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.