Termination right a penalty
 EWHC 350 (Ch)
The termination provisions in a rent concession side letter to a lease were penal in nature. The purported termination provisions were therefore unenforceable and the rent remained payable at the reduced rate.
T took a lease of premises for a term of 15 years, at an initial rent of £110,000 reviewable in 2014 and 2019. At the time the lease was executed, a side letter was entered into (personal to T) which provided that if the open market rent review in 2014 produced a rent of more than £125,000 pa, the rent would be capped for the next five years at £125,000 pa.
The side letter also contained a termination right which provided that the agreement contained in the side letter for the reduced rent would end “immediately” if any of a number of events occurred and also provided that:
- “If [T] breach any of the terms and conditions contained in this agreement or any term of the Lease….[L] may terminate this agreement with immediate effect and the rents will be immediately payable in the manner set out in the Lease as if this agreement had never existed”
The landlord’s interest was transferred a number of times, and in due course the landlord granted a concurrent lease to L making L the immediate landlord of T.
The open market rent in 2014 was established at £232,500. L argued that T had breached the terms of the lease, because it had paid some of the rent due under the lease late, and therefore L had been entitled to, and had in fact terminated the side letter.
- Whether the side letter imposed a conditional primary obligation, or a secondary obligation which took effect on breach of a primary obligation so that the rule on penalties was engaged?
- If a secondary obligation, whether the termination clause was unenforceable because it was a penalty?
The High Court found for T and held that it was only liable for the capped rent at £125,000 pa. The Court referred to the decision in Cavendish Square Holding BV v Makdessi (Parking Eye)  UKSC 67 where the Supreme Court comprehensively reviewed the law on penalties. Timothy Fancourt QC (sitting as a Deputy Judge of the High Court) said:
- “The several judgments of the Justices reveal differences of approach on the application of the main principles to the facts of that case, however the main principles are clearly restated. These are that:
- i) Whether or not a contractual provision is a penalty is a question of interpretation of the contract, and the real question is whether it is penal or punitive in nature (paras 9, 31, 243).
- ii) In English law, a penalty clause can only exist where a secondary obligation is imposed upon a breach of a primary obligation owed by one party to the other. It is to be distinguished from a conditional primary obligation, which depends on events that are not breaches of contract (paras 14, 32, 258).
- iii) Whether a clause imposes a secondary liability upon a breach of contract is a question of substance and not of form (para 15).
- iv) A provision that in substance imposes a secondary liability for breach of a primary obligation is penal if it imposes on the party in default a detriment out of all proportion to any legitimate interest of the innocent party in the performance of the primary obligation (para 32), or (using traditional language) which is exorbitant, extravagant or unconscionable in comparison with the value of that legitimate interest (paras 152,255).
- v) The onus lies on the party alleging that a clause is a penalty to show that the secondary liability is exorbitant, extravagant or unconscionable (para 143).
- vi) Since the penalty rule is an interference with freedom of contract, it is not lightly to be concluded that a term in a contract negotiated by properly advised parties of comparable bargaining power is a penalty (paras 33, 35)”
The court held that the reduced rent was fundamental to the bargain reached between the parties when entering into the lease, and as such T’s primary obligation under the lease was to pay rent at the reduced level set out in the side letter; and it was only on breach of any of those primary obligations that T was obliged to comply with a secondary obligation, namely to pay rent at the higher level. The threshold test was therefore satisfied and the law of penalties was engaged.
The next question to consider was whether, "…on the basis of the true interpretation of the Side Letter, are the specified consequences of its termination [i.e. the non-concessionary rent being payable retrospectively and prospectively] for any non-trivial breach exorbitant and unconscionable, having regard to the disparity with the loss likely to flow from any breach." The Court held that this obligation was penal in nature.
The court also noted that the Landlord was entitled to "two types of compensation for the breach [i.e. the tenant having paid late] (interests and costs) in generous measure, in addition to common law damages". The ‘specified consequence’ (ie T’s obligation to pay the non-reduced level of rent both retrospectively and prospectively) was, “out of all proportion to the legitimate interest of the lessor in having [T] comply with every one of its obligations rather than pay full compensation for any breaches”.