Pursuer: J Brown; Balfour & Manson

Defender: D Maclean; Thorley Stephenson

28 January 2014

Introduction

[1] The pursuer bought Mr McCallion's business in October 2009. It agreed to pay him £100,000 on completion of the sale agreement ('the initial consideration'). It also agreed to pay him five further instalments as part of the purchase price ('the deferred consideration'). Mr McCallion ceased to be engaged in the pursuer's business in October 2010. After he left, he breached the restrictive covenant in the sale contract. In this action the pursuer seeks to recover part of the deferred consideration from him. It founds upon a recoupment provision in the sale contract. The issue for determination is whether it is a penalty clause and therefore unenforceable.

The facts

Background

[2] For a period of about 20 years, Mr McCallion operated a domestic oil business in the North East of Scotland. He supplied oil to retail outlets, including fish and chip shops. He also removed waste oil from the same outlets, which he aggregated and sold at a profit for conversion into bio-diesel. He held a licence from the Scottish Environment Protection Agency (SEPA) for that purpose.

[3] The pursuer is an unlimited company involved in the same field of business. It was formerly known as "Agri Energy", but it changed its name to Olleco with effect from 2 April 2013. It operates from ten locations throughout the United Kingdom and has a substantial turnover. In 2009, it approached Mr McCallion with a view to purchasing his business. Previously, it had purchased other similar businesses in Scotland, including MacLennan Oils and Richardson Oils.

The original agreement

[4] The parties negotiated sale terms, which are recorded in a written contract dated 9 October 2009. They agreed that he would continue to run the business on its behalf. It was envisaged that he would stay on as an employee for a period of at least five years. The initial consideration was £100,000. The deferred consideration was payable at the end of each year from the date of completion. Each instalment could not exceed £20,000. The precise sum to be paid depended on the financial performance of the business:

"If the Collection Target is not achieved for any particular Year, the Deferred Consideration payable to the Seller pursuant to clause 3.2 in respect of that Year shall be payable to the Seller subject to a pro rata adjustment and the Buyer shall retain the balance of the Deferred Consideration payable to the Seller pursuant to clause 3.2 in respect of that Year."

[5] Accordingly, the maximum purchase price was £200,000.

The Amendment agreement

[6] The pursuer paid Mr McCallion the initial sum. Before he had received the first instalment payment, however, he decided to terminate the sale contract. The parties entered into an amendment agreement dated 14 October and 1 November 2010, which varied the terms of the original sale agreement. Under the revised terms, the pursuer had to pay sums to Mr McCallion on two dates. In October 2010 it required to pay him: (a) £20,000, being the first instalment of the deferred consideration; and (b) £40,000, being an advance payment toward years 2, 3, 4 and 5. In October 2014, it had to make a final payment of £40,000.

[7] The pursuer paid the sum due in October 2010. After he left the business, Mr McCallion breached the undertakings contained in the restrictive covenant. These allegations are set out in more detail, in my opinion in the interdict action brought by the pursuer against Mr McCallion. It is enough to say here that he substantially admits the breaches in his defences.

The basis of the claim
[8] The pursuer bases its claim upon clause 3.7.2 of the amended sale agreement, which states:

"[If] the Seller (in the reasonable opinion of the Buyer) has breached any of the Seller's undertakings set out in clause 15.2, the Seller shall:

(a) return the full amount of the advance payment to the Buyer within 10 Business Days of being requested to do so by the Buyer; and

(b) forfeit the Seller's right to receive any payments due from the Buyer or that may become payable by the Buyer under this Agreement including, without limitation, any amount of the final payment that may be payable by the Buyer."

[9] Clause 15.2 is the restrictive covenant provision. It was not altered by the amendment agreement. Mr McCallion undertook various 'non-compete' obligations, for a period of five years from the date of completion, that is, until midnight on 8 October 2014.

