REUTERS | Fabrizio Bensch

Does the genuine pre-estimate of loss test work?

The “genuine pre-estimate of loss” test is closely-tied to the liquidated damages clause (also known as LDs or LADs), which is a common feature in construction and engineering contracts. In the wider commercial context, it is part of the test of whether a court will strike down a clause as an unenforceable penalty.

Having been a part of the legal landscape in England, Wales and Scotland for some time, the Scottish Government recently dipped its toe into these previously settled waters and published a consultation on the Penalty Clauses (Scotland) Bill. The Bill has been drafted by the Scottish Law Commission (SLC), in an attempt to address concerns raised in this area of law.

Of course, if passed, the Bill would only affect contracts entered into under the law of Scotland, but it may be interesting to see what effect legislative intervention could have on this fairly settled sphere of the common law.

Existing Law

So what’s wrong with the current position?

According to comments received by the SLC, the existing genuine pre-estimate of loss test used to determine whether or not a penalty clause is penal is poor.

Why? For one thing, the SLC considers that the courts’ control over penalty clauses is too restrictive, not least because the courts can only review penalty clauses in the context of breach of contract.

The SLC points out that this could result in a situation where a reasonable clause was struck down (because it failed the legal test and was a “penalty”) yet a clause that was truly penal, but which did not come in to operation on breach of contract, might be enforced because it was outside of the courts’ remit when reviewing “penalties”.

What does the SLC propose?

According to the Bill, the courts will have the power to modify a penalty clause (as opposed to striking it down in entirety), but only where the penalty clause is “manifestly excessive”.

In determining what is manifestly excessive, the courts would move away from the genuine pre-estimate of loss test, and instead look to all the circumstances since the clause was agreed. That may include looking at the actual loss suffered. Therefore, in essence, it seems that the courts would be given the power to modify a penalty provision with the benefit of hindsight.

The Bill also extends to situations where a penalty is due “if the promisor fails to perform, or to perform in a particular way… or when there is an early termination of contract”. In other words, clauses that are triggered by events other than breach of contract would also be subject to the scrutiny of the courts.

Some questions…

Is it right, or indeed fair, to use information not within the parties’ knowledge at the time the clause was agreed, to decide whether a penalty clause is manifestly excessive? Would this lead to uncertainty from day one as to whether a clause would actually be enforceable?

From a construction and engineering perspective, one potential situation that springs to mind is where liquidated damages are to be paid to compensate for loss of sale income on a residential development in the event of late completion. Due to changes in the housing market during the construction period, it may transpire that the actual loss suffered because of late completion is far less than predicted at the time the clause was agreed.

If the Bill became law, could a court then modify the liquidated damages provision to reflect actual loss, notwithstanding that there was a genuine pre-estimate of the loss at the time the clause was agreed?

Into the unknown

While the SLC cannot be criticised for giving serious consideration to any concerns raised about penalty clauses, the bigger question is whether the Bill might create more problems than solutions.

Arguably, the present position in relation to liquidated damages and penalties is well known and understood. After all, it is rare that a liquidated damages provision fails because it is not a genuine pre-estimate of the loss.

However, if the Bill becomes law, it will change the basis on which liquidated damages is to be tested, and may give rise to uncertainty in relation to the amount that will be paid by a party, notwithstanding the provisions of the contract. Many in the construction and engineering sector may find that surprising, particularly given that there are so many other variables for prospective developers, funders and contractors to grapple with.

As for the power to modify controversial penalty provisions, how would the courts identify appropriate alternative amounts and drafting? And how comfortable would they be in adjusting parties’ contracts in this way, as opposed to simply holding that a clause is unenforceable?

The Bill would also open up a potentially important difference between the law of Scotland and that of England and Wales, at least for businesses that commonly encounter penalty clauses and liquidated damages when contracting.

It remains to be seen whether the Bill will become law.

3 thoughts on “Does the genuine pre-estimate of loss test work?

  1. And what would be the effect on subcontractual arrangements? What if the main contractor failed to or chose not to contest the clause as a penalty but merely sought to recover in full from the subcontractor, passing on the damages sustained. Could the subcontractor rely also on this test to contest the amount paid as being unreasonable and would that leave the main contractor at risk of a shortfall? There are of course already cases concerning the range of acceptability of any settlement/damages that are sought to be passed on but might this expand the opportunities for dispute?

  2. Louise. Thanks for your comment, which certainly raise some valid points and gives more food for thought. This is something I may return to, depending on the results of the consultation.

  3. If this throws doubt on the LAD’s being reviewed, could this result in Employers claiming an increase in damages, to actual losses made if market fluctuations cause losses to be higher than that perceived at time of contract?
    Surely contracts are made for the benefit of both parties.
    It will be interesting to see the consultation conclusions.

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