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Penalty clauses: primariness, secondariness and the categorisation of obligations in a penalties case

For lawyers, as for football referees, it can be tricky to work out what is and is not a penalty.

The Cavendish Square Holding BV v El Makdessi and ParkingEye Ltd v Beavis litigation was welcomed widely as providing clarity in determining what will amount to an unenforceable penalty clause and what will not (for example, a genuine pre-estimate of damages).

The judgment in Vivienne Westwood Ltd v Conduit Street Development Ltd shows that applying the Cavendish approach to varied commercial situations may not be as simple as the Supreme Court had led us to hope.

The facts of the case are discussed elsewhere: suffice it to say that it concerned the effect of a side letter entered into between a tenant and landlord where there was also a lease. The side letter conferred on the tenant (personally) the benefit of a lower rent than that conferred by the lease. According to the side letter, if the tenant breached it, the rent reverted to that contained in the lease.

Following Cavendish, a clause can only be penal where, as a matter of substance not form:

“… 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”.

It was argued for the landlord that – correctly analysed – the case fell into the latter category: the tenant had a conditional right to a discount to which it was not otherwise entitled. For the tenant, it was argued that the true primary obligation was to pay the lower rent; the secondary obligation to pay the higher rent was imposed upon breach.
Reading the lease and the side letter as a single transaction, the judge preferred the tenant’s analysis. Given the terms of the side letter, there was no primary obligation on the tenant to pay rent at the higher rate in the lease. The judge’s focus was clearly on the core of the bargain: what the parties had really agreed would happen and, to some extent, why (the judge refers, for example, to the fact that the landlord had seen the tenant as an attractive tenant to have in its property). So far, so clear.

The difficulty arises in the use of “primary” as the way of describing the obligation. One might use the word to mean “most important obligation” or one might use it simply to mean “prior to a secondary obligation”. For the latter, one could say “a primary obligation”; the former necessitates saying “the primary obligation”.

Arguably, at paragraph 49 of his judgment, the judge appears to be applying the test as if the question were “what is the primary obligation?”. He says:

“… the provisions of the Side Letter in this case amount to a change in the primary obligation with which the Claimant must comply.”

That conclusion finds support in paragraph 52 (in which the judge is dealing with whether or not the landlord had a legitimate interest in having the tenant perform all its obligations promptly), where he says:

“…[t]his question must be approached in the light of my conclusions on the threshold issue, namely that the reduction in rent payable by the Claimant is not simply a conditional right to which it was not otherwise entitled but a substantial term of the bargain it struck…”

It is as if there could not be a penalty arising out of breach of a clause that did not go to the heart of the bargain.

My view is that Cavendish does not require the courts to find the most important obligation in the contract, it being understood that only a breach of that obligation is capable of giving rise to a penalty. The law asks whether or not breach of one obligation gives rise to a new one, one that did not otherwise exist but for the breach. In that sense, the first can be described as primary and the second as secondary.

Litigators should take care to ensure that their analysis of a case chimes with how “primary” and “secondary” are to be understood following Cavendish.

Littleton Chambers Grahame Anderson

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