In a recent case of Vivienne Westwood Limited -v- Conduit Street Development Limited [2017 EWHC 350 (Ch)] the court was again asked to grapple with the issue of whether certain terms of an agreement should be considered a penalty and unenforceable.

The parties entered into a rental agreement whereby the tenant leased retail premises for a term of 15 years at an initial rent of £110,000 per annum, the annual rent being subject to reviews of the open market rent in the fifth and tenth years (lease). At the same time the parties also entered into a side letter under the terms of which the landlord agreed to accept a lower rate of rent increasing gradually from £90,000 for the first year to £100,000 for the fifth year (side letter). The rent would then subsequently be capped at £125,000 per annum for the following five years if a higher open market rent was determined upon the first review.

The lower rent set out in the side letter was terminable by the landlord if the tenant breached any of the terms and conditions of the side letter or lease, in which case rent would then be payable as set out in the lease as if the side letter had never existed.

The tenant failed to pay the rent in June 2015 and the landlord declared that the side letter had been terminated and that open market rent was now payable in accordance with the original lease. The question before the court was whether the terms of the side letter amounted to a penalty and were therefore unenforceable.

The judge referred to and used the Supreme Court decision of Makdessi -v- Cavendish Square Holdings BV (2015) to guide his interpretation of the clause. The judge believed that it was clear from the agreement between the parties that the primary obligation was to pay rent at the lower rate, and that only changed if one of the conditions in the side letter was no longer satisfied or in the event of a breach of contract by the tenant. However the rent payable could be increased if the tenant failed to perform any of its obligations regardless of the impact of any such breach. Accordingly the provisions of the side letter amounted to a change in the primary obligation on the tenant. Since the side letter permitted the landlord to impose a greater obligation on the occurrence of any breach in the lease, the secondary obligation was capable of being a penalty.

It was therefore necessary to consider the legitimate interest of the landlord in having the tenant comply with its obligations and whether the burden of the side letter was exorbitant or unconscionable compared with any loss likely to flow from a breach.

The judge came to the conclusion that under the side letter the same substantial financial adjustment applied whether a breach was oneoff, minor, serious or repeated and, without any due regard to the nature of the obligation, broken or if any actual or likely loss to the landlord. He held that this had long been recognised as one of the hallmarks of a penalty. The wording of the side letter was such that termination had retrospective effect meaning that the tenant would have to pay additional rent for all of the preceding years of the term which had passed, as well as paying for it in the future.

The judge held that the obligation to pay rent at the higher rate regardless of the nature and consequence of any breach was clearly penal in nature and further, that the extra financial detriment to the tenant did seem exorbitant and unconscionable when compared with any legitimate interest the landlord had in full performance. Accordingly the judge ruled that the purported termination of the side letter was unenforceable as against the tenant.

This case shows that great care needs to be taken when drafting documents which allow for the financial burdens within an agreement to change or vary depending upon the actions of the parties. Even though it was expressed not to vary the terms of the lease, the side letter characterised the tenant’s primary obligation as the obligation to pay rent at the reduced rate under the side letter.