Side letters

Side letters are common in practice. They're often used to agree 'personal' or 'one off' arrangements that are intended to be private and which may not bind successors. There are potential pitfalls, but typically side letters can be enforced as a matter of pure contract law…but what if the terms of a side letter are penal?

Raising the standard

You're trying to attract a better quality of tenant to your property. You find a high profile tenant that you like, but they can't (or won't) pay full rent. The market's a bit choppy so you decide to go with the tenant but, to maintain appearances and to protect against unappealing assignments, you say that the lease must be granted at the full rent but that you'll grant your tenant a personal concession.

A quiet side letter

The concession will be contained in a private side letter. It will record that you've agreed to accept a much lower rent, but it will also say that the side letter can be terminated if the tenant breaches the lease in any way. "That's fine" says the tenant and all parties happily sign the lease and the side letter at the same time.

Troubles ahead?

The arrangement works smoothly… for a while. Then the tenant is late in paying rent – a clear breach of the lease. So you rub your hands together and take the opportunity to tell that tenant that the side letter is terminated and you demand the full market rent.

"Not so fast", says the tenant. The provisions in the side letter are caught by the law against penalties – they impose a secondary obligation that arises on breach and the consequences don't protect a legitimate interest in a proportionate way.

Is it a penalty?

The facts above broadly mirror those in the recent case of Vivienne Westwood Limited v Conduit Street Development Limited. In that case the court held that a provision in a side letter allowing the landlord to terminate a very material rent concession on the basis of any breach was a penalty. In substance, the agreement between the landlord and tenant had been to pay the reduced rent and the draconian consequences of breach were disproportionate to the damage caused to the landlord.

Can I still use side letters?

Yes. Generally speaking the provisions of side letters remain enforceable. However, if side letters impose obligations for breach that are onerous and disproportionate to the legitimate commercial interests of the landlord then they are open to challenge on the basis that they are penalties.

Think carefully about exactly what breaches should trigger consequences and how severe those consequences should be. If a side letter only imposes proportionate consequences that protect a legitimate interest, the courts will not interfere with the deal that the parties have done and they will remain enforceable.

Note that side letters that are entered into at the same time as the lease are particularly vulnerable as they reflect the substance of the deal at the outset. Side letters that are entered into during the term and for which the landlord receives little or no benefit, for example monthly rent or reduced rent agreements to help struggling tenants, are still likely to be lawfully terminable on breach.