Cleverly drafted side letter: No penalty kick

Side letters are commonly used by landlords to side step the terms of a lease and confer a temporary personal concession to a tenant. However the recent case of Vivienne Westwood Limited v Conduit Street Developments Limited [2017] EWCH 350 has highlighted that landlords can find themselves scoring an own goal.

 

What are Penalty Provisions?

 

Cavendish Square Holding BV v EL Makdessi and ParkingEye Ltd v Beavis [2015] UKSC 67 previously confirmed that a penalty clause can be found to exist where:

 

  • a secondary obligation is imposed on a breach of a primary obligation; and
  • the secondary obligation imposes a disproportionate detriment to any legitimate interest of the innocent party.

 

Background to the Vivienne Westwood Case

 

Vivienne Westwood Limited (“Vivienne Westwood”) took a 15 year lease of a ground floor and basement shop premises with five yearly rent reviews. The rent was stipulated in the lease to be £110,000 per annum with upwards only rent reviews. Both parties entered into a side letter in which the landlord agreed to accept a lower rent for the first 10 years of the term, capped at £125,000 per annum.  This concession was personal to Vivienne Westwood and the landlord reserved the right to terminate the side letter if there was a breach of any of the terms of the lease.  If the side letter was terminated, the rent would revert to the amount payable on the terms set out in the lease.

 

In June 2015 Vivienne Westwood missed a rent payment and, subsequently, the landlord wrote to them advising them that they had breached the terms of the lease triggering the termination of the side letter with immediate effect. Vivienne Westwood then paid the rental arrears in full, but the landlord considered this to be part payment only of the arrears as the first rent review remained outstanding. The yearly rent was later reviewed to £232,500 and both parties agreed that if the side letter had been validly terminated, this rent would now be payable.

 

The question as to whether the landlord’s right to terminate the side letter for breach of the lease by the tenant would be deemed a penalty was now raised. If the termination was considered a penalty  it would be unenforceable.

 

Primary and Secondary Obligations

 

Vivienne Westwood argued that their primary obligation was to pay the rent specified in the side letter rather than the rent specified in the lease which was a secondary obligation. Therefore the termination of the side letter was a penalty and unenforceable by the landlord. Given the reputation of Vivienne Westwood the landlord agreed to accept a lower rent than what they could expect to obtain on the open market. The judge sided with Vivienne Westwood, confirming that their primary obligation was to pay the rent specified in the side letter and that there was no obligation on the tenant to pay the rent specified in the lease.

The court concluded that Vivienne Westwood remained entitled to pay the rent at the capped rate of £125,000 per annum, provided they continued to adhere to the terms of the side letter.

 

Although a landlord has a legitimate interest in protecting the investment value of their property, the court found that the landlord in this case could not argue a legitimate interest in seeing the rent revert to the market level.

 

Exorbitant or unconscionable?

 

When making its decision the court also considered whether the obligation on the tenant to pay the open market rent, in the event of the termination of a side letter, could be viewed as being exorbitant or unconscionable. The judge found that the obligation on the tenant to pay the open market rent was penal in nature. He found that due to the other remedies available to the landlord under the lease for a tenant breach,  an obligation to pay all future rents at the higher level was disproportionate to the loss suffered by the landlord. Therefore it was a penalty and was unenforceable.

 

Conclusion

 

Rent concession side letters are very common in today’s market with tenants often requesting to pay their rent monthly rather than quarterly and as a result are capable of creating primary obligations between the parties from the outset.  Any side letters granted to tenants should be reviewed to ensure that they do not include terms that could be viewed as imposing penalties on tenants for non-performance. Although tempting, landlords should try to refrain from imposing onerous terms in side letters and should be aware that in some cases, they may not be able to terminate a side letter for non-performance of the terms of the lease.

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While great care has been taken in the preparation of the content of this article, it does not purport to be a comprehensive statement of the relevant law and full professional advice should be taken before any action is taken in reliance on any item covered.