A recent decision by the High Court 1, applying the principles set out by the Supreme Court in El-Makdessi v Cavendish Square Holdings BV 2 illustrates that when deciding whether a term of a contract is a penalty, and therefore unenforceable, the Court will consider the consequences of the obligations between the parties and whether the result may be out of all proportion to the innocent party's legitimate interests and consequently exorbitant or unconscionable to the party in default.

Summary of the facts

The claimant, Vivienne Westwood Ltd (the "Tenant"), leased retail premises from the defendant, Conduit Street Development Ltd (the "Landlord"). An initial rent of £110,000p.a. was agreed, subject to reviews of the open market rent after the fifth and tenth years (of a fifteen year term). As well as entering into the lease, the parties entered into a side letter under which the Landlord accepted a lower rate of rent for the first year of the term, which would then gradually increase to £100,000 for the fifth year of the term. For the next five years, the rent would be capped at £125,000 p.a. if the open market rent review produced a higher rent amount. In the event that the Tenant breached any of the terms and conditions contained in either the side letter or lease, the rent would be payable in accordance with the payment provisions of the lease (effectively as if the side letter had never existed).

The Tenant did not pay the rent due in June 2015, and the Landlord asserted that the side letter had been terminated and open market rent was now payable. The key question for the Court was whether the obligation to pay the higher rent as stipulated in the lease following any breach of the lease or the side letter (the "Higher Rent Obligation") amounted to a penalty and was therefore unenforceable.

Was the Higher Rent Obligation a penalty?

In order to decide this question, the Court considered the three stages set out by the Supreme Court in the Cavendish case: (i) whether the Higher Rent Obligation was a secondary obligation triggered by the breach of a primary obligation (the threshold test); (ii) whether the Landlord had a legitimate interest in having the primary obligation performed (legitimate interest in performance); and (iii) whether the Higher Rent Obligation was exorbitant or unconscionable (in amount or effect).

The threshold test

The law on penalties only applies to secondary obligations which flow from a breach of a primary contractual obligation. The Court held that, as the parties had entered into the lease and side letter at the same time, the primary obligation (and the intention of the parties) was for the Tenant to pay the lower amount of rent, as specified in the side letter. As a result, the Higher Rent Obligation was a secondary obligation triggered by a breach of the primary obligation to pay the lower rent and the threshold test was therefore satisfied.

Legitimate interest in performance

The Landlord argued that it had a substantial legitimate interest in ensuring the Tenant performed all its obligations promptly and therefore had a legitimate interest in seeing the rent revert to the full market value in the event of the Tenant's default. The Court's view that the lower rate of rent was not simply a conditional right but a substantial term of the deal between the parties meant the Landlord could not argue that it had a legitimate interest in seeing the rent revert to the uncapped open market level. That would be a legitimate interest in the non-performance of the Tenant's obligations, not a legitimate interest in its performance.

The same financial adjustment applied under the side letter regardless of the type of breach or consequences for the Landlord and the Court considered this a real difficulty for the Landlord. Serious loss or harm would not flow from a minor or one-off breach of an obligation as compared to sustained or more serious breaches. In addition, the right to terminate the side letter was drafted in such a way that it had retrospective effect and, therefore, on termination the Tenant would be required to pay the additional rent retrospectively, as well as paying the higher rate in future.

Exorbitant or unconscionable

The Judge stated that he had "no doubt" that the Higher Rent Obligation was penal in nature because it was out of all proportion to the Landlord's legitimate interests under the lease. The Judge noted that a court "should not lightly infer a penalty in a contract freely negotiated by two advised parties of equal bargaining power". However, he described the Higher Rent Obligation as a 'blunt instrument' that could give rise to substantial and disproportionate detriment, depending on why and when the side letter was terminated. In addition, the Higher Rent Obligation was in addition to the Landlord's right to claim interest, costs and common law damages for breach of lease obligations. As such, it was out of all proportion to the Landlord's legitimate interest as it was exorbitant and unconscionable.

What does this mean for you?

The Court will protect genuine 'legitimate interests' which are included in a contract for the benefit of one of the parties. In Cavendish the Supreme Court recognised that Cavendish had a legitimate interest in preventing the founder of the business which it had acquired from diminishing its value in the hands of the purchaser, by competing with it.

When drafting clauses which are designed to protect a party's 'legitimate interests' it is important to keep a record of what the 'legitimate interests' are and any figures to show why the figures chosen are proportionate and not exorbitant or unconscionable. This will help to persuade a court that the clause is not penal in nature if it is a secondary obligation triggered by breach of a primary obligation.