Prime fashion + prime location = prime setting for a contractual side letter penalty dispute

23rd May 2017

A recent case involving premium fashion brand Vivienne Westwood and its flagship store in London’s Mayfair encompasses commercial contract and lease issues that will be of particular interest to retailers and any commercial clients who enter into concession or side letters as part of their contractual arrangements, as well as their professional advisers and agents. Commercial Dispute Resolution and Real Estate Litigation partners Gwendoline Davies and Martin McKeague, both of whom have significant experience and expertise in the retail sector, review the case and offer their practical advice.

Case and context

It is often in the interests of contracting commercial parties to agree concessions between themselves (such as price adjustments or rent reductions), which are recorded in separate concession or side letters so as not to vary the main contract or lease document.

The practice is particularly common in the retail context, where a landlord may be willing to offer a lower rent to a particular tenant (whose reputation or business-type may help boost market rents in the locality or may support the landlord’s wider tenant-mix objectives), but without that concession appearing in the lease itself and therefore adversely affecting comparable values.

That was exactly the scenario underpinning the recent case of Vivienne Westwood Ltd v Conduit Street Development Ltd [1].

As is common in such arrangements, the reduced rent was documented in a side letter which was completed contemporaneously with the lease. The lease was for 15 years from 18 November 2009 at an initial rent of £110,000 pa, subject to upwards-only rent reviews to the open market in 2014 and 2019.  The side letter, which was personal to the luxury fashion brand, provided for a lower initial rent of £90,000 stepped to £100,000 by year 5 and then capped at £125,000 following the 2014 rent review.  The side letter was, however, subject to the proviso that if Vivienne Westwood breached “any of the terms…contained in this agreement or any term of the Lease… [the landlord] 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.”

When, following some administrative confusion, the tenant fell into arrears – albeit only temporarily – the landlord sought to terminate the side letter and to recover, both prospectively and retrospectively, full rent as per the terms of the lease (namely, the initial £110,000 pa and the post 2014 review market rent of £232,500 pa). In reliance upon the 2015 case of Cavendish v Makdessi and ParkingEye v Beavis [2] and the common law rule against penalties, the tenant issued court proceedings claiming that the termination provision in the side letter was an unenforceable contractual penalty.

Outcome and implications

The High Court agreed with the tenant, and the landlord’s clause and higher rent claim were effectively struck out. Of real interest for retailers and all those involved in concessional contractual arrangements, however, are the lessons that can be learned from the court’s reasoning.

The following legal and practical points arise:

Contracting parties frequently wish to pre-emptively protect themselves against the breach of their counterparty. Parties therefore often agree in advance, either in a side letter or otherwise within their contractual arrangements, the consequences that will flow from a party’s breach. In doing this, parties must beware the common law rule against penalties which provides that, to the extent that such a clause is a penalty, it will be unenforceable.

In Cavendish and ParkingEye the Supreme Court explained that a penalty is a contractual provision that imposes a detriment on the party in breach of a primary obligation which is out of all proportion to any legitimate interest of the innocent party in the performance of that obligation. Breaking that down, there are three tests which can help to determine whether a provision amounts to an unenforceable penalty. The Vivienne Westwood case helps to clarify how those tests operate in practice:

1. The ‘threshold test’ – is the penalty rule engaged at all? In English law, the court will not generally interfere with a party’s ‘primary’ contractual obligation to do something, but it can regulate the ‘secondary’ liability that may be imposed when a party breaches that obligation. The penalty rule is only engaged at all, therefore, if the provision in question imposes a secondary liability for breach of a primary obligation. In this case, the landlord had done a deal to attract the tenant to its premises. The tenant had entered into the lease and the side letter simultaneously, but could not be under two different rent obligations at the same time. The true, primary obligation was to pay the reduced rent as per the side letter deal and so the obligation to pay the higher lease rent was a secondary liability that only arose in the event of a breach of contract. The initial ‘threshold test’ was therefore met, and the penalty rule was in play.
2. The ‘legitimate interest test’ – does the clause serve to protect any legitimate interest? A clause that is potentially penal in nature may nevertheless be allowed if it serves to protect a legitimate interest of the innocent party in the performance of the primary obligation; and…
3. The ‘exorbitance test’ – if so, is the provision out of proportion to the protection of that interest, by being extravagant or unconscionable?… so long as the provision in question is not exorbitant or unconscionable in amount or effect as against the legitimate interest which it serves to protect, then it may not amount to a penalty. Here, the termination provision in the side letter and its consequences were very significant and applied regardless of the nature or seriousness of the breach. The consequences of the termination provision would also apply in addition to the other remedies that the landlord already had for rent arrears, including generous interest and costs provisions. The court therefore determined that the provision was penal and unenforceable [3].

