Penalty clauses have been a way for parties to protect a legitimate interest in the event of a breach of contract. There has been a trend towards finding penalty clauses unreasonable and unenforceable.
The test for penalty clauses was set out in Cavendish Square Holding BV v Talal El Makdessi; Parking Eye Limited v Beavis; a penalty clause must relate to a primary obligation and cannot be disproportionate.
The matter was recently re-addressed in Vivienne Westwood Limited v Conduit Street Development Limited.
Westwood had entered into a 15 year lease with Conduit for a retail unit. Rent was stated to be £110,000, with an upward only rent review in year 5 and year 10.
The lease was subject to a side letter providing for a payment of a lower sum for rent. The rent stated in the side letter was initially £90,000, rising to £100,000 in year 5 and subject to an open market review in year 5, but capped at £125,000 for the next five years.
The reversion of the lease changed ownership 3 times. In March 2015 a draft invoice for rent capped at £125,000 was received. A final invoice was not provided, but the rent was paid. June’s quarter was not paid.
In July 2015 a surveyor was appointed to assess the market rent pursuant to the rent review.
Conduit claimed the lease had been breached and gave notice terminating the side letter. Westwood paid the rent arrears. Conduit accepted the payment as a part payment on the basis that the rent review was outstanding.
The surveyor determined the market value of the rent as £232,500.
Conduit argued Westwood had not paid the rent on time, had not complied with the terms of the side letter, the higher rent was due retrospectively and the higher rent was payable for the remainder of the term.
Westwood argued that there was an implied agreement that the rent review had been agreed at £125,000 and that the termination provisions of the side letter were unenforceable as they amounted to a contractual penalty.
The court decided that the rent review had not been determined by the parties at £125,000, Conduit was merely offering to accept £125,000 on an interim basis until rent was determined by the surveyor.
The termination clause was held to be unenforceable as it did not satisfy either of the branches of the Cavendish test; Westwood’s primary obligation was to pay rent and there had been no breach; paying the higher rate of rent was a secondary obligation.
The clause was deemed to be a ‘blunt instrument’ as it did not take into account the nature and seriousness of the breach: (1) Westwood’s primary obligation was to pay rent at the reduced rate, (2) Conduit had not shown a legitimate interest in Westwood’s performance only its non-performance and (3) payment of rent at the higher rate retrospectively and prospectively, regardless of the nature and consequence of the breach, was a penalty.
Should you have any issues arising out of the enforceability of side letters please contact Inderjit Gill at email@example.com .