Scottish Court of Session Decisions

There are three actions between the parties arising from disputes relating to a series of agreements. They are in dispute whether the several elements constitute a single contract or separate contracts and as to their respective rights and obligations on either hypothesis. Two of the cases were sent to debate and called together on 29 June, 1999. By that date counsel had agreed that with limited exceptions the issues between the parties could not be resolved without proof. The major issue which was debated was whether a stipulation in one of the agreements, the agency agreement, was unenforceable as a penalty. For the pursuers, Mr Currie argued that the provision in question was not penal in character, and that the defenders did not have averments relevant for proof of circumstances which would bear on its enforceability. For the defenders, Mr Keen argued that the provision was, on its terms, penal in character, and that the pursuers had no averments relevant for proof that it was reasonable in the circumstances. The argument took as its focus the defenders' averments, which were taken pro veritate for present purposes, and it is therefore appropriate to refer to them for an explanation of the context for the dispute.

The pursuers are involved in the leasing of items of capital plant for use in the printing industry. The defenders are printers. The defenders aver that on 18 December, 1990 representatives of the defenders and of the pursuers' parent company signed three documents relating to a Roland R606 printing press, a substantial and high value item of plant. The documents were (a) a leasing agreement; (b) an agency agreement; and (c) an options agreement. The parties are in substantial agreement that the press was purchased by the pursuers' parent, Summit Leasing Limited, and was supplied to the defenders. There is dispute over the timing of the leasing agreement and the parties to it which cannot be resolved without evidence. The defenders aver that the agreement was entered into on 18 December with Summit Leasing Limited, and that the lessor's part of the agreement was subsequently transferred to the pursuers. The agency agreement and the options agreement were made between Summit Leasing Limited and the defenders.

The defenders contend that the agreements adopted the forms of a typical finance lease of the period. There are averments of common practice in relation to such transactions. It is said that normally the arrangements involved "full pay-out" lease terms under which the rentals were fixed at a level which would secure for the lessor a total return of capital and full interest over the fixed term of the lease. The lessee normally hoped to retain the plant as its property at the end of that term, but to stipulate for such a right would have exposed the transaction to classification as hire purchase. That would have prevented the lessor from qualifying for capital allowances for corporation tax purposes. Accordingly, an agency agreement was entered into under which the lessor appointed the lessee as exclusive agent for the sale of the plant. The economic realities of the parties' relationship were reflected in the terms of the agency agreement which typically provided that the major part of the proceeds of sale (in this case 99%) became the measure of a rebate of rental payment to which the lessee became entitled on the sale. It is averred that the normal practice was for the plant to be sold to and bought back from a dealer at market value, thereby providing a measure of the 1% share of the proceeds to which the finance house was entitled. The dealer normally took a small commission. The options agreement introduced an element of flexibility in the last two years of the fixed term by providing for the replacement of the plant on certain conditions. I was informed by Mr Keen that in the instant case the aggregate of the rental payments provided for, over the seven years of the lease, would have amounted to £1.92M. The market price of the plant at the expiry of the term was said to have been £400,000. Had the transaction followed the normal course, according to the defenders, Summit Leasing would have taken the sale proceeds as principals in the sale transaction, but remitted to the defenders £360,000 in name of rebate of rental payments. Parties' taxation positions would thereafter have been adjusted appropriately.

The lease agreement stipulated for monthly rental payments over the seven years' term on a rising scale from £13,000 per month to £28,500 per month. Clause 3 of the conditions applicable to the agreement provided that the payments were to be made on the stipulated dates, regardless of whether or not they had been invoiced. They were payable: "without any deduction on any account whatsoever or any counterclaims, claims or set-off, and demands against the Lessor.." Clause 12 applied inter alia on default in payment. It provided:

On termination, the lessee was liable to make payment of all outstanding rental payments, with compound interest at Midland Bank base plus four-and-a-half per cent, and all future rental payments due for the fixed term duly discounted for advance payment, again with compound interest. Clause 18 provided:

on the same basis as provided in clause 12. The agency agreement, by clause 1, provided:

