Fashion designer Vivienne Westwood has fended off a rent hike on her Mayfair flagship because the consequences of a side letter were considered an unfair penalty.
Landlords often use side letters to confer temporary or personal concessions on tenants. If such concessions are terminable on breach, landlords should ask themselves whether the rule against penalties is engaged.
Vivienne Westwood Ltd v Conduit Street Development Ltd [2017] EWHC 350 (Ch); [2017] PLSCS 50 appears to be the first reported case on the effect of such a provision in a side letter between a landlord and tenant since the Supreme Court ruling in Cavendish Square Holding BV v Talal El Makdessi [2015] UKSC 67; [2016] EGLR15.
The tenant had accepted a 15-year lease of a shop in Mayfair. The initial rent reserved by the lease was £110,000 pa, but the landlord signed a side letter reducing the rent during the first five years of the term, and then capping it at £125,000 pa during the next five years of the term (even though the open-market rent might be higher following a rent review due under the lease). The parties also agreed that the side letter would fall away if the tenant were to assign the lease or cease trading from the premises.
In due course, the landlord purported to take advantage of a provision stating that the arrangement was terminable, with immediate effect, if the tenant was in breach of “any” of the terms in the lease, or in any supplemental licence, or in the side letter itself. The tenant’s rent was a few days late, due to confusion about the landlord’s identity following changes in the ownership of the reversion. Consequently, the landlord claimed to be entitled to collect the open-market rent for the premises, which had increased to £232,500 pa.
Primary obligation
The rule against penalties does not affect primary obligations in contracts. However, the court can consider whether secondary obligations, triggered by breaches of contract, constitute penalties.
This means that the court will not regulate a primary obligation to do something, or to pay a price. But it will regulate the remedies that are available if a contract breaker fails to comply with a primary obligation to pay an amount due or to do what was required of him. In Cavendish, Lord Neuberger, Lord Sumption and Lord Carnwarth categorised a clause in a share sale agreement – providing that the seller would not be entitled to receive payments that were otherwise due, were he to break important non-competition covenants – as a price adjustment clause. As such, it was a primary obligation and not a penalty.
Secondary obligation
How did these rules apply in this case? The judge explained that the answer to the question of whether a contractual provision constitutes a penalty turns on the interpretation of an individual contract. He asked himself what rent the tenant was liable to pay and whether the rent concession could be characterised as a contingent variation in the price, or discount for prompt payment.
The landlord had done a deal in order to attract the tenant to its premises. The tenant could not be obliged to pay two different rates of rent simultaneously and was under a primary obligation to pay rent at the reduced rate. It followed that the liability to pay rent at the higher rate, triggered by a breach of contract, constituted a secondary obligation, which fell within the scope of the rule against penalties.
A secondary obligation is penal if it imposes a detriment on the contract breaker out of all proportion to any legitimate interest of the innocent party in the performance of the primary obligations in a contract. Was the tenant’s obligation to pay the higher rent disproportionate? Or, to put it another way, was it extravagant, exorbitant or unconscionable in amount or in its effect?
Penal consequences
It was in the tenant’s interests to argue that the side letter meant exactly what it said. It claimed that the termination provision applied on “any” breach of the lease, no matter how trivial. But the judge disagreed. The tenant was almost certainly bound to be in breach of its extensive obligations to the landlord at some point during the lease and, if the tenant were correct, the landlord could terminate the concession on a whim. Consequently, the judge ruled that the side letter was terminable if breaches of contract were “non-trivial”.
However, the judge did accept that the consequences of termination were penal. The side letter stated that, if the concession was terminated for breach of contract, the rent due under the lease would become payable “as if this agreement had never existed”. The judge ruled that this operated prospectively and retrospectively. In other words, the tenant would have to pay the open market rent due under the lease for all the preceding, and subsequent, years of the term.
Furthermore, the tenant would have to pay regardless of the nature of the breach, and no matter when it occurred, without taking into account any remedies (such as interest, costs and damages) available under the lease or at common law, and irrespective of the impact on the landlord. On that basis, the judge stated that the termination provision was penal, even if it did not operate retrospectively. The consequences for the tenant were out of all proportion to the legitimate interest of the landlord in the performance of the lease. Therefore, the side letter continued in full force and effect.
Watch this space
The distinctions between primary and secondary obligations appear very fine indeed. Will the Court of Appeal be asked to opine? We must wait and see.
Key points
- A termination provision in a side letter imposed disproportionate consequences on a tenant and fell foul of the rule against penalties
- The decision turned on the exact terms of the parties’ side letter, but illustrates the danger of overly harsh terms
Allyson Colby is a property law consultant
