February 2017 – In terrorem “Penalty clauses” in contracts – the Scottish Law Commission review

Author: Brian
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The Scottish Law Commission is currently reviewing the law on “penalty clauses” in contracts. Their consultation exercise closes at the end of this month. It’s worth outlining what “penalty clauses” are; the current state of the law; and what the Scottish Law Commission has in mind.

What “penalty clauses” are

  • Happily, the use of Latin by lawyers is out of fashion. Nevertheless, some Latin phrases cling on and in terrorem is one of them. Here one doesn’t need to be a Latin scholar to get the gist: something which is in terrorem is designed to act as a deterrent or warning. The term usually crops up in the context of “penalty clauses”.
  • Many contracts provide that if one party breaches the contract then a specified sum of money is payable to the other party. In principle, if the specified sum exceeds a genuine pre-estimate of the loss likely to be suffered on the breach then such a contract term may be classified as a “penalty clause” and a court will not enforce it. If however the sum to be paid on a breach is found to be a genuine pre-estimate of the loss – sometimes referred to as “liquidated damages” – then it will be enforceable.
  • The general idea is that, as a matter of policy, a contract cannot provide for the punishment of a contract-breaker as distinct from compensation of the innocent party who has suffered the breach. In a leading case in 1914 it was said that “the essence of a penalty [clause] is a payment of a sum of money stipulated as is in terrorem of the offending party”. If such a cause is found to be in terrorem then it will be held to be a “penalty clause” and as such unenforceable.
  • The above now needs some qualification following a decision of the Supreme Court in 2015. We touch on that below. Meantime, the following extract from the 1914 leading case (Dunlop Pneumatic Tyre Company Limited v The New Garage and Motor Company Limited) gives an illustration of how the courts identify “penalty clauses” at the same time as showing that it may not always be easy to distinguish between what counts as a genuine pre-estimate of loss (or “liquidated damages”) which is enforceable and a penalty clause (or one in terrorem) which is not:

“… [Dunlop Tyres] entered into a contract with the [New Garage Company] under which they supplied them with their goods, which consisted mainly of motor-tyre covers and tubes. By this contract … the [New Garage Company] bound themselves …: not to tamper with the manufacturers’ marks; not to sell to any private customer … at prices less than the current price list issued by [Dunlop Tyres]; … Finally, the agreement concluded (clause 5), “We agree to pay to [Dunlop Tyres] the sum of 5 l. for each and every tyre, cover or tube sold or offered in breach of this agreement … 

[Dunlop Tyres], having discovered that the [New Garage Company] had sold covers and tubes at under the current list price, raised action and demanded damages… 

… it is evident that the damage apprehended by [Dunlop Tyres] owing to the breaking of the agreement was an indirect and not a direct damage. So long as they got their price from the [New Garage Company] for each article sold, it could not matter to them directly what the [New Garage Company] did with it. Indirectly it did. Accordingly, the agreement is headed “Price Maintenance Agreement,” and the way in which [Dunlop Tyres] would be damaged if prices were cut [has been] clearly explained … But though damage as a whole from such a practice would be certain, yet damage from any one sale would be impossible to forecast. It is just, therefore, one of those cases where it seems quite reasonable for parties to contract that they should estimate that damage at a certain figure, and provided that figure is not extravagant there would seem no reason to suspect that it is [a penalty clause] … to be held in terrorem.”

The current state of the law on “penalty clauses”

  • The Dunlop Tyres case was decided in 1914. Just over a hundred years later (in 2015) the Supreme Court re-evaluated the law on “penalty clauses”.
  • The case in 2015 made a significant adjustment to the law on penalty clauses in England & Wales. The law is still set against the imposition of a punishment by one party on another by way of a penalty clause. But it is no longer a general requirement of a clause’s enforceability that it be a pre-estimate of the financial loss which the innocent party to the contract may suffer if there is a breach. Instead, the question is whether the clause offers protection for a legitimate interest of the innocent party that is not “extravagant, exorbitant or unconscionable.”
  • The Supreme Court case (being an English case) is not strictly binding on the Scots Courts but is likely, at least, to be highly persuasive.

The Scottish Law Commission review 

  • The Scottish Law Commission has however concluded that there is enough doubt about the Supreme Court’s approach in the 2015 case to justify some discussion of the law’s further reform by way of legislation. The Commission does not think that anyone wishes to go back to a system under which a clause must be either a “liquidated damages” clause that genuinely pre-estimates loss or else an unenforceable “penalty clause”.
  • The Commission has canvassed various alternative approaches including in particular the abolition of the law against “penalty clauses” on the basis that statute already deals with some major areas where protections are required (e.g. the Unfair Contract Terms Act 1977, the Consumer Rights Act 2015 and the Consumer Credit Act 1974) and, in commercial cases, parties are generally well-equipped to look after their own interests and should be free to contract as they wish.
  • It will be interesting to see how matters develop.

Note: This material is for information purposes only and does not constitute any form of advice or recommendation by us. You should not rely upon it in making any decisions or taking or refraining from taking any action. If you would like us to advise you on any of the matters covered in this material, please contact Paul Neilly: pdn@mitchells-roberton.co.uk


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