For the purposes of the debate, Mr Keen accepted that the defenders had delayed in making payment of certain rentals. The pursuers founded on that failure as disabling the defenders from obtaining the benefit of the agency agreement. The defenders offered three lines of defence to that claim, of which one only was material for the purposes of the debate. The opening words of clause 1 of the agency agreement constituted a penalty and were accordingly unenforceable by whichever member of the pursuers' group was the relevant contracting party at the time. The parties were agreed that the other issues should be sent to proof before answer if the case could not be disposed of on that basis. The pursuers contended that clause 1 could never operate as a penalty clause. The defenders contended that it would be wholly premature to reach a conclusion on that without enquiry into the factual matrix. There was a relevant case that the provision could be a penalty. Proof before answer would be appropriate. The agency agreement was an integral part of the leasing agreement. In that context, it conferred very substantial benefits on the lessee, readily quantified in this case at £360,000. If the pursuers were correct that valuable right could be lost if any breach of the terms of the lease occurred. A day's delay in paying a single rental instalment would suffice to deprive the lessee of the whole rebate. That was clearly penal: Dunlop Pneumatic Tyre Company Ltd. v New Garage and Motor Company Ltd [1915] AC 59 per Lord Dunedin at page 86, paragraphs 2, 3 and 4(a) and (c). The clause was in terrorem of the offending party: it was in no sense a genuine pre-estimate of damage. The stipulation was extravagant and unconscionable in its financial impact in comparison with the greatest loss which the lessor might suffer. The same consequence flowed from every breach, great or small. Lord Dunedin's observations were expressed in terms of a money payment. But the loss of a right, in property, under contract, or otherwise, or suffering retention of sums otherwise due, were treated alike: Jobson v Johnson [1989] 1 W.L.R. 1026 at 1034 and 1042. Payment of money was not essential. Indeed the mechanism was irrelevant. The rule applied if the court saw the provision as a penalty on examining its terms. The court had to have regard to the substance of the matter: Export Credits Guarantee Department v Universal Oil Products [1983] 1 W.L.R. 399; [1983] 2 All E.R. 205. Mr Keen relied particularly on the observation of Slade L.J. at pages 209-10 in the latter report, approved by Lord Roskill at page 223. In the present case the substance of the matter was that any breach allowed the lessor to retain the whole proceeds of sale of the plant to the exclusion of the lessee's right to a rebate of rental payments. There was a relevant case that the operation of the clause was a penalty. It was obvious that at 18 December, 1990, the relevant date, the benefits of the agency agreement formed a very important element in the transaction as a whole. Retention of the sale proceeds by the lessor would have been seen as depriving the lessee of a very valuable right. It was just as much a penalty as a stipulation for payment of an equivalent sum. The question then arose whether the loss was out of all proportion to the consequences of breach of any of the terms of the contract. The lessees' obligations were primarily, and almost exclusively, expressed in terms of payment of rental. The most likely trigger for the operation of clause 1 was late payment. There were generally other remedies available to the lessor in such circumstances. Compound interest was due in terms of clause 18 of the lease agreement. The lessor might give notice of termination, with the financial consequences set out in clause 12. These remedies would compensate the lessor fully for any loss associated with late payment. The loss of the rights under

