Landlords: don’t give away a penalty. Points to consider when preparing a rent concession agreement

The details will vary, but many will offer a temporary reduction in rent, a change to monthly, rather than quarterly payments or a rental holiday. Hopefully, the majority of these arrangements will be complied with – and therefore will not be contested or interrogated too closely – however there will inevitably be some tenants, or landlords, who default, and a dispute arises.

While the case in question is not new, given the recent proliferation of side arrangements, the judgment should be carefully considered before entering into any side arrangement as the implications could be significant.

Vivienne Westwood v Conduit Street Development Limited [2017] involved a disputed concessionary rent arrangement, which was entered into simultaneously with lease grant. The tenant, Vivienne Westwood, missed a June 2015 rent payment and the landlord, Conduit Street Limited, sought to terminate. The side letter contained a right for the landlord to terminate in the event of any breach.

Vivienne Westwood follows an earlier case, Cavendish v Makdessi [2015] itself a landmark case, which replaced the traditional test in relation to penalty clauses. Before Cavendish, it was only necessary to establish that the ‘fine’ imposed by a particular clause in a contract was not a “genuine pre-estimate of loss”. That test has now been abolished and replaced with a new test.

The main principles set down in Makdessi were:

• whether a contractual provision is a penalty comes down to interpretation of the contract and assessing whether it is penal or punitive in nature;
  
  
• that a penalty clause can only exist where a secondary obligation is imposed following a breach of a primary obligation. This is different from a conditional primary obligation, which depends on events that are not breaches of contract;
  
  
• that a provision that imposes a secondary liability for breach of a primary obligation is a penalty if it imposes a liability that is out of all proportion to the legitimate interest of the other party in the performance of the primary obligation (i.e. which is “exorbitant, extravagant or unconscionable”);

The Vivienne Westwood case centred around a discussion of whether a clause is, in substance, a secondary obligation that takes effect following a breach of a primary obligation (thereby engaging the rule on penalties) or whether it is a conditional primary obligation, which falls outside the rule. The distinction between these is a fine one and the view is that, where a clause applies as a result of a breach, one should assume that the rule on penalties is indeed engaged. The discussion then focuses on whether that clause is enforceable. This comes down to whether it is out of all proportion to the non-defaulting party’s legitimate interest in performance of the contract.

A crucial factor for determining a penalty clause is where the outcome is the same, regardless of the severity of the breach. In other words, if a party commits a trivial or immaterial breach and the clause in question is engaged as a result, this tends to suggest it will be found to be a penalty, and therefore unenforceable. The judge himself offered some guidance on this point, saying that trivial or de minimis breaches should not give rise to the right to terminate, otherwise, the side letter will not have any ‘sensible commercial effect’.

The determining factor in Vivienne Westwood was that the termination provision in the side letter:

• terminated the side letter ab initio, so the tenant was obliged to pay the higher rent both retrospectively (i.e. from day one of the lease) and prospectively for the rest of the term – regardless of the nature and seriousness of the breach or when it occurred; and

• obliged the tenant to pay interest and costs to the landlord, plus damages for losses caused by a breach.

This was held to be penal in nature and, therefore, unenforceable. However, the judge said that even if the termination applied prospectively only, it would still have been a penalty clause.

The rental concession was found to be a primary obligation, whilst the obligation to pay the higher rent reserved by the lease was held to be a secondary obligation, engaged on breach of the provisions of the side letter (here, non-payment of rent). As a result, the threshold test set out above was met and so the law of penalties came into play. It was then a matter of determining whether the obligation to comply with the secondary obligation to pay the higher rent was exorbitant or unconscionable as against the landlord’s interest in compliance and whether the landlord could be adequately compensated by damages, costs (which were payable on an indemnity basis) and interest at the contract rate of 4% above base rate. It was found that these remedies would be satisfactory, and that compliance was out of all proportion.

Whilst the position remains a little unclear, and there are likely to be many potentially offending documents out there, below are a few useful pointers for landlords that could help to avoid a similar situation arising:

• You should set out clearly in the letter:
  
  a. the nature of the relevant party’s legitimate interest in enforcing the particular primary obligation;
  
  b. why the parties have determined that the secondary obligation is proportionate to that interest; and
  
  c. keep evidence of the intent of the parties.
  
  
• Where possible, you should prepare your document in such a way that it is a conditional obligation (not secondary) where the relevant condition does not involve a breach of contract.

• You might wish to include some form of materiality element restricted to certain types of breach or breaches of particular provisions.

If you have agreed any such concession, or are contemplating doing so, speak to one of our team, who will be more than happy to help.