Most commercial contracts will contain arrangements for what will happen if one of the parties fails to perform their obligations under the contract. In the absence of specific provision, the matter is dealt with under common law. A contract may provide for a tenant to pay interest on arrears if the rent is not paid on the due date, or for a purchaser to pay interest on the price if he pays late, and for other losses incurred by the seller to be met. At common law, where one party to the contract is in breach, the aggrieved party can sue for damages, based on their loss as a result of the breach, but it is necessary to provide evidence of that loss so that the claim can be quantified. It is not uncommon for the parties to agree in advance on the amount that would be payable in the event of a breach. However care must be taken when making such provision in a contract, as a condition which, in fact, imposes a penalty on a party will be unenforceable. This was one of the issues highlighted in the recent Court of Session case of Tawne Overseas Holdings Limited v The Firm of Newmiln Farm and Others and serves as a useful reminder of the difficulties that can arise in distinguishing between legitimate damages provisions and those which apply an unreasonable penalty.

Problems with payment

Tawne Overseas Holdings Limited bought Newmiln Farm and the adjacent Newmiln House in Perthshire from Mr and Mrs McFarlane, whose firm, Newmiln Farms took a lease back of the farm, and Mr and Mrs McFarlane, took a lease back of Newmiln House. From the outset, Tawne had difficulties in obtaining rental payments on time from the McFarlanes.

Tawne raised this action for declarator that both leases had been irritated due to late payment of rent, and wanted to remove the tenants from both properties, as well recovering outstanding rent in respect of the leases.

Newmiln House had previously been run as a hotel, but when the business fell into difficulties, Tawne had agreed to a substantial reduction in the rent payable under both leases, and it was agreed that if the McFarlanes failed to make a payment of rent within one month of the due date, Tawne would be entitled to claim the original rent which it would have been entitled to collect in terms of the original leases.

Payment of rent continued to be problematic and in July 2004, a number of notices were served on the McFarlanes, all relating to the house lease, requiring payment within 14 days of the date of the notices to avoid an action for irritancy and ejection. At that time, the outstanding rent on the house was £10,000 and the outstanding rent in relation to the farm was £25,000. The McFarlanes submitted three cheques totalling this amount, but one of the cheques was post-dated and was rejected.

Further rent demands were made in October 2004, this time for the original, higher rent, which Tawne claimed was due following delays in payment. The McFarlanes submitted a cheque for the revised aggregate rent of £17,500, which was rejected. Later that month, notice of intention to irritate was served and was followed by a further notice intimating to the McFarlanes that Tawne was treating the leases as irritated and that court proceedings were being raised.

Alternative rental payments or new rent?

Mr and Mrs McFarlane submitted that the negotiated provision within the leases which provided for the higher, original rent to be paid in the event of the rent falling into arrears was unenforceable under the common law, as a penalty, as they said that the original lease agreements had in fact been abandoned and new arrangements put in place, since not only the rent had changed, but a number of other aspects of the original leases had been varied. Tawne however claimed that the application of the original rent was not a penalty, but rather the revised lower rent was a concession granted to the McFarlanes because of their difficulties in paying the original rent. The McFarlanes' interpretation was preferred by the court, on the basis that the original leases had been altered in various material respects, so the change of rent could not be seen as a concession. The sums sought by Tawne amounted to unenforceable penalties, and so their actions for payment failed.

When does a penalty go too far?

It is perfectly permissible for parties to agree in the contract the basis on which damages will be calculated in the event of a breach. To avoid disputes in quantifying the amount of the actual loss, such a clause sets out in advance what the defaulting party must pay. These provisions (sometimes loosely termed "penalty" provisions) are known as liquidated damages clauses, and are generally regarded as enforceable. Such clauses assume that the aggrieved party will suffer loss because of the breach, and this type of provision provides a basis for calculating what the parties agree will be paid as damages for that loss. If however, the purpose of the provision is to punish the defaulting party for his failure to perform, or frighten him into performing, then it is likely it will be seen by the court to be a penalty provision in the strict sense and will be unenforceable.

Whether a clause is enforceable as a liquidated damages clause or unenforceable as a penalty clause will depend on the facts and circumstances, at the time of entering into the contract, not when the breach occurred, and also on what was intended by the parties. Case law provides us with some clear guidelines although it should be borne in mind that particular types of contract have their own specialities.

Enforceable or unenforceable?

The intention of the parties is a chief consideration in identifying whether the provision is likely to be enforceable or not. Where the intention is to fix the amount of damages that would be payable in the event of a breach, to avoid having to prove the actual amount of any loss, then it is likely to be sustained, but a provision that penalises non-performance, intended to "scare" the parties into performing, is likely to be unenforceable. What the clause is called in the contract is not necessarily a material factor, since if the effect of a provision is to penalise, then the fact that the contract describes it as a liquidated damages provision will be irrelevant.

The 1915 case of Dunlop Pneumatic Tyre Co Limited v New Garage and Motor Co Limited sets out various tests that earlier case law had formulated to assist in the correct construction of such a provision in the contract:

  • If the amount of the sum specified is "extravagant and unconscionable" compared with the largest amount of loss that could conceivably be proved to have followed from the breach, then it will be held to be a penalty.
  • If the breach is simply not paying a sum of money, and the amount specified in the provision is greater than the amount which was due to be paid, then it will be a penalty.
  • There is a presumption that it is a penalty when there is provision for a single sum to be payable as compensation on the occurrence of different events, some of which may be serious but others trivial.
  • The sum specified must be a genuine pre-estimate of damage, even where the consequences of the breach would have made accurate pre-estimation impossible.

A fair balance

A familiar liquidated damages provision for those buying and selling land and buildings in Scotland is the "standard interest clause" contained in virtually all missives for both commercial and residential properties. In fact, this provision is so familiar that many practitioners had ceased to read or challenge its provisions. For technical reasons unconnected with the liquidated damages v penalty considerations, the standard interest clause has come under review recently due to the outcome of two property cases in 2006 – Black v McGregor and Wipfel Limited v Auchlochan Developments Limited – but the potential for what is intended to be a liquidated damages provision in this type of clause to become a penalty provision is real and problematic.

The standard interest clause provides for interest (usually at 4% over base) to be payable not only on the price when paid late, but also when the price is never paid and the contract is rescinded. However in the latter circumstances the clause also provides for the seller to be entitled to claim his losses as well, which is where the difficulties could arise.

Current thinking is therefore to revert to the common law in the latter circumstances and to provide that the seller is entitled to claim in respect of actual losses incurred in the event of the default of the purchaser. The outcome would then be fair for both parties and the seller does not run the risk of recovering a lot less than he expected, or nothing at all.

Property Standardisation Group

The Property Standardisation Group, of which Shepherd and Wedderburn are founder members has recently launched a standardised form of Commercial Offer to Sell, which incorporates interest and damages provisions adopting this new approach. The offer provides in the usual way for interest to be payable on the price, if the purchaser fails to pay on the due date. If, however, the seller decides that it wants to rescind the missives and re-sell the property, the offer provides that it would no longer be entitled to any interest, and instead, it would look to recover costs and losses actually incurred. Several heads of loss are identified, including re-marketing costs, any shortfall in the price, and generally other financial losses that are actually incurred The list is not exhaustive and the common law provides a degree of flexibility.

To view the text of the decision in the case of Tawne Overseas Holdings Limited v The Firm of Newmiln Farm and Others please click here.

To view the work of the Property Standardisation Group please click here.