For the pursuers, Mr Currie argued that the defenders' averments relating to penalty were irrelevant and should be excluded from probation, if proof were otherwise allowed. If the defenders were correct, they were entitled to the benefit of the agency agreement however material the breach or breaches of contract of which they might be guilty. That could not be correct. There was no dispute on many of the issues raised by Mr Keen. The approach to money penalties and to penalty provisions involving forfeiture of property interests was not in issue. Battle was joined on two issues: (a) the true nature of the benefit which might be conferred by the agency agreement; and (b) the width of the doctrine of penalty. It appeared that the defenders sought to advance a proposition far removed from the authorities. On their approach the doctrine was elevated into a general equitable remedy available to adjust parties' interests whenever the court though appropriate. That was wrong. The doctrine was narrower. For present purposes Mr Currie accepted the defenders' general approach that the whole documents fell to be considered as components of a single transaction. There were nuances which would be contentious if the case proceeded to proof. The proper analysis of the agency agreement was that the lessees were appointed agents for the sale of the plant if and only if they had fully performed their obligations under the lease, and that included making prompt payment of rentals. It was erroneous to construe the contract as conferring an instant right of agency which would take effect only at a later date. The agreement conferred no benefit unless and until it became operative. There was no advantage until that time. If the lessees failed to qualify for appointment at the material time, the agreement never became effective. That was obvious from the language of clause 1. The pursuers were able to demonstrate that the defenders had been in breach of their obligations under the lease agreement. The agency never became effective. The defenders effectively invited the court to delete the opening words of the clause and to confer on the lessees a right they never had, nor were ever intended to have. The authorities all dealt with situations in which there was an obligation to pay on breach, or a forfeiture of a right which had already been acquired by the person in breach. The present provision could not be equiparated with retention, as under a building contract, for example. In such cases there was money admittedly due by certification. In approaching the issue of penalty, it was important to bear in mind that the onus of showing that a contractual provision was unenforceable as a penalty lay on the person in breach who sought to avoid the effect of the clause: Robophone Facilities Ltd. v Blank [1966] 1 WLR 1428; and Philips HongKong Ltd v Attorney General of Hong Kong [1993] 61 B.L.R. 49. The defenders put few facts and circumstances in issue. There would be dispute if the case proceeded to proof whether the other remedies available to the pursuers were adequate, having regard to the nature of the transaction. On the issue of principle, the authorities identified three broad categories of provision which might be undermined as penalties: (a) where a payment of money was triggered by breach; (b) where the was provision for forfeiture of money already paid or due; and (c) where there was forfeiture of proprietary or possessory rights already conferred: Chitty on Contracts 27th edition, paras 26-064 and -065. The defenders' approach, that the mechanics were irrelevant and the court would not enforce any provision which was considered to be a penalty, was wrong. There was no general principle that the court would relieve a party of the consequences of failure to pay or duly to perform some other contractual obligation: Scandinavian Trading Tanker Co. A.B. v Flota Petrolera Equatoriana [1983] 2 A

In reply, Mr Keen argued that the defenders had averments that there was no obligation to pay rental after the expiry of the fixed term of the lease. There was therefore an issue for proof on any view.

In my opinion, the pursuers are not entitled to decree de plano on the basis of Mr Currie's final submissions. The defenders have a sufficient response in averment for proof before answer on the issue whether there was a continuing liability for rent following notice of termination. It would be premature to form or express any view on that issue.

On the main issue between parties, I consider that proof before answer is necessary. In my view it is not possible to reach a concluded view without deciding whether the three agreements were part of a composite contract. The defenders have a sufficient basis in averment for the contention that the three agreements entered into were components of a single transaction. Mr Currie was correct in accepting that as a basis for examination of the main issue between parties at debate. But much of his argument appeared to me to depend on the opposite view. The strength of the argument based on the language of clause 1 may depend critically on the resolution of this point. Clause 1 uses the language of a future appointment: "Summit shall when termination of the hiring under the Lease occurs, appoint the Lessee its exclusive agent...". However, the whole terms of the agency, and the consequences of it becoming operative are prescribed. And there are terms which may point to an intention that the agency should operate throughout, though its principal operative effect was to be postponed. Clause 2 (f) and (g) contain provisions which may be to reflect aspects of the relationship between lessor and lessee under a broader contractual scheme. Clause 2 (g) may be capable of being construed as imposing a continuing obligation throughout the term of the lease where it provides for indemnity in respect of the condition quality or fitness of purpose of the machines. The use of the sale proceeds as a measure of the rebate of rentals under the lease may point to the true character of the scheme. But these questions could not be resolved without evidence. In my opinion, one could not properly determine any aspect of the construction of the critical provisions of the agency agreement without evidence of the factual matrix in which the arrangements were made. In particular, one could not conclude at this stage that, properly construed, the opening words of clause 1 imposed a condition precedent of the defenders' appointment. The issue of principle can be tested only on the hypothesis that the defenders may establish that there was a present appointment as agent, in the context of a single composite contract, with the benefits which would follow from sale of the plant, which might be defeated by breach of a condition of the lease agreement component of the contract. The single question is whether such a provision could be held unenforceable as a penalty or forfeiture clause if the defenders establish the whole factual averments made in the defences to the delivery action.

