The line between an (enforceable) liquidated damages clause and an (unenforceable) penalty clause

A recent decision from the Inner House,  Hill and Anor v Stewart Milne Group and Gladedale (Northern) Ltd [2011] CSIH 50 sheds light on liquidated damages clauses and when they may amount to unenforceable penalties. 

The alleged penalty was contained in a minute of agreement and provided that, where the construction of the subjects in question had not been completed by both defenders by a Longstop Date, a penalty of £5,000 per month would be payable to the pursuers.  The Inner House, in a decision delivered by Lord Brodie, reminded us of the tension taking place in cases concerning clauses of this type:

“The context is the law's attempt to resolve the tension between competing principles: on the one hand, as Lord Justice Clerk Inglis put it in Craig v M'Beath (1863) 1 M 1020 at 1022, "it is not legal to stipulate for punishment" and, on the other, as Lord Blackburn said in Caledonian Rly Co v North British Rly Co (1881) 8R (HL) 23 at 31, "a bargain is a bargain". Hence the uncontroversial rules that Lord Macfadyen summarised in paragraph [15] of his Opinion in City Inn Ltd v Shepherd Construction Ltd 2002 SLT 781:
"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 (EFT Commercial Ltd v Security Change Ltd 1992 SC 414), 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 (Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co [1915] AC 79, per Lord Dunedin at 86, para 2; Clydebank Engineering and Shipbuilding Co v Castaneda (1904) 7F (HL) 77; AMEV UDC Finance Ltd v Austin (1987) 68 ALR 185)."”

The case contains analysis of whether the defenders were actually in breach.  This argument arose because the defenders were under an obligation to use all reasonable endeavours to ensure completion by the Longstop Date.  Thus, the pursuers argued, although reaching the Longstop Date without the development having been completed might suggest that a breach had occurred, this may not be the case.  The defenders could only be in breach if they failed to use reasonable endeavours to achieve this outcome.  The Inner House, describing this as a “nice question” (para [14]) indicated that they did not require to come to a decision on this point given their decision on the second issue before them.

Looking then at the second issue, i.e. whether the provision was, in fact, a penalty, the Inner House noted that the Sheriff Principal had erred in his analysis of the onus of proof.  It is for the party who has asserted that a provision is a penalty to establish, by evidence and averment, that it is “…exorbitant and unconscionable and designed to operate in terrorem” (para [15]).  The primary question was therefore whether the defenders had made sufficient specific averments to support their proposition (para [15]).  Here the defenders had provided little more than a statement that the provision was a penalty and therefore unenforceable.  This was insufficient to discharge the onus which lay on them. 

The Sheriff Principal had also been wrong when he found the pursuers’ case to be irrelevant on the grounds that the loss they had suffered had not been caused by the defenders’ breach:

“Moreover, stipulating for pre-estimated damages is recognised as a useful means of allowing the need for proof of a loss caused by breach and accordingly, the party founding on such provision does not need to prove such loss: Clydebank Engineering supra at 83 and Dunlop Pneumatic Tyre supra at 95.”

They later summarised the law on this point by saying:
“Whether a party suing on a liquidated damages provision in the contract had in the actual event suffered damage in consequence of the breach was irrelevant.”

A liquidated damages clause is, of course, enforceable if it represents a genuine pre-estimate of loss.  A clause is only unenforceable as a penalty if it seeks to impose a penalty that is not such a pre-estimate of loss. 

Finally, the Inner House confirmed that whether a provision falls to be regarded as an unenforceable penalty is to be determined by reference to the position at the date of conclusion of the contract and not at the date of the breach (para [18]).  It is at the date of formation that the parties have the opportunity to estimate their potential losses in the event of a particular breach and set the level of the liquidated damages accordingly:

“The proper approach for the Court was to consider whether the sum stipulated for is extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved to have followed from the breach: Dunlop Pneumatic Tyre supra at 87.”

