Liquidated damages: are times changing for penalty clauses under Scots law - Part 1

Over the summer, the UK Supreme Court heard two conjoined appeals – Cavendish Square Holdings BV v. Makdessi and ParkingEye Ltd v. Beavis. Both cases focussed on the correct application of English contract law to penalty and liquidated damages clauses.

The Court considered, among other matters, whether the rule against penalties applies to commercial contracts between sophisticated parties; whether a liquidated damages clause needs to be a genuine pre-estimate of loss; and, whether a clause should be enforceable even though its main function is to deter a breach? The Court’s decision is going to have a profound effect on this area of law.

This article, the first of two parts, briefly considers an area of commercial law that can appear as straight-forward to commercial clients as it is contentious to commercial litigators, as per the imagined conversation below.

“We (A+B) agreed that A would pay us (B) £100,000 in the event that A failed to act as we agreed. A is in breach, so we (B) are entitled to recover £100,000 from A, obviously.”

“The £100,000 is not related to the breach. There is no correlation between that sum and any loss that actually may be suffered. The sum is a penalty and therefore the clause is unenforceable, obviously.”

Which statement belongs to the businessman, and which to the lawyer, will be apparent. The above are not the facts of Makdessi and ParkingEye - those will be set out in part 2 – rather a crude attempt to frame some of the issues in this area of law. What follows is an introduction into some of the key issues for businesses across the UK, with a particular focus on Scotland, set out by way of responses to a series of questions.

Why make provision for liquidated damages?

It is worth considering briefly why the use of liquidated damages clauses is widespread in commercial contracts. Only the parties themselves will know but one can readily envisage a number of reasons why they may wish to agree to the payment of damages from one to the other in the event of a breach of contract. These may include the following: where it would be extremely difficult to assess the quantification of loss should there be a breach; to incentivise performance on time; to provide commercial certainty; and, as they avoid a protracted dispute, that they are good for preserving the commercial relationship.

What does a penalty clause look like under Scots law?

Where one party looks to rely on a liquidated penalty clause, what matters should their advisor be considering when assessing the merits of doing so? In 2011, the Inner House, Scotland’s Civil Court of Appeal, approved Lord Macfadyen’s passage in the case of City Inn Ltd v Shepherd Construction Ltd (2002). I can do no better than to set it out here.

“For a contractual provision to be regarded as imposing a penalty, and therefore as being unenforceable, it must, in my opinion, stipulate for payment by one party to another of a sum of money which (a) is payable on the occurrence of a breach of contract committed by the former party … and (b) does not constitute a genuine pre-estimate of the loss likely to be suffered by the latter party as a result of the relevant breach of contract, but is instead unconscionable in respect that it is designed to operate in terrorem, or oppressively or punitively.”

In addition to the points raised above, an advisor will be considering whether the term ‘liquidated damages’ has been used. This will not be conclusive but it can be indicative of what the parties intended. What evidence has been retained of the parties’ reasons for agreeing the components of the mechanism to be used to calculate damages in the event of a breach? This may prove more significant should the commercial justification argument find favour before the UK Supreme Court. Is there an intelligible relationship between the penalty and the possible loss caused by the party in breach? If so, this enhances the prospects of the clause being enforceable.

Why should a decision regarding English contract law matter so much in Scotland?

The phrase which forms the general test in both jurisdictions - ‘a genuine pre-estimate’ – probably originated in the decisions of Scottish judges and was imported into English law at the turn of the Twentieth century by Lord Dunedin. His leading judgement in the House of Lords’ case of Dunlop Pneumatic Tyre Co. Ltd. v New Garage & Motor Co. Ltd is considered by my English colleagues to be the key judgment on English law in this area. This cross reference to cases between jurisdictions has continued in modern times. As such, while the cases of Makdessi and ParkingEye focus on English contract law, the decision of the UK Supreme Court by a panel seven justices, including Lord Hodge, is likely to shape Scots law in this area going forward. Moreover, the Scottish Law Commission sees merit in pressing for reform in this area and a Discussion Paper will be brought forward in 2015. Given that the Commission’s website notes that the decision in Makdessi and ParkingEye will be issued shortly, it would be surprising if the Commission does not wait until this has digested before releasing its Paper. In short, change is coming.

Preliminary conclusion

Businesses, as far as possible, want certainty in their commercial transactions. There is a sense that the UK Supreme Court may introduce a greater degree of flexibility into considerations of what should be struck down as being penalties. If that is the case, then this could erode the certainty that clients, and their advisors, consider themselves to have presently. It is extremely likely that businesses will need to revisit their approach to liquidated damages clauses in light of the Court’s decision, both retrospectively and prospectively.

Euan heads DWF’s Litigation team in Scotland. He advises clients in the retail, food & drink and banking sectors throughout Scotland. His principal areas of practice are commercial litigation, property litigation and corporate crime. He is a Solicitor Advocate with rights of audience in the Court of Session and the Supreme Court. He regularly appears in arbitrations and, as an accredited mediator, is an active promoter of mediation as a means of resolving disputes.

This information is intended as a general discussion surrounding the topics covered and is for guidance purposes only. It does not constitute legal advice and should not be regarded as a substitute for taking legal advice. DWF is not responsible for any activity undertaken based on this information.

Euan McSherry

Partner - Head of Real Estate Litigation (Scotland)

I provide litigation advice to clients in the retail, food and banking sectors. I am the first Scottish lawyer to be listed on the Register of RICS Accredited Mediators.