Rent reductions in Side Letters: do they work?

Reducing the rent by means of a concession in a side letter is a common way of making a lease more attractive. This is usually conditional on the tenant performing its other lease obligations correctly but a recent High Court decision suggests that it is not as simple as that.

Whenever terms are agreed between parties the courts are keen to ensure that the details of these are not unconscionable.  Penalty clauses are not looked on kindly and whether or not a clause is a penalty is decided by determining whether the consequence of that clause, and the remedy to the innocent party, is out of proportion.

In many lease agreements, often in retail, a personal rent concession or reduction is agreed and is contained in a side letter.  This has the benefit to the landlord of securing the desirable tenant and also increasing the attractiveness of the wider shopping area, whilst still ensuring that if the lease is passed on to a less enticing brand, the landlord is not stuck with a lower rent.  This is not just important for the lease itself but also to ensure that other rents within the area are not set using the lower rent as the compoundable evidence.  

It is also common to ensure that these arrangements last so long as the "good" tenant complies with the other terms of the lease.  This is unfortunately where such arrangements may become unstuck.  A recent High Court decision has held that an arrangement to terminate the side letter and revert to the higher rent was a penalty and therefore potentially unenforceable.  

It is reasonable for a tenant to expect consequences where it breaches the covenants in its lease.  However, where a breach results in fresh obligations on the tenant the law will consider the proportionality of those obligations.  If these result in a benefit to the landlord which exceeds the remedies normally envisaged for such a breach the court will not enforce these obligations.

In this case, the rent reduction could, potentially, be terminated even for a minor breach.  The minor breach could result in a new obligation to pay a higher rent than had been originally agreed.  This minor breach could therefore result in a major windfall of an increased rent for the landlord.  The court held that this would be out of proportion to the landlord's interest in ensuring that the tenant did not commit the minor breach and, therefore, such an arrangement was penal in nature.

This outcome protects tenants who would not expect a higher than agreed rent to be payable as a result of what they might consider to be an irrelevant and easily rectifiable breach. On the other hand, if the tenant repeatedly commits serious breaches of the lease then it becomes a less desirable tenant to the landlord, who will not want to allow it valuable concessions.  

It is important, therefore, to consider these arrangements carefully.  Although the courts are reluctant to interfere in the freedom of the parties to agree their own terms, it will deem these clauses unenforceable even when agreed between properly advised parties of comparable bargaining power.