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On 30 November 2016, the Scottish Law Commission (‘SLC’) published a discussion paper on penalty clauses as part of its current review of contract law in Scotland (‘2016 Discussion Paper’). It has been a long standing principle of Scots law (and the law of England and Wales) that penalty clauses are unenforceable. Identifying a need for review of this area of the law, SLC previously published a discussion paper (1997) and report (1999) on the issue which set out proposals for reform. However, following a consultation on a draft Penalty Clauses (Scotland) Bill (which took forward the recommendations made by the SLC) the Scottish Government determined that further work was required in relation to this area of the law.

What are Penalty Clauses?

Under Scots law, a breach of contract will give rise to a claim for damages. Where damages are claimed, the amount of damages awarded by the court are limited to the loss actually suffered by the innocent party. It is often the case that the parties to a contract will wish to agree in advance what will happen in the event of a breach of the agreement. Such contractual provisions may include agreeing the amount of damages that will be paid upon a breach. Provided that the amount stated is a genuine pre-estimation of the loss suffered, such clauses which are referred to as ‘liquidated damages clauses’, are enforceable. However, if the contractual provision provides for a sum which has the intention of penalising the party in breach (rather than pre-estimating the loss that could be suffered by the innocent party), it will be struck down as being an unenforceable penalty clause.

Dunlop Pneumatic Tyre Co v New Garage & Motor Co [1915] AC 79

The general principle that penalty clauses are unenforceable arose from the judgment of Lord Dunedin in the 1915 House of Lords case of Dunlop Pneumatic Tyre Co v New Garage & Motor Co. Dunlop Pneumatic Tyre Co (‘Dunlop’) were manufacturers of motor tyres, covers and tubes. In order to prevent underselling, Dunlop would sell goods to purchasers at a discount provided that the purchaser entered into a price maintenance agreement, pursuant to which it agreed not to resell the goods at a discount or at a price less than the list price (‘Price Maintenance Agreement’). The Price Maintenance Agreement also required the purchaser (as agent for Dunlop) to obtain similar undertakings from any sub-purchasers who were trade customers. Dunlop sold goods to a purchaser who subsequently sold them to New Garage & Motor Co. Despite having entered into the Price Maintenance Agreement, New Garage & Motor Co sold a tyre cover to a purchaser at a price less than the list price in breach of the agreement. The Price Maintenance Agreement provided that New Garage & Motor Co were required to pay Dunlop a specified sum for each type, cover or tube sold in breach of the agreement ‘as and by way of liquidated damages and not as a penalty’.

Lord Dunedin’s judgment in the Dunlop case set out four guidelines in relation to penalty and liquidated damages clauses which he considered to be authoritative from previous case law:

1. The use of the words ‘penalty’ or ‘liquidated damages’ is not conclusive.

2. The essence of a penalty is a payment of money in order to act as a deterrent for breach whereas the essence of liquidated damages is a genuine pre-estimate of damage cause by the breach.

3. Whether a sum stipulated is a penalty or liquidated damages is a question of construction to be decided upon the terms and inherent circumstances of each particular contract, judged at the time the contract is made and not at the time the breach occurred.

4. Lord Dunedin also set out a further four tests which may assist in the construction of such clauses:

(a) it will be held to be penalty if the sum stipulated is extravagant and unconscionable in comparison with the greatest loss that could conceivably be proved to have followed from the breach;

(b) it will be held to be a penalty if the breach is the non-payment of a sum of money and the sum stipulated to be paid on breach is a sum greater than that which should have originally been paid;

(c) there is a presumption (but no more) that it is penalty when a single lump sum is payable as compensation on the occurrence of one or more or all of several events, regardless of the differing degrees of severity of damage caused by each event;

(d) the fact that it is almost impossible to make a precise pre-estimation of damage is not an obstacle to the sum stipulated being a genuine pre-estimate of damage.

The guidelines laid down by Lord Dunedin became the generally accepted test in England, Wales and Scotland in relation to penalty clauses. However, the 2015 UK Supreme Court conjoined cases of Cavendish Square Holding BV v Talal El Makdessi and ParkingEye v Beavis set out a new test in relation to such clauses.

Cavendish Square Holding BV v Talal El Makdessi and ParkingEye v Beavis [2015] UKSC 67

In the Cavendish case, Talal El Makdessi entered into a share purchase agreement with Cavendish Square Holding BV for the sale of shares in the holding company of an advertising and marketing communications group. Talal El Makdessi breached a non-compete clause in the agreement and as a result he was not entitled to the final instalments of the purchase price and was required to sell his remaining shares in the company to Cavendish Square Holding BV. In the case of ParkingEye, Mr Beavis parked his car in a carpark which was managed by ParkingEye. Mr Beavis was charged £85 for overstaying the permitted period of free parking in the car park. The Cavendish case considered the issue of penalty clauses in commercial contracts whereas ParkingEye considered them in the context of a consumer contract. The Supreme Court held that neither clause was a penalty.

Lords Neuberger and Sumption commented that Lord Dunedin’s tests in Dunlop were useful in relation to simple damages clauses in standard contracts but that they are not easily applied to more complex cases. The four tests were not rules but rather considerations which could be helpful or conclusive if applicable to the relevant case, but not necessarily in every case. It was also noted that in the Dunlop case, the other three judges did not expressly agree with Lord Dunedin’s tests.

