Penalty Clauses & Side Letters – Having a ‘bit on the side’

Landlords and tenants quite frequently enter into side letters (supplemental to the lease) to reflect particular arrangements between them.
Side letters can include rent concessions where the landlord might, for example, agree to accept a lower rent than that specified in the lease.  It is relatively common practice for a landlord to specify in such a case that if the tenant breaches a condition of the concession or a term of the lease then the concession given to the tenant will be cancelled.
The property industry was taken by surprise recently in a case concerning a concessionary rent where the tenant was late in paying an instalment. In that case the Court decided that the landlord’s attempt to bring the concession to an end (so as to revert to the higher rent referred to in the lease) was void on the basis that it amounted to a “penalty”.
The Court referred to a recent decision of the Supreme Court which reviewed the law relating to penalties. Previously, a penalty might broadly have been described as a payment specified as being due by a party in breach of contract which was not a genuine pre-estimate of the innocent party’s loss arising as a result of the breach.  The decision of the Supreme Court suggests that rather than being focused on whether a sum payable on breach is a genuine pre-estimate of loss (i.e. a liquidated damages clause), there is now a more general test as to whether the sum or remedy stipulated as a result of breach of contract is exorbitant or unreasonable in the circumstances.  Against this background, one can understand that if a side letter states that a remedy for the landlord following a breach by the tenant is to cancel the concession itself then the tenant might seek to argue that the remedy is exorbitant or unconscionable.
The law remains complex and each individual case will depend, amongst other things, on how the individual side letter is drafted and construed.  The reality, however, is that a landlord will no longer have the guaranteed ability to cancel a concession or other term of a side letter in the tenant’s favour purely because the side letter states that such remedy is available to the landlord.Landlords must be mindful of this when negotiating any side letters which include concessions.
Penalty Clauses & Side Letters

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