The Sheriff Principal had approached this case by placing the onus of proof on the pursuers (the parties who were not arguing that it was a penalty) and had also found against the pursuers on the basis that they had failed to prove that the breach had caused them loss.  As explained above, the Sheriff Principal’s decision was wrong on both of these points and was overturned by the Inner House.  All in all, this is a succinct judgment outlining both the method to be used in determining whether the clause is a (valid) liquidated damages clause or an (invalid) penalty clause, and outlining the mechanics of dealing with a clause of this type in litigation. 


Vicarious liability: Skandinavska Enskilda Banken AB v Asia Pacific Breweries (Singapore) Pte Ltd

The vicarious liability of an agent is an issue which has not been analysed in much depth by the Scottish courts.  Some argue that there is no such thing as vicarious liability in agency: merely that the agent is treated as an employee and the established rules relating to employment applied to an agent (P. S. Atiyah, Vicarious Liability, (1967), p.100).  This approach arguably fails to take into account the role of the agent’s authority in assessing the principal’s liability.  The recent case of Skandinavska Enskilda Banken A.B. (Publ.) v Asia Pacific Breweries (Singpore) Pte Ltd and anor [2011] S.G.C.A 22, decided by the Court of Appeal of Singapore, contains extremely useful analysis of the policy factors underlying vicarious liability (available here:

More significantly, the court applied the “sufficient connection” test for vicarious liability developed in the leading English House of Lords case of Lister v Hesley Hall Ltd ([2001] UKHL 22, [2002] 1 A.C. 215)
in a commercial context.  The court recognised that there may be very different policy factors underlying a decision in a commercial as opposed to a domestic or private situation (Lister was a case which concerned the employer’s vicarious liability where an employee had sexually abused vulnerable children in his care.) 

Skandinavska also contains very useful analysis of apparent authority in agency, and comments on the difficult case of First Energy v Hungarian International Bank [1993] 2 Lloyd’s Reps 194).  The apparent authority angle is not discussed here, but may appear in this blog in the future.

In Skandinavska, the Court of Appeal identified the two main policy reasons underlying vicarious liability as, firstly, effective compensation for the victim and deterrence of future harm (para 76).  Crucially, the Court suggested that in some factual contexts the person best placed to prevent the tort may be the victim himself or a third party (para 81).  They opened the door for other policy reasons to be relevant to the determination of vicarious liability, not all of which could be identified outside the facts of a particular case (para 81).  They suggested that the following was an accurate representation of the law (taken from Bokhary P.J. in Ming An Insurance Co (/HK) Ltd v Ritz-Carlton Ltd [2002] 3 H.K.L.R.D. 844 at para [25], approved by the Singapore Court of Appeal at para 81):

“By “close connection” is meant a connection between the employee’s unauthorised tortious act and his employment which is so close as to make it fair and just to hold his employer vicariously liable….[V]icarious liability [is imposed] when, but only when, it would be fair and just to do so.” 

The difference in factual context, i.e. a commercial as opposed to a domestic or private situation was noted (at para 88):

 “…the case of a commercial fraud perpetrated by an employee of a trading company against international banks which could have prevented the fraud by taking basic precautions presents quite a different situation.”

The court then analysed the agent’s authority on the facts of the specific case, which was extremely limited in financial matters.  As such they held that it would not be reasonable for the principal to have expected the agent to carry out the fraud in question, in fact, the sequence of events was “entirely unforeseeable” (para 91).  The Court decided to let the loss caused by the agent's fraudulent act fall on the third party who had purported to contract with the agent on behalf of the principal/employer, and not the principal as the agent's employer.  The Court made the following comment about the role of banks (para 93):

“Banks play a vital role in the economic life of a community as deposit-taking institutions and suppliers of investment capital for the economy.  There is, therefore, a greater need for banks, (as compared to trading companies such as APBS) to act responsibly and not take undue risks with their depositors’ funds so that the public will have confidence in the banking system.”

As a Singapore case, Skandinavska is, of course, persuasive rather than binding.  The Court of Appeal’s approach must surely be correct: vicarious liability ought to take into account the realities of the commercial situation.  These may be very different from those which applied in Lister, where the harm caused was physical rather than financial, and the victim of the delictual conduct a vulnerable person.   


