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Off side? No, it’s a penalty! A Recent Case Concerning Commercial leases, Side Letters and Penalty Clauses

June 14, 2017

When parties are agreeing the terms of a commercial lease, they will sometimes use a “side letter” to record more favourable terms which are particular to a specific tenant. Such terms may include, a reduced rent, a rent free period or limits on future rent reviews.

Sometimes, and especially where the landlord may own multiple commercial properties, the parties will want to keep such terms confidential.  Unlike many longer term leases, a side letter does not need to be lodged at the Land Registry.

However, use of a side letter is not without commercial risks, and the ending of the favourable term is not always straightforward.  This was highlighted in the recent case Vivienne Westwood Limited v Conduit Street Development Limited when the court considered whether, based on the facts of the case, the Landlord exercising the termination provisions in a side letter amounted to a “penalty” and would therefore be unenforceable.

Burroughs Day Commercial Leases

The Facts

In 2009 the tenant took a lease of a shop premises in central London. The lease provided for an agreed rent of £110,000 per annum with upwards only rent reviews to open market level every five years. On the same day that the lease was completed a side letter was agreed which provided more favourable terms including a reduced rent of £90,000 per annum and the rent increase being capped at £125,000 after the first five years.  The side letter terms stated that any breach of any terms of the letter or of the lease “may terminate the letter 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 ownership of the freehold changed over the course of the next few years which directly led to uncertainty whereby the tenant received two rent demands for different amounts; one from the previous freeholder and one from the company acting as agent for the new landlord. The tenant also received conflicting figures following the rent reviews, and in the resulting confusion as to who to pay and how much, the tenant failed to pay the June rent. Consequently the company acting as agent for the landlord wrote to the tenant claiming the lease terms had been breached and that the favourable terms in the side letter were ended with immediate effect.

The tenant made two claims against the landlord:

  1. The demand, payment and acceptance of a market rent, at a different rate to that stated in the lease or the side letter, was an agreement between the landlord and the tenant that the yearly rent was reviewed to an annual sum of £125,000. It could not be that the money was paid and accepted without there being implied from that conduct there was some agreement as to the payment. 
  2. The termination provisions in the side letter amounted to a penalty clause and were therefore unenforceable.

The Decision

  1. The court found that the landlord’s conduct did not amount to settling the outstanding rent at £125,000.
  2. Were the termination provisions in the side letter found to be unenforceable “penalty” provisions?

The side letter provides for the landlord to terminate the more favourable terms with immediate effect in the event of any breach by the tenant of any of the terms and conditions of the side letter or lease. 

Case law provides that “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.” In the current circumstances, in return for having a tenant with an excellent retail reputation, the landlord agreed to accept a lesser rent under the terms of the side letter. The primary obligation of the tenant, therefore, was to pay this reduced rent and the secondary obligation of paying the higher rent, as stipulated in the lease, if the tenant was in breach of the side letter or lease, was potentially a penalty clause. 

The landlord had agreed to forego the higher rent due under the lease in favour of the terms of the side letter. Therefore it could not be said that the landlord had a legitimate interest in having the tenant pay a higher rent. 

The court found that any obligation to pay the higher rent would have had to have been backdated to the commencement date of the lease some ten years earlier and would be due regardless of the nature of the breach. This was deemed to be overly harsh on the tenant especially as the landlord had the benefit of the other potential remedies in the lease for breach of the tenant’s obligations. 

The court held that the termination provision in the side letter was a penalty clause and was therefore unenforceable. The tenant was able to continue paying the reduced rent so long as it continued to comply with the terms of the side letter.

Practical Points

Side letters can be a useful tool where there are terms that are particular to a specific tenant and especially ones which may be confidential in nature. 

If a side letter is therefore deemed necessary due to the nature of the relationship between the landlord and the tenant, legal advice should be sought to ensure that:

  • The wording in a side letter is drafted in a sufficiently clear manner in relation to the termination provisions so as to avoid misinterpretation which could lead to the provisions being deemed to be too harsh and therefore unenforceable; 
  • Any onerous consequences of termination are carefully drafted in light of the termination provisions in the lease; 
  • The provisions made should be justified and there should be a “legitimate interest” of the landlord in the effect of the termination on the tenant; and
  • Any “legitimate interest” is well documented during the negotiation stage of the lease.

Our commercial property solicitors can help you understand your options and obligations as a landlord or as a tenant, so call today on 01179 929 0333 or email.  We also offer fixed fee Business Advice Meetings to assist with specific queries you may on your commercial premises.  Enquiring costs nothing and remember, it’s not just the family law team who advise that a bit on the side can be expensive!

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