A termination provision in a side letter, which had the effect of entitling a lessor to increased rental payments in the event of any breach by the tenant, was held to be an unenforceable penalty. This is the first application of the restated test for penalties set out in the Supreme Court’s Makdessi decision which has resulted in a clause being found to be penal. It is a reminder of the care that should be taken when setting termination payments: Vivienne Westwood Ltd v Conduit Street Development Ltd  EWHC 350 (Ch).
This case concerned a lease and side letter entered into simultaneously between DER Travel Service Limited, a lessor of retail property, and Vivienne Westwood Limited, as tenant. Under the side letter, the lessor agreed that it would accept a lower rent from the tenant than that provided for in the lease if certain conditions were met. The side letter included a provision that if the tenant breached “any of the terms and conditions” of the side letter or lease, the lessor could terminate the side letter with immediate effect. In the event of termination, “the rents will be immediately payable in the manner set out in the lease as if this agreement had never existed”.
The dispute arose between Westwood and a subsequent lessor, Conduit Street Development Limited. Conduit asserted that the tenant had breached the lease and gave notice of termination of the side letter, requiring the tenant to pay the higher rent in the lease. One of the issues for determination by the court – and the focus of this article – was whether the right of the lessor to terminate the side letter upon any breach by the tenant, thereby requiring the tenant to pay the higher rent in the lease, was a penalty.
The Makdessi test
The approach to potentially penal provisions in contracts was restated by the Supreme Court in Cavendish Square Holding BV v Makdessi. In applying this test, the High Court broke it down into the following stages:
- first, assess whether the provision in question is in substance a secondary obligation that is engaged upon breach of a primary obligation;
- second, identify the extent and nature of the legitimate interest of the innocent party in having the primary obligation performed; and
- third, determine whether, having regard to that legitimate interest, the secondary obligation is exorbitant or unconscionable.third, determine whether, having regard to that legitimate interest, the secondary obligation is exorbitant or unconscionable.
The court contrasted one of the provisions considered in Makdessi – a clause providing for a reduction in payments due to a seller who was in breach of contract – with the present case: an obligation to pay a specified sum in the event of a breach.
An unenforceable penalty
The court applied the Makdessi test and concluded that the termination provision in the side letter was an unenforceable penalty.
The threshold: a secondary obligation
In order for the Makdessi test to be engaged, the provision in question must give rise to a secondary obligation. The court found that the true bargain between the lessor and tenant was that, in return for having a tenant with the reputation of Westwood, the lessor would accept a lower rent. On that basis, the tenant’s obligation to pay the lower rent under the side letter was its primary obligation. The obligation to pay the higher rent under the lease upon termination of the side letter was a secondary obligation.
Legitimate interest in performance
A secondary obligation is capable of being a penalty. Determining whether or not it is penal depends, first, on the lessor’s legitimate interest in the tenant’s performance of its obligations. The lessor argued that it had a legitimate interest in the rent reverting to the higher rate, whereas the tenant argued that it did not. The court found that the reduced rent agreed under the side letter was a substantial term of the bargain. It concluded that the lessor cannot have had a legitimate interest in the rent reverting to the higher rate; that would give rise to a legitimate interest in non-performance of the tenant’s obligations, rather than in their performance.
Exorbitant or unconscionable
Having identified a secondary obligation and established that the lessor’s legitimate interest did not extend to the higher rent, the court considered whether the burden of the higher rent, payable by the tenant in the event of termination of the side letter, was exorbitant or unconscionable and therefore penal. First, the court observed that the wording of the side letter appeared to entitle the lessor to terminate in the event of any breach by the tenant. After finding that some level of qualification was necessary to give the provision a sensible commercial effect, it concluded that the right to terminate arose on the occurrence of any “non-trivial breach”. Secondly, the court agreed with the tenant’s argument that a natural reading of the termination provision requiring that “the rents will be immediately payable in the manner set out in the Lease as if this agreement had never existed” gave it retrospective (as well as prospective) effect. As such, the provision required the tenant to pay additional rent for the preceding years as well as paying the higher rent in the future.
The court concluded that the obligation to pay the higher rent in the event of a breach and termination was “out of all proportion” to the lessor’s legitimate interest and was penal. In his reasoning, the judge emphasised that: (i) the obligation to pay the higher rent applied regardless of the seriousness of the (non-trivial) breach; and (ii) the higher rent was payable in addition to other remedies provided to the lessor (including interest, costs and damages). He added that he would have reached the same conclusion even if the termination provision had only prospective effect.
This is the first application of the restated test for penalties set out in the Supreme Court’s Makdessi decision which has resulted in a clause being found to be penal. The ruling highlights the risk for commercial parties in negotiating termination provisions which give them a substantial benefit, or which impose a significant financial detriment on their counterparty, in the event of a breach, regardless of its seriousness. As in this case, the courts may find a clause to be an unenforceable penalty despite the fact that the provision was agreed between two advised parties of equal bargaining power.