There are difficulties, in this area, of finding an acceptable principle capable of providing comprehensively for the range of possibilities which can readily be envisaged. Chapter 5 of the Scottish Law Commission's Report on Penalty Clauses (No 171, 18 May, 1999) underlines some of the problems which arise, especially in relation to land. Not least there is the difficulty that breach of contract is a pre-requisite of the application of the rule relating to penalties in Scotland, as in England: Granor Finance Ltd v Liquidator of Eastore Limited 1974 S.L.T. 296, and EFT Commercial Ltd. v Security Change Ltd 1992 S.C. 414. These problems have prevented the law from developing in a coherent way. In relation to the more common types of penalty clauses, Lord Dunedin's summary of the law in Dunlop Pneumatic Tyre Company Ltd. v New Garage and Motor Company Ltd is an appropriate starting point, as was accepted by Mr Keen. But the general test of enforceability, whether the sum payable or the property transferable represents a genuine attempt to estimate in advance the loss which the innocent party would suffer from breach of a contractual obligation, has no obvious direct application to a case such as the present. Nor would it be sufficient for the defenders' purposes to substitute some reference to incorporeal rights generally for Lord Dunedin's reference to a sum of money payable by the party in breach in the various paragraphs set out. The propositions are concerned with the balancing of considerations. Rule 2 compares provisions which reflect a genuine covenanted pre-estimate of damage with provisions which are properly characterised as in terrorem of the offending party. Rule 4(a) compares the greatest loss that could conceivably be proved to have followed from the breach with a specified sum which is extravagant and unconscionable in amount. Rule 4(f) tests the genuineness of a single provision for breach against the range of breaches in respect of which it might be payable. In each case one is concerned with tests which relate to the stipulation as damages for breach of some provision of the contract. It is in the application of the principles to forfeiture that the defenders must, in my opinion, seek support if there is to be a case relevant for proof. If the authorities relating to penalty clauses are applicable, it must be by analogy, and depend on the equiparation of the principles applicable to the two forms of stipulation in a fairly comprehensive way.

In the earliest of the Scottish cases referred to, Hannan v Henderson, Lord Deas and Lord Shand, in obiter comments, gave support to the submission that conventional irritancies which operated forfeiture of substantial rights must, in Lord Deas words, "be based on a fair and reasonable stipulation looking to the terms of the contract". In Watson v Noble there is a more direct application of the principle for which Mr Keen contended. For becoming drunk, the pursuer was dismissed, and stood to lose by forfeiture certain shares in the vessel of which he was captain. Lord Young said: "The main question in the case, and that on which its decision must turn, relates to the clause of forfeiture, that if the pursuer gets drunk, although he does no damage at all, he is to forfeit the shares which he has bought and paid for. Now, I am not prepared to enforce that. I think it is a penalty, and that it cannot be enforced - at least in this action." Lord Craighill agreed. Lord Rutherford Clark added: "I do not think that we can enforce that condition of forfeiture, not merely to the disadvantage of the pursuer, but to the effect of retransferring his property to the defender." In Roberts & Cooper Ltd. v Christian Salvesen & Company Ltd, Lord Skerrington expressed the view that a clause of forfeiture of a deposit might, in a proper case, be construed as a stipulation for the infliction of a penalty, and be unenforceable. In each of these cases what was in contemplation was the forfeiture of money or property rights held by or on behalf of the offending party. There is a question, raised by Mr Currie's submissions, whether that was of the essence of the views expressed. But leaving that aside, these authorities seem to me to support the view that in Scots law similar principles might be applied in deciding whether forfeiture clauses were enforceable as were applicable in dealing with penalty clauses. I was not referred to Zemhunt (Holdings) Ltd. v Control Securities plc 1992 SC 58, which may have a bearing on the argument at the end of the day.

