Commission proposes overhaul of penalty clause rule

Replacement, or even simple abolition, of the rule against penalty clauses in contracts is proposed by the Scottish Law Commission in the latest phase of its review of contract law in Scotland, published today.

A discussion paper on the rule raises for consultation the possibilities that the rule be abolished outright, or be completely replaced by new, much better-targeted rules to deal appropriately with real abuses of contract power. However the Commission also recognises the possibility that the law be left as it is meantime, until the effect of a recent UK Supreme Court decision can be assessed.

Traditionally under the common law, the Commission observes, parties to a contract could fix their own regime of damages for breach of contract only if the relevant term constituted a genuine pre-estimate of the loss likely to be suffered. Anything else was to be regarded as an unenforceable penalty, the policy of the law being that a contract could not provide for punishment of a contract-breaker as distinct from compensation for the innocent party.

This distinction has long been criticised as out of line with commercial reality, as businesses seek to provide incentives for their contracting counterparties to perform contracts in full accordance with their terms. In its Cavendish Square decision in November 2015, the UK Supreme Court attempted to revise what it described as the "haphazardly constructed" rule.

The court recognised that compensation for loss caused by breach was not the only legitimate interest that an innocent party might protect by way of a penalty clause, and that a clause protecting other interests – for example, the promotion of business goodwill, distribution networks and other such commercial interests – could be enforceable even though not based on a pre-estimation of loss. Such a clause would become unenforceable, however, if it was unconscionable, extravagant or disproportionate in its terms. However, the court had no power in England & Wales to modify the clause to make it acceptable; the penalty was either enforceable or not as it stood.

While welcomed in some respects, the ruling has also been criticised for being too uncertain in its scope, and insufficiently radical. The Scottish Law Commission, which was already considering the rule against penalties, has therefore decided to canvass the possibility of further reform, leaving open the possibility of doing nothing for the moment, to see how the Supreme Court decision beds in.

If reform is to be pursued, the Commission raises two options:

• abolish the present law, apart from the statutory rules protecting consumers from unfair penalties; or
• replace the present law with a rule that a penalty clause could only be challenged if the actual effects of its enforcement were shown to be out of all proportion to the interest of the innocent party that it was designed to protect, with a successful challenge leading to the court modifying the penalty rather than declaring it unenforceable. Again there would be an exception for the statutory consumer protection rules.

In each alternative, the rule against penalties would be succeeded by a starting point that, apart from consumer contracts, penalty clauses are generally enforceable.

Professor Hector MacQueen, the commissioner leading the contract law review, commented:

“Although we think that our suggested new system does strike a better balance between certainty and the correction of real unfairness, the Commission’s eventual conclusions and recommendations to the Scottish Government will be very much led by the responses which we receive to this consultative document. We know that many commercial lawyers favour outright abolition of the rule against penalties; but we are concerned that this might leave small businesses, employees and other persons of relatively low bargaining power vulnerable to excessive penalisation. We need to know how realistic these concerns are, and we therefore hope that the consultation response will be widespread.”

Click here to access the discussion paper. The closing date for the consultation is 24 February 2017, and the Commission hopes to complete its report on the subject by the end of next year.