Penalty clauses: are they out of fashion?

The High Court has applied the Makdessi test on penalty clauses to the terms of a side letter between a tenant of retail premises and the landlord. In doing so it held that the termination provision in the side letter amounted to an unenforceable penalty.

Following Makdessi, when considering whether a clause is a penalty, the first question to ask is whether the provision is a primary or secondary obligation. The penalty rule will not be engaged if the provision is a primary obligation. The next task is to identify the extent and nature of the legitimate interest of the promisee in enforcing the primary obligation. Finally, one must determine, having regard to that legitimate interest, whether the secondary obligation is unconscionable or exorbitant.

In Vivienne Westwood Ltd v Conduit Street Developments, the tenant, Vivienne Westwood entered into a lease of retail premises. The parties simultaneously entered into a side letter which required the landlord to accept a lower rent than provided for in the lease, if certain conditions were met. The side letter also stated that it was terminable if “any term of the lease” was breached.

The landlord argued that Vivienne Westwood had breached the lease and sought to terminate the side letter, requiring Vivienne Westwood to pay the higher rent. The Court held that payment of reduced rent under the side letter was a primary obligation and the obligation to pay higher rent in the lease was a secondary obligation triggered upon breach. The side letter could be terminated no matter how trivial the breach and termination had retrospective effect. The court decided that the termination clause and resulting obligation to pay higher rent, regardless of the nature or consequences of the breach, was exorbitant compared with any loss likely to flow from the breach. Therefore the termination clause was penal and unenforceable.

This case reinforces the importance of the distinction between whether a clause creates a primary or secondary obligation. In practice this is not always easy to ascertain but it matters since if the obligation is primary it won't be caught by the penalty rule at all. The case also serves as a reminder that the court is often uncomfortable with termination payments that are significant irrespective of the seriousness of the breach.

Note June 2018:  We believe that this case and First Personnel Services v Halfords are the only, since Cavendish v Makdessi, to have found a provision to be penal. In Halfords, the court found that a contractual rate of interest of 2% per month on unpaid agency fees was a penalty principally relying on there being a lack of commercial  justification  for a rate which was well above the "commercial norm" or the rate payable under the Late Payment of Commercial Debts (Interest) Act 1998. Instead the court awarded the rate under the Act of 8% per annum above the official bank rate.