Dissolution of Partnerships – Scottish and English Differences

A recent English High Court case, Boghani v Nathoo [2011] EWHC 2101 (Ch) provides an interesting illustration of the differences between Scots and English partnership law caused by the fact that the Scottish firm has separate legal personality whilst the English firm does not.  The decision also sheds light on the meaning of s.38 of the Partnership Act 1890, the interpretation of which has caused difficulties in the past.

The parties to the dispute had been in a partnership at will and had run the Splendid Hotel Group from 1993 until April 2011.  The firm had been dissolved by notice from Boghani to Nathoo.  At the time of dissolution, two major hotel development projects, known as the ICH Development and the Hilton Development, remained uncompleted.  The partners had been unable to agree how the developments should be disposed of in the winding up of the firm’s affairs.  Boghani argued that they should be marketed for a period of three months and then disposed of to the highest bidder, which might include one of the partners.  Nathoo disagreed, arguing that they should be completed first, and then disposed of. 

The terms of s.38 of the Partnership Act were fundamental to the dispute.  These are as follows:

“After the dissolution of a partnership the authority of each partner to bind the firm, and the other rights and obligations of the partners, continue notwithstanding the dissolution so far as may be necessary to wind up the affairs of the partnership, and to complete transactions begun but unfinished at the time of the dissolution, but not otherwise."

Nathoo argued that s.38 obliged the parties to complete the developments until the court, in its discretion under s.39, determined otherwise. Boghani argued that the section did not have this effect.  He argued that, before dissolution, the partners were under no unconditional obligation to complete the development, and also that completion was not necessary for the partnership to wind up its affairs.  In any event, he argued that the court should exercise its discretion and order the sale on the terms he proposes. 

The issue depended, the Chancellor of the High Court indicated, on what the words “necessary” and “complete” meant in the context of s.38 (para 31).  At the time of dissolution, the partnership was bound by valid contracts with developers requiring them to complete the transactions.  Did such binding obligations under the development contracts mean that it was indeed “necessary” for the firm to complete performance?  The Chancellor thought that it was relevant that many firms would not have the funds to complete every contract at the point of dissolution (para 31).  He interpreted “necessary” as meaning necessary for the purposes of winding up the partnership.  It followed, therefore, that completion of these developments was not necessary for the purposes of dissolution of the partnership (para 33).  Evidence had been led to the effect that other parties were interested in taking on the obligations of the firm in those developments.  Both of the partners individually had also indicated that they would be willing to do so.  This being the case, completion of the developments by the firm was not “necessary” in terms of s.38.   

Nathoo did not obtain the order in the terms requested, i.e. ordaining the firm to complete the developments.  The Chancellor indicated that, if the developments were to be completed, it could only be on a consensual basis.  Absent that agreement, either party would be free to bid for the developments against any outside bidders who may also be interested in the developments (para 34).  Boghani’s application, which requested decree that the partners were not under any continuing obligation, whether under s.38 or otherwise, to complete the developments, was also refused (para 35).  To do so would be “at worst incorrect and at best misleading” – the firm remained under obligation to complete the developments notwithstanding dissolution (para 35).
Paragraphs 19 to 27 of the decision contain some interesting and useful discussion of the meaning of s.38.  Reference is made inter alia to two Scottish decisions: a Scottish appeal to the House of Lords, Inland Revenue v Graham’s Trustees (1971 SLT 46) and an Outer House decision from Lord Reed, Duncan v MFV Marigold PD145 [2006] CSOH 128; 2006 SLT 975.  In the former case, on the death of one of the partners, the firm had ceased to exist.  The argument raised was that s.38 permitted the surviving partners to continue the lease of a farm which had been held in the name of the firm.  That argument failed.  The Chancellor quoted from Lord Reid’s speech (at page 48):

"What is meant by transactions begun but unfinished when the partnership was dissolved? If the common law had been clearly settled before 1890, I would interpret this section in light of the earlier law. But it appears that there was then little authority on this matter. So this section should if possible be construed so as to reach a reasonable result. It was argued that "transactions" means bargains. But that would deprive this provision of all content, for it is clear that surviving partners have no right to bind the assets of the dissolved firm by making new bargains or contracts. Their right and duty is to wind up its affairs. In my view this must mean that the surviving partners have the right and duty to complete all unfinished operations necessary to fulfil contacts of the firm which were still in force when the firm was dissolved.  Otherwise the position would be intolerable. Suppose the firm was employed to build a bridge and the bridge was half finished when the firm was dissolved. The surviving partners must be bound to finish the work, for otherwise they could hold the employer to ransom by refusing to proceed unless he made a new contract more favourable to them, and conversely the employer could refuse to allow the work to proceed unless the surviving partners made a new contract more favourable to him. That could not be right."