There are similar views in some of the English authorities relied on by Mr Keen. In due course, these will require close examination. In Granor Finance Ltd., Lord Keith expressed reservations about the direct application of rules derived from English equity. It may be that doubt on that matter has been removed by Zemhunt (Holdings) Ltd. In the opinion of Nicholls L.J. in Jobson v Johnson there is an extensive discussion of procedure, some of which seems to me to be important in setting the scene. At page 1040, he said: "Although in practice a penalty clause in a contract .. is effectively a dead letter, it is important in the present case to note that, ..., the strict legal position is not that such a clause is simply struck out of the contract, as though with a blue pencil, so that the contract takes effect as if it had never been included therein. Strictly, the legal position is that the clause remains in the contract and can be sued upon, but it will not be enforced by the court beyond the sum which represents, in the events which have happened, the actual loss of the party seeking payment." The penalty provision was scaled down to the proven loss. At pages 1041-2, he distinguished the court's approach to the enforcement of forfeiture clauses. The example discussed was forfeiture for default in payment of rent due under a lease. Practice was to grant relief on condition of payment of arrears of rent with interest and costs. But if the defaulter failed to implement the conditions of relief, the forfeiture provision was then enforced by an order for possession.he concludes: "Thus the innocent party is in a better position when seeking to enforce a forfeiture clause than when seeking to enforce a penalty clause in a contract." In relation to forfeiture clauses, he applied the views of Lord Wilberforce in Shiloh Spinners v Harding [1973] A.C. 691 at page 722:

Jobson v Johnson was concerned with the forfeiture of shares. Relief was ordered. In Workers Trust & Merchant Bank Ltd. v Dojap Investments Ltd., which related to the forfeiture of deposits on the purchase of property, there was a more general equiparation of the law relating to penalties and forfeiture: pages 579 and 580. But the context is important. The Board were concerned with a deposit which, if reasonable, had always been regarded in English law as a guarantee of performance as well as a payment to account. As such, forfeiture had never been regarded as a penalty. There was a recognised risk that what was truly a penalty for breach could be represented as a deposit. Even then, the focus was on relief, the mechanism being to limit the enforceability of the forfeiture provision appropriately. The current edition of Chitty is somewhat ambivalent in its comments; para 26-064 in the final sub-paragraph, and generally para 26-070, where it is stated: "However, no English court has yet equated the two clauses" of forfeiture and damages. Given the very different procedural context, I consider that it would be inappropriate to place too much weight on the observations in the English and Privy Council cases at this stage without the benefit of counsel's submissions on Zemhunt (Holdings) Ltd, when the factual context has yet to be determined. There is a question whether, assuming the principles to be the same in both jurisdictions, they support the present defenders' position that the proviso to clause 1 of the agency agreement should simply be disregarded as unenforceable. Whether this proves material at the end of the day will depend on the outcome of the factual enquiry.

All of the cases on forfeiture to which I was referred involved the forfeiture of money held as a deposit, money due, or of property or possessory rights already held by or for the offending party, and it is necessary to consider Mr Currie's submission that this is of the essence of the matter. In my view it is not determinative of the issue between parties at this stage. It appears to me that the present clause could be of that general nature. It may appear after proof that, at the date of making the contract in this case, the parties contemplated a sale at the expiry of the fixed term of the lease. The agency agreement may have looked to that event and made provision for the sale, the disposal of the proceeds, and for ancillary matters, including the calculation and payment of a rebate of rental. It may have been in contemplation that at the time at which the operation of the agency contract became effectual, there would have been a significant market value in the plant. 99% of that value may have been expected therefore to be a significant sum. Forfeiture of the right to realise that sum could be out of all proportion to any breach of contract which may have happened in the course of the fixed term. I do not think that one could properly conclude at this stage that there is necessarily any material difference between that situation and a situation in which the sum liable to forfeiture has become due for payment for the performance of work under a contract. In each case the sum could be considered to be merely the expression in money terms of certain rights arising under the contract at a point in time. In the present case the forfeiture may be related to breach of contract only if it is correct to view the whole arrangements made as a single contract. Otherwise failure to implement the terms of the leasing agreement would not be a breach of the agency agreement, and there might be force in Mr Currie's analysis: the clause might be held merely to specify a pre-condition of the coming into effect of the agency agreement. But if the whole were held to operate as a single contract, after proof, there might be scope for the application of the law relating to penalties.

In the circumstances, I consider that proof before answer should be allowed on the whole matter. It would be inappropriate to express any further views on the issue debated before proof.