Summary

The court interpreted a side letter to a lease, under which a landlord granted a rent concession to a tenant. A termination provision provided that if the tenant breached the terms of the side letter or lease it would need to pay the higher rent contained in the lease, with retrospective effect. That provision seemed exorbitant and unconscionable in comparison with any legitimate interest of the landlord. It caused a disproportionate detriment to the tenant and was therefore penal in nature and unenforceable.

Facts

The claimant tenant asked the court to determine the effect of a side letter which it had entered into with the defendant landlord.

The tenant leased retail premises from the landlord. The premises were demised for a term of 15 years from November 2009, at an initial rent of £110,000 per annum, subject to reviews of the open market rent in the fifth and tenth years. The side letter was entered into at the same time as the lease. Under its terms, the landlord agreed to accept a lower rate of rent from the tenant, increasing gradually from £90,000 for the first year to £100,000 for the fifth year. It would then be capped at £125,000 per annum for the following five years if a higher open market rent was determined upon the first rent review. The lower rent set out in the side letter was terminable by the landlord if the tenant breached any of the terms and conditions of the side letter or lease, in which case the rents would be payable in the manner set out in the lease, as if the side letter had never existed. The tenant failed to pay the rent in June 2015 and the landlord asserted that the side letter had been terminated and that the open market rent was payable.

The issue was whether the terms of the side letter amounted to a penalty and were therefore unenforceable.

Held

Makdessi v Cavendish Square Holdings BV [2015] UKSC 67 clearly showed that in considering whether a contractual stipulation was a penalty, it was necessary to first ask whether the stipulation was a secondary obligation engaged upon breach of a primary contractual obligation. Second, it was necessary to identify the extent and nature of the legitimate interest of the promisee in having that primary obligation performed, and then determine whether, having regard to that legitimate interest, the secondary obligation was exorbitant or unconscionable in amount or effect. In the instant case, the primary obligation was to pay rent at the lower rate. That only changed if one of the conditions of the side letter was no longer satisfied or in the event of a breach of contract by the tenant. Unlike the situation in Makdessi, the rent payable could be increased if the tenant failed to perform any one of its obligations, regardless of the particular impact of the breach. The provisions of the side letter therefore amounted to a change in the primary obligation with which the tenant had to comply. To the extent that the side letter purported to permit the landlord to impose a greater obligation upon the happening of any breach of any obligation in the lease, that secondary obligation was capable of being a penalty. Whether it was a penalty depended on the legitimate interest of the landlord in having the tenant comply with its obligations under the lease and whether the burden of the secondary obligation was exorbitant or unconscionable compared with any loss likely to flow from the breach. The reduction in rent payable by the tenant was not simply a conditional right to which it was not otherwise entitled, but a substantial term of the bargain which it struck with the landlord in consideration of its taking the lease. The landlord could not therefore argue that it had a legitimate interest in seeing the rent revert to the open market level. Under the side letter, the same substantial financial adjustment applied whether a breach was one-off, minor, serious or repeated, and without regard to the nature of the obligation broken or any actual or likely consequences for the landlord. That had long been recognised as one of the hallmarks of a penalty. If the terms of the side letter were to have any sensible commercial effect, it was necessary to exclude a de minimis breach of covenant from triggering the landlord's right to terminate the side letter. However, it was not necessary that any breach would have to be material or substantial before the termination provision could be activated. The landlord's right to terminate the side letter arose on the occurrence of any non-trivial breach by the tenant of its obligations. It was also clear from the wording of the side letter that its termination had retrospective effect, meaning that upon termination, the tenant would have to pay additional rent for all the preceding years of the term that had passed, as well as paying it for the future. The obligation to pay rent at a higher rate as from the rent commencement date of the lease, regardless of the nature and consequences of the breach, was penal in nature. It might give rise to a very substantial and disproportionate financial detriment. The extra financial detriment to the tenant seemed exorbitant and unconscionable in comparison with any legitimate interest in full performance. The termination provision would also be penal in nature even if it had only prospective effect. The purported termination of the side letter was unenforceable, Makdessi followed (see paras 41-49, 52-53, 56-61, 63-65, 72 of judgment).

Judgment for claimant