, in substance, a price adjustment clause. He said, however, that care must be taken when applying that reasoning to the very different facts of this case, in particular because here the rent was increased because of any failure by the tenant, regardless of its impact, whereas in Makdessi the price reduction occurred on breach of a centrally important non­-competition obligation.

The judge added:

"As to the conditional right argument, it is easy to envisage a case in which a primary obligation to pay is then qualified by an agreement to accept a lesser payment, conditional on various matters including the due performance by the payor of the obligation. If the conditions are not satisfied, the discount does not apply. … But where the obligation is from the outset in substance an obligation to pay the lesser amount, the conditional right analysis does not apply and the primary obligation is to pay at the lesser rate."

Whether or not the provisions of the side letter were a penalty therefore depended on whether the secondary obligation to pay the higher rent was exorbitant or unconscionable compared with the landlord's legitimate interest in having the claimant comply with its obligations in the lease.

Legitimate interest in performance

The defendant argued that as landlord it had a substantial legitimate interest in having the claimant perform all its obligations promptly, both because of the cash flow implications and because of the impact on the investment value of the landlord's reversion (ie because a tenant in default will be seen as being of lesser value than a performing tenant). Accordingly, the defendant argued, it had a legitimate interest in seeing the rent revert to the full market rent, to counteract the impact of the breach on the investment value.

The judge rejected this argument. He accepted that, in theory, a tenant's failure to perform was capable of impacting on the value of the reversion in a way that could go beyond cash flow benefits and financial compensation for delayed performance. However, that was only likely in the case of serious breaches of covenant. The defendant's main difficulty was that the financial adjustment provided for by the side letter was substantial regardless of whether a breach was "one-off, minor, serious or repeated" and without regard to the nature of the obligation broken or its consequences. Although it was not conclusive, he said, that had "long been recognised as one of the hallmarks of a penalty".

The defendant had to establish that it had a greater interest in the claimant's performance than would be compensated by interest, damages and costs that were otherwise recoverable for the tenant's breach of covenant, bearing in mind that the lease provided for interest at 4% above base rate on overdue rent and for the landlord's costs to be paid on an indemnity basis.

Termination for "any breach"

Before determining whether the obligation to pay the higher rent was exorbitant or unconscionable, the court had to assess how onerous the obligation was. This gave rise to two issues relating to the interpretation of the side letter:

1. Whether the right to terminate for "any breach" was to be interpreted as requiring a "material" breach – he concluded that it was not, but that the breach would have to be more than trivial or de minimis to trigger the right to terminate. The judge's reasoning is outlined below.
2. Whether the termination would have retrospective as well as prospective effect – he concluded that it would be retrospective, on the natural reading of the relevant provision, as it referred to the rents being "immediately payable in the manner set out in the Lease as if this agreement had never existed".

On the "any breach" point, the judge noted that terms are only implied into professionally drafted contracts where it is necessary to give the contract business efficacy and/or it is obviously what the parties meant to provide (see Marks and Spencer plc v BNP Paribas Securities Services Trust Co (Jersey) Ltd [2015] UKSC 72 outlined here). He doubted whether it could ever be right to imply a term that would cause uncertainty or difficulty in the operation of a contract that was otherwise unambiguous in its terms, and said he considered it unclear how the materiality of any breach should be judged.

On the other hand, given that the reduced rent was part of the substantial bargain made between the parties, he did not think they could have meant that a trivial breach would allow the landlord to impose the higher rent. He said that if the side letter was to have any sensible commercial effect, it was necessary to exclude a trivial, or de minimis, breach from triggering the landlord's right to terminate. However, it was not necessary that a breach would have to be "material" or "substantial", in the colloquial sense, as opposed to just being more than trivial. He added:

"Although there may be a dispute about whether a particular breach is trivial, there is no real difficulty in applying such a test, whereas the test of materiality is fraught with conceptual uncertainty."

Exorbitant or unconscionable

The next question was whether, on the true interpretation of the side letter, the consequences of termination for any non-trivial breach were "exorbitant and unconscionable, having regard to the disparity with the loss likely to flow from any breach".

The judge said he was in no doubt that the obligation to pay rent at the higher rate retrospective to the commencement of the lease, regardless of the nature and consequences of the breach and when it occurred, was penal in nature.

He was conscious that one should not lightly infer a penalty in a contract freely negotiated by two advised parties of equal bargaining power. However, particularly given that the higher rent was payable in addition to the other remedies the landlord had for the breach, including generous interest and costs provisions, it was out of all proportion to the landlord's legitimate interest in having the claimant comply with its obligations.

The judge said that, if he had held that the clause had only prospective effect, the issue would be less clear cut, but he would still have concluded that the provision was penal in nature.

Practical points for those drafting contracts

As this case demonstrates, it may not be straightforward to draft a clause so as to ensure that it cannot be struck down as a penalty. However, some practical steps can be taken to reduce the risk, including the following:

1. Consider if the clause can be drafted as a conditional obligation or right, where (if possible) the relevant condition does not involve a breach of contract.
2. Look at the circumstances in which the clause is triggered and whether there should be a materiality threshold or whether it can be limited to breaches of particular provisions.
3. Consider setting out expressly in the agreement: the nature of the relevant party's legitimate interest in enforcing the relevant primary obligation; and why the parties have determined that the secondary obligation is proportionate to that interest. If these points are not addressed in the agreement, it would be prudent to document them so that, if the provision is challenged in the future, there is contemporaneous evidence of its intent.