High Court revisits the law on penalty charges

High Court revisits law on penalty charges following the Supreme Court decision in Cavendish Square Holding BV v Makdessi.

Liquidated damages are a common feature in construction contracts, and have attracted much judicial comment over the years. Following the well-publicised Supreme Court decision in Cavendish Square Holding BV v Makdessi, we thought that the law on liquidated damages was fairly well settled.

We now live in the post Makdessi era, and the recent High Court decision in Vivienne Westwood Limited v Conduit Street Development Limited is a clear illustration of how the court apply the Makdessi principles.

One of the key issues in Vivienne Westwood was whether a termination provision in a side letter (which allowed a landlord to charge higher rent as set out in the main lease) was a penalty. It was held that the provision was penal in nature and, therefore, unenforceable.

This case will be of interest to the construction industry, given the bearing it has on whether liquidated damages (levied in the event of breach or delay) are enforceable.

Facts

  • The Claimant agreed to enter into a lease with the Defendant in respect of a clothing and fashion store in Mayfair.

  • At the same time as entering the lease, the Claimant and Defendant agreed the terms of a side letter.

  • The effect of the side letter was that, notwithstanding the terms of the lease, the Defendant agreed to accept yearly rent at a lower rate from the Claimant.

  • The parties agreed that, in the event of a breach of any of the terms of the side letter and/or lease, the Defendant was able to terminate the agreement in the side letter with immediate effect and charge the higher rents set out in the lease retrospectively (as if the side agreement never existed).

  • The Claimant missed a rent payment and, as a result, the Defendant wrote to the Claimant asserting a breach of the terms of the lease, and notice was given terminating the agreement in the side letter with immediate effect.

Did the termination provision amount to a penalty?

The judge referred to the “main principles” in respect of the law of penalties, that were clearly restated in Makdessi, and summarised them as follows:

  1. 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.

  2. 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.

  3. Whether a clause imposes a secondary liability upon a breach of contract is a question of substance and not of form.

  4. 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, or (using traditional language) which is exorbitant, extravagant or unconscionable in comparison with the value of that legitimate interest.

  5. The onus lies on the party alleging that a clause is a penalty to show that the secondary liability is exorbitant, extravagant or unconscionable.

  6. 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.

Further, the judge commented that, as set out in Makdessi, the following approach must be taken when considering whether a contractual stipulation is or is not a penalty:

Step 1 - address the threshold issue (ie, is the stipulation in substance a secondary obligation engaged upon breach of a primary obligation)

Step 2 - identify the extent and nature of the legitimate interest of the promise in having the primary obligation performed

Step 3 - determine whether or not, having regard to that legitimate interest, the secondary obligation is exorbitant or unconscionable in amount or in its effect.

Applying the Makdessi principles to the facts of this case, the judge held that:

  • The threshold test was satisfied (on the basis that the Claimant’s obligation to pay the higher rent in the lease is a secondary obligation, engaged upon breach of the primary obligation in the side letter to pay the rent). Accordingly, the penalty rule was engaged.

  • The Defendant’s legitimate interest did not extend to being paid a higher rent by the Claimant - that would “be a legitimate interest in non-performance of the Claimant’s obligations, not a legitimate interest in their performance”.

  • The obligation to pay rent at a higher rate, regardless of the nature and consequences of the breach and when it occurs, is penal in nature (not least given the higher rent is payable with retrospective effect). Further, given that the increased rent is payable in addition to interest and costs incurred as a result of the breach, the judge commented that this is:

“…exorbitant and unconscionable in comparison with any legitimate interest in full performance that will not otherwise be compensated by interest, costs and damages.”

On that basis, the judge said he would have reached the conclusion that the termination provision is penal in nature even if it has only prospective effect.

In light of the above, the Defendant’s notice of termination of the benefit of the side letter was held unenforceable.

Comment

This case highlights the need for parties entering into construction contracts to carefully review the wording of liquidated damages clauses, and consideration should be given as to whether a secondary obligation is imposed which is engaged upon breach of a primary obligation (ie the threshold test). Employers will also need to give careful consideration to what their commercial legitimate interests are in enforcing the liquidated damages, at the time the contract is entered into.

More on the Makdessi decision can be found in our article.

This document (and any information accessed through links in this document) is provided for information purposes only and does not constitute legal advice. Professional legal advice should be obtained before taking or refraining from any action as a result of the contents of this document.