The Scottish Law Commission (SLC) is considering alternative approaches to the rule against penalty clauses in contracts.
Historically, penalty clauses in contracts required the courts to distinguish between such clauses that represented a “genuine pre-estimate” of the loss that would be suffered (in the event of a breach), and those clauses whereby the sum quoted is designed to threaten the offending party to prevent such a breach. The former are referred to as “liquidated damages” clauses and are generally enforceable, as opposed to the latter, which are “penalty” clauses and are unenforceable (on the basis that these clauses are being used as a deterrent and that the sum quoted exceeds a pre-estimate of the loss).
The recent decision in the Cavendish and ParkingEye cases provided that the new legal test for a penalty clause is whether or not, in the enforcement of the primary obligation under the contract, the clause is a secondary obligation, which imposes detriment to the offending party that is disproportionate to the legitimate interest of the innocent party. If this test is satisfied by such a clause, the court will determine that it is a penalty clause, which will therefore render it unenforceable.
The SLC is currently reviewing Scots contract law, which includes consideration of reforming the law on penalty clauses. In their discussion paper, they presented three possibilities for dealing with penalty clauses, namely:
- allowing the development of this law following on from the Supreme Court judgement in the Cavendish and ParkingEye cases;
- completely abolishing the current common law regime on penalty clauses; or
- abolishing the current common law on penalties and introducing new reforms.
The Faculty of Advocates’ view is that the law on penalty clauses should stay unchanged, while the Cavendish and ParkingEye decision is given time to become established law. The Faculty also stated that any further development of the law on penalty clauses should be kept under scrutiny, with no law reforms being considered at this juncture.
However, if the common law rule against penalties was to be abolished, given that the Government would be interfering with valid and enforceable contracts and thereby limiting the ability of parties to enter into such, the Faculty warned that any draft legislation would have to be carefully considered.
The Faculty commented: “As the discussion paper notes, Lord Hodge’s judgment addressed Scots Law directly… he was persuaded that the rule against penalties should remain part of the law of Scotland… he referred specifically to the fact that the Scottish Law Commission itself had in 1999 recommended the retention of judicial control over penalties. The Faculty’s view is that specific law reform is not recommended at this time but rather that development in the law, post Cavendish supra, ought to be kept under active review for a reasonable period of time.”
Should you require any advice on penalty clauses (or any other clauses) in contracts, please contact a member of our Corporate and Technology Group.
To view the SLC’s discussion paper, click here.