The Chancellor also quoted Lord Upjohn from that same case, where he indicated that s.38 would not often be required in England, given that the obligations under contracts would bind the outgoing partner and his estate under the general law:

 "Thus, for example, if a firm contracts to build a bridge, that contract is not affected by its dissolution. The remaining partners and the outgoing or the estate of a deceased partner will normally remain both entitled and jointly and severally liable under the general law to complete the bargain. Section 38 makes it plain that the continuing partners can in doing so bind the ex-partners or their estates. But I can well understand that in Scots law, without giving it any different a construction, it may be necessary to invoke the section more often than under English law because of s.4(2) of the Partnership Act, and the partnership having come to an end as a legal person on dissolution, the contract presumably must come to an end. But, nevertheless, this section makes it plain that the ex-partners will remain entitled and bound to carry out the contracts made in the name of the partnership and must complete all those contracts and other matters which are in medio when the partnership was a going concern. But their rights under s.38 are limited by the provision that they may only do so so far as it may be necessary to wind up the affairs of the partnership and, this is the important passage, to complete transactions begun but unfinished at the time of the dissolution, and this is equally true of course of contracts in English law but, as I have said, it is less likely to be necessary to invoke that section."

The Lord Chancellor referred to Lord Reed’s decision in Duncan v MFV Marigold, noting that he had referred to both of the House of Lords speeches quoted above, and, quoting him:

“On any view, however, s.38 cannot warrant the continuation of the business for more than a temporary period…[it is] necessary to examine the facts in order to determine whether a given transaction arose from the conduct of the business of the dissolved partnership by former partners for the purpose of winding up the affairs of the partnership and was "necessary" for that purpose, or whether it was attributable to some other relationship between the partners."

Having analysed this authority, the Chancellor summarised the legal position under s.38 as follows:

“In my view the terms of s.38 as explained in the authorities to which I have referred, in particular Inland Revenue v Graham's Trustees, demonstrate the following propositions:

(1) The obligations of partners to third parties continue notwithstanding the dissolution of the partnership.
(2) In England, if not in Scotland, the satisfaction of those obligations by performance, release or novation or the payment of damages will not usually involve reliance on the terms of s.38.
(3) S.38 does not entitle the surviving partners to engage in new bargains or contracts so as to bind a deceased or former partner.
(4) Even in relation to transactions, not being new bargains or contracts, begun but unfinished at the time of dissolution s.38 applies only if and to the extent that the completion of such transactions is necessary to wind up the affairs of the partnership.
(5) S.38, if applicable, confers a power; it does not impose any additional duty.”

It would be interesting to analyse the source and development of s.38.  The 1890 Act was a codifying statute.  As such, it was not intended to be an exhaustive statement of the law, but rather a statement of the central principles in a series of general propositions.  Lord Reed touched on this point in Duncan v MFV Marigold at para 26.  No doubt, as Lord Reid pointed out in Inland Revenue v Graham’s Trs, there was little case law on the operation of s.38 prior to the entry into force of the 1890 Act.  Arguably, however, the ability of the partner in this respect is simply the common law ability of an agent to continue transactions even if the principal dies or becomes bankrupt.  In theory, an agent cannot act for a non-existent principal.  But the common law permitted the agent to do so in order to complete unfinished transactions.  This idea is analysed in a significant agency case, Pollok v Paterson Dec 10, 1811, F.C. at 375, where the origins of this idea in Roman law are analysed.  Analysis of the the agency law principles underlying s.38 may help to shed further light on this difficult section of the Partnership Act 1890.