Rules For Taking Penalties

The Scottish Law Commission has recommended that the law on penalty clauses should be reformed in Scotland. It has drafted a Penalty Clauses (Scotland) Bill setting out its proposals.

At the moment, the law on penalties in England and Scotland is the same. The courts will enforce clauses that provide for payment of a genuine pre-estimate of damages. However, clauses that do not make any genuine attempt to pre-estimate losses and merely fix an amount that is payable will not be enforced by the courts.

Most construction contracts provide for a certain sum of money to be paid in the event that the contract works are not completed within the agreed time. These provisions are based on a pre-estimate of damages and are known as liquidated damages. A clause that purports to be a liquidated damages clause will not be enforceable if it is viewed by the courts as a penalty rather than a genuine pre-estimate of loss.

The benefit of liquidated damage, as the law stands, is that it avoids the need to prove loss

The benefit of having liquidated damages provisions is that it avoids the need to prove actual loss. If there are no liquidated damages provisions, then the employer must prove the loss it has suffered as a result of the contractor's breach of contract.

There is case law to suggest that an employer is entitled to the specified amount of liquidated damages even if it has not sustained any loss. Conversely, if the employer has suffered greater loss than the amount stipulated, then it may not choose to ignore the liquidated damages provisions and is not entitled to claim such losses as it can prove. Furthermore, case law supports the view that no liquidated damages will be payable to the employer for delay if the rate is specified as "nil".

Under the bill, only penalties that are not ‘manifestly excessive’ will be enforceable

The distinction between a penalty and liquidated damages can be a fine one. It is particularly difficult to apply the test of genuine pre-estimation where it is impossible to estimate losses in advance, arguably the situation where a liquidated damages clause is most useful. It is also the case that a penalty not arising on breach of contract is not subject to review by the courts. For example, clauses that are penal in effect may be enforceable if they become active in the event of insolvency, since this is an event of default not arising on breach of the contract.

The Scottish Law Commission's draft bill proposes that the courts should continue to be able to exercise control over contractual penalties. However, the commission proposes that the criterion for exercise of that control should be if the penalty is "manifestly excessive" rather than if the clause is not based on a "genuine pre-estimate of damages". This is in line with the Council of Europe's recommendation on the test for penal clauses. Those penalties that are not manifestly excessive are to be enforceable even if they cannot be regarded as based on a genuine pre-estimate of loss. The onus of showing that a penalty is unenforceable is to lie on the party contending the position.

Under English and Scottish law, the courts start off by looking at the position of the parties when the contract was entered into. However, what happens after this date may influence the court in determining whether or not a provision is a penalty. The draft bill proposes that all the circumstances arising after the contract should be included in assessing whether or not a penalty is just that. The commission's rationale for this is that, provided that the sum payable is not extortionate in relation to the breach or other triggering event that has occurred, there is no reason why the penalty should not be enforceable.