The case is also important for its analysis of the provision that the side letter was terminable for “any” breach. As part of the court’s assessment of the exorbitance test, the judge had to determine the meaning of the phrase “any” breach. Did this really mean absolutely any breach at all no matter how trivial, or was it to be interpreted as requiring a material breach?

As per the leading case of M&S v BNP Paribas [4]:

• The implication of terms into commercial contracts is potentially intrusive, such that terms will not be implied lightly.
• When deciding whether or not to imply a term into a detailed commercial contract the court will consider the presumed intention of the parties at the time the contract was made.
• In order for a term to be implied, it must be necessary to give business efficacy to the contract. (The test is not an absolute one but whether, without the term, the contract simply does not work, either commercially or practically.)
• Where the parties have entered into a carefully drafted contract, particularly where they have been legally advised, it will be difficult to imply any term(s) as it will be doubtful whether any omission was the result of the parties’ oversight or a deliberate decision.
• In addition, for a term to be implied, it must be obvious; capable of clear expression; and must not contradict any express term of the contract.

While the judge did not think that it could ever be right to imply a term that caused any uncertainty in relation to the interpretation of a contract that was otherwise unambiguous in its drafting (as here), he also believed that the rent concession was a significant part of the deal between the parties The judge therefore considered that the parties could not have intended that (and the side letter would not have sensible commercial effect if) any trivial breach could trigger the higher lease rent requirement.

The court therefore concluded that, in this case, “any” breach did not mean any material breach, but it did mean that a breach would have to be more than trivial (or de minimis) to trigger termination of the side letter.

Practical advice

So what does this mean in practice, particularly for those responsible for negotiating contractual and/or lease arrangements?

• Where there is a contract/lease and a concessional or side arrangement, the court will consider the substance of the deal overall when assessing the enforceability of a particular provision.
• Parties should consider framing contractual terms as primary obligations to which the penalty rule does not apply, rather than secondary provisions which impose consequences for breach. For example, can the provision in question be drafted as a conditional obligation which does not give rise to a breach of contract?
• Where a secondary obligation is required, parties should avoid imposing overly severe consequences for breach. Parties should particularly beware provisions which impose multiple concurrent remedies and/or have both prospective and retrospective effect.
• Parties should consider the circumstances in which the provision in question is triggered, and whether there should be a materiality threshold or some other means of limiting the clause’s scope to that which is really necessary.
• Parties may wish to specify the commercial context and why the particular clause provides reasonable and proportionate protection of a legitimate interest.
• Businesses would be well advised to review their existing contract/ lease arrangements and negotiations – particularly any concessional/side arrangements with termination provisions – in light of this decision, just in case any provisions are likely to fall foul of the rule against penalties.

If you have any queries or would like any advice or assistance in relation to your own commercial contracts or lease arrangements, please do not hesitate to contact Gwendoline or Martin, who will be happy to help.

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[1] [2017] EWHC 350 (Ch)
[2] [2015] UKSC 67, and see our Walker Morris briefing
[3] The judge stated that, even if the side letter termination provision did not operate so that higher lease rent would be payable both retrospectively as well as prospectively, the issue would be less clear cut but he would still have found the clause to be a penalty.
[4] Marks and Spencer plc v BNP Paribas [2015] UKSC 72