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Penalty clauses in contracts 01/12/2016 The SLC has published a Discussion Paper on the rule against penalty clauses in contracts, raising for consultation purposes the possibilities that the rule be abolished outright, or be completely replaced.

Penalty clauses in contracts

The Scottish Law Commission has published a Discussion Paper on the rule against penalty clauses in contracts, raising for consultation purposes 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.

For a long time the judge-made law of penalties allowed parties to fix their own regime of damages for breach of a contract only if the relevant term (or clause) constituted a genuine pre-estimate of the loss likely to be suffered on a breach. Anything else was to be regarded as an unenforceable penalty, in line with the policy of the law that a contract could not provide for punishment of a contract-breaker as distinct from compensation for the innocent party.

This distinction has been heavily criticised as being out-of-line with commercial reality, in which businesses seek to provide real incentives for their contracting counterparties to perform contracts in full accordance with their terms. In a case decided in November 2015 the UK Supreme Court made an attempt to revise what it described as “an ancient, haphazardly constructed edifice which has not weathered well”.

But the ruling, while welcomed in some respects, was also criticised for being too uncertain in its scope and insufficiently radical in the changes it brings about.

The Scottish Law Commission, which was already considering the rule against penalties, has therefore decided to canvas the possibility of further reform (although leaving open the possibility of doing nothing for the moment, to see how the Supreme Court decision beds in).

Apart from doing nothing, the Scottish Law Commission raises two options for reform:

  • should the present law simply be abolished, apart from the statutory rules protecting consumers from unfair penalties?
  • should the present law (again, apart from the statutory consumer protection rules) be completely replaced?

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

According to the Commission, with the second option of an altogether new system, 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. Moreover, a successful challenge could lead, not to unenforceability, but rather to the court modifying the penalty. This would mean, not reducing the penalty to the amount of any actual loss suffered by the innocent party, but only the removal of its excessive element.

“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,” said Professor Hector MacQueen, the Commissioner leading the contract law review.

“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,” he explained.

The closing date for the consultation is 24th February 2017, and the Commission hopes to complete its report on the subject by the end of that year.

More information, including the Discussion Paper, is available here.


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