Scottish Law Commission consulting on penalty clauses in contracts

2 December 2016

By Kevin Zakreski

The Scottish Law Commission has just published its Discussion Paper on Penalty Clauses (PDF). In a news release (PDF) accompanying the discussion paper, the commission notes that it is “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.”

“As a general rule,” the discussion paper explains:

the victim of a breach of contract may recover damages representing compensation for its loss from the perpetrator of the breach. The law on contract damages is however “default” in nature, in that contracts can provide their own scheme for payment of a sum or other remedy by the perpetrator of a breach of contract. The advantages of doing so for the contracting parties are the facilitation of contingency planning, the avoidance of disputes and litigation, and the consequent reduction of uncertainty about the outcomes of breach. Under Scots law since the end of the nineteenth century, a distinction has been made between clauses which genuinely pre-estimate the damages payable on a breach of contract, and clauses which do not. Clauses which attempt to provide for the recovery of a genuine pre-estimate of loss have been referred to as liquidated damages and are enforceable. Clauses which provide for a fixed payment to be made instead of damages, but do not base this upon any attempt to pre-estimate loss, have been referred to as penalty clauses, and are unenforceable.

After a brief introductory chapter, the discussion paper surveys the current law on penalty clauses in Scotland, making comparisons to other civil-law and common-law jurisdictions. Then, the paper sets out its law-reform options, which the news release boils down to three:

  • abolish the present law, apart from statutory rules protecting consumers from unfair penalties;
  • completely replace the present law, again apart from the statutory consumer-protection rules;
  • do nothing for the moment, keeping tabs on how the courts develop the law.

“With the second option of an altogether new system,” the commission explains in its news release:

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.

The discussion paper contains 32 law-reform questions and proposals for comment. The consultation’s closing date is 24 February 2017. Information on responding and an electronic response form are available on the commission’s consultations webpage.

The discussion paper has been issued as part of the commission’s large project on Contract Law in Light of the Draft Common Frame of Reference. It is the sixth major publication issued as part of the project.

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