In Cavendish and ParkingEye, Lords Neuberger and Sumption set out a new test in relation to penalty clauses:

The true test is whether the impugned provision is a secondary obligation which imposes a detriment on the contract-breaker out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation. The innocent party can have no proper interest in simply punishing the defaulter. His interest is in performance or in some appropriate alternative to performance. In the case of a straightforward damages clause, that interest will rarely extend beyond compensation for the breach, and we therefore expect that Lord Dunedin's four tests would usually be perfectly adequate to determine its validity. But compensation is not necessarily the only legitimate interest that the innocent party may have in the performance of the defaulter's primary obligations.’

Under this new test, in order to determine whether a clause is a penalty and therefore unenforceable the questions are as follows:

1. does the provision operate as a secondary obligation rather than a primary obligation or a conditional primary obligation?

In Cavendish and ParkingEye, Lords Neuberger and Sumption stated that where a contract contains an obligation on Party X to perform an act (the primary obligation) and also provides that if Party X does not perform that act then he will pay to Party Y a specified sum of money, the payment of the specified sum of money is a secondary obligation (which has arisen on the breach of Party X’s primary obligation) which is capable of being a penalty (but not necessarily a penalty). The Lords further stated that where the contract does not impose an express or implied obligation on Party X to perform the act, but provides that if Party X does not perform the act he will pay Party Y a specified sum of money, the obligation to pay the specified sum of money is a conditional primary obligation and is not a penalty.

2. does the provision protect a legitimate interest of the party not in breach?

3. is it nonetheless extravagant, exorbitant or unconscionable in relation to such legitimate interest?

This new test means that a provision which is triggered by a breach can still be enforceable even where it is not a pre-estimate of loss and its purpose is to act as a deterrent (provided it is for the protection of a legitimate interest and it is not extravagant, exorbitant or unconscionable).

2016 Discussion Paper

In the 2016 Discussion Paper, the SLC considered the cases of Dunlop, Cavendish and ParkingEye and set out three options for the future of the law relating to penalty clauses:

1. Allow the law to develop itself in light of the Cavendish and ParkingEye case – the decision has made it more difficult for a party in breach to demonstrate that a clause is an unenforceable penalty. A party in breach would require to show (i) that the clause is a secondary obligation and that it does not protect a legitimate interest, or (ii) if it does protect a legitimate interest (and is a secondary obligation), that the clause is extravagant, exorbitant or unconscionable in relation to such interest. In addition, it was noted in Cavendish and ParkingEye that where a contract is negotiated between properly advised parties of comparable bargaining power, there is a strong presumption that the parties themselves are the best judges of what is legitimate when dealing with the consequences of a breach under the contract.

Further case law will be required to determine what is considered to be ‘legitimate interests’. In addition, distinguishing between ‘primary’, ‘conditional primary’ and ‘secondary’ obligation may also present difficulties when deciding whether the penalty rule is applicable. The 2016 Discussion Paper noted that there would have been more certainty had the court held that the rule against penalties applied to all clauses which were triggered upon a breach.

2. Abolish the present common law on penalty clauses entirely – the basis of this proposal is that the penalty rule is contrary to freedom of contract. The parties should be free to agree the provisions of their contract and that even in cases where the parties have unequal bargaining power there are statutory provisions which protect the ‘weaker’ party. However, there may be circumstances where a particular provision does not fall within any statutory protections.

3. Abolish the present common law on penalty clauses and replace it with a new regime – the SLC’s proposed regime is to treat ‘penalty clauses’ as being generally enforceable but that they would fall within the scope of regulation should they be ‘excessively penal’.

The SLC have not expressly committed to any of the proposed outcomes however, it is appears that they favour the third option.

A feature of the SLC’s proposed new regime (which was also included in their 1999 report) was for regulation of penalty provisions which were not triggered by a breach of contract, for example:

• where a party is required to pay a sum when they exercise a right of early termination;

• where a party has different options for performing its obligations under the contract and one of these options has adverse consequences in comparison with the other(s).

It should be noted that Lord Neuberger and Lord Sumption in Cavendish and ParkingEye rejected a submission that the penalty rule should be extended to include penalty provisions which are triggered by circumstances other than breach:

Modern contracts contain a very great variety of contingent obligations. Many of them are contingent on the way that the parties choose to perform the contract. There are provisions for termination on insolvency, contractual payments due on the exercise of an option to terminate, break-fees chargeable on the early repayment of a loan or the closing out of futures contracts in the financial or commodity markets, provisions for variable payments dependent on the standard or speed of performance and ‘take or pay’ provisions in long term oil and gas purchase contracts, to take only some of the more familiar types of clause. The potential assimilation of all of these to clauses imposing penal remedies for breach of contract would represent the expansion of the courts' supervisory jurisdiction into a new territory of uncertain boundaries, which has hitherto been treated as wholly governed by mutual agreement.’

An extension of the penalty rule to include provisions which are triggered otherwise than by breach would further restrict parties’ freedom of contract. As can be seen in the judgment of Lord Neuberger and Lord Sumption, there are many different types of clause which would be brought within the scope of such a rule.

The closing date for the consultation is 24 February 2017. It therefore remains to be seen whether the penalty rule will survive and if so, in what form.

If you have any queries in relation to the above please get in touch with a member of the Stronachs Upstream Oil & Gas Team or Corporate Team.

Laura Bisset, Solicitor

Chambers UK 2018

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