In a recent decision, the High Court has held that a clause in a side letter, which allowed a landlord to terminate the side letter and insist on payment of the higher rent set out in the lease, was a penalty and therefore unenforceable: Vivienne Westwood Limited v Conduit Street Development Limited  EWHC 350 (Ch).
This is one of the few decisions to have struck down a clause as penal since the Supreme Court substantially rewrote the law on penalties in its decision in Cavendish v Makdessi  UKSC 67 (see our blog post on that decision here and our contract disputes practical guide which considers liquidated damages here). That decision replaced the traditional test of whether a clause is (or is not) a “genuine pre-estimate of loss” with a test of whether it is out of all proportion to the innocent party's legitimate interest in enforcing the counterparty's obligations.
The latest decision is of particular interest for its discussion of whether a clause is in substance a secondary obligation which takes effect on breach of a primary obligation, so that the rule on penalties is engaged, or whether it is a conditional primary obligation and therefore falls outside the rule. In Makdessi itself, a number of the Justices found that a clause depriving the seller of a business of deferred consideration in circumstances where he breached a non-compete provision was, in reality, a price adjustment clause – ie a primary rather than a secondary provision, which was not susceptible to the rule on penalties. (In any event, the Supreme Court found that the clause was not out of proportion to the seller's legitimate interest in enforcing the non-compete provisions, and was therefore enforceable.)
The present decision gives a further illustration that the distinction between a conditional primary obligation and a secondary obligation is a rather fine one. The practical message is that, whenever a clause takes effect on breach, it would be prudent to assume that the rule on penalties may be engaged. The question of whether it is enforceable will then come down to whether the clause is out of all proportion to the innocent party's legitimate interest in performance of the contract.
The decision also suggests that the question of whether a clause provides for the same consequences irrespective of whether a breach is minor or serious, which the judge said had long been a hallmark of a penalty clause, remains an important consideration post-Makdessi.
The case is also of interest for its discussion of the meaning of a clause allowing termination for "any breach" of contract. In a number of cases, such a clause has been interpreted as requiring a breach that is repudiatory at common law, on the basis that a broader interpretation would flout business common sense (see our contract disputes practical guide on termination here). Here, however, the judge was not prepared to imply even a term requiring a "material" breach, commenting that the test of materiality is "fraught with conceptual uncertainty" – which may come as a surprise to many, given the frequency with which commercial parties agree provisions allowing termination for "material" breach.
David Nitek and Maura McIntosh, a partner and professional support consultant in the disputes team, consider the decision further below.