The rival contentions
[10] Mr Maclean submits that the action should be dismissed. He argues that clause 3.7.2 is a penalty provision, designed to punish Mr McCallion. It deprives him of a single sum (£40,000 plus £40,000), irrespective of the actual breach that occurs. Accordingly, it cannot be construed as a genuine pre-estimate of loss, as the consequences of a breach widely differ. It follows that clause 3.7.2 is presumptively penal: Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd [1915] AC 79.

[11] Mr Brown candidly concedes that if the penalty rules apply, then the clause is unenforceable. He submits, however, that the rules do not apply to this particular provision.
Is this a penalty clause?

[12] In The Law of Contract in Scotland 3rd edn (at para 22-163), Professor McBryde states:

"If the contract provides for forfeiture of sums already paid, such as deposits and instalments of the price, the rules on penalty clauses are inapplicable. There is some limited authority which suggests that there might be an equitable relief against the consequences of forfeiture. There is now, however, a decision of the Privy Council on appeal from the Court of Appeal of Jamaica that forfeiture of the deposit of 25 per cent in a contract for the sale of land was not reasonable and was a penalty."

[13] He cites three Court of Session decisions in support of the proposition contained in the first sentence: Commercial Bank of Scotland Ltd v Beale (1890) 18R 90; Roberts & Cooper v Salvesen & Co 1918 SC 794; and Zemhunt (Holdings) Ltd v Control Securities plc 1992 SC 58. Counsel focused their submissions upon Zemhunt. In that case a purchaser bid £1,650,000 at public auction to purchase heritable subjects in Glasgow. Under the articles of roup, it undertook to pay (a) a ten per cent deposit, and (b) the balance of the purchase price on the settlement date. It defaulted in paying the balance and the seller resiled from the contract. The purchaser sued for return of the deposit on the basis of restitution. At first instance, Lord Marnoch held that as the purchaser was responsible for the termination of the contract, there was no basis for allowing a remedy based upon equity.

[14] There are two points in Lord Marnoch's judgment that are relevant to the present case. First, he observed (at p 62) that "if parties intend a deposit to be 'non‑returnable' it is a very simple matter to make express provision to that effect." Applying that dictum to the present case, in my view the parties made plain the consequences of a breach of the restrictive covenant. Any sums already paid were returnable, and any right to sums to be paid was forfeited.

[15] Second, Lord Marnoch considered an argument that the clause was a penalty (at p. 65):

"I am in no doubt whatever that the cases of Commercial Bank of Scotland Ltd v Beale and Roberts & Cooper v Salvesen & Co are authoritative for the view that deposits do not fall within that chapter of the law which is concerned with penalties and liquidate damages."

[16] The Inner House upheld Lord Marnoch's decision. Lord Clyde analysed the relevant clause as being one "designed to affirm the commitment of the purchaser to the contract" (at p 71). It followed that "its nature as a guarantee involved its forfeiture on the failure in performance by the pursuers" (at p. 72). The pursuer did not insist on the penalty clause argument in the reclaiming motion.

[17] The Privy Council decision to which Professor McBryde refers is Workers Trust & Merchant Bank Ltd v Dojap Developments Ltd [1993] AC 573. It also involved the sale of land by way of auction. Unlike the position in Zemhunt, the sale agreement stipulated that the purchaser would forfeit the deposit if it failed to comply with its contractual obligations. Lord Browne-Wilkinson stated:

"In general, a contractual provision which requires one party in the event of his breach of the contract to pay or forfeit a sum of money to the other party is unlawful as being a penalty, unless such provision can be justified as being a payment of liquidated damages being a genuine pre‑estimate of the loss which the innocent party will incur by reason of the breach. One exception to this general rule is the provision for the payment of the deposit by the purchaser on a contract for the sale of land. Ancient law has established that the forfeiture of such a deposit (customarily 10% of the contract price) does not fall within the general rule and can be validly forfeited even though the amount of the deposit is no reference to the anticipated loss to the vendors flowing from the breach of contract.

This exception is anomalous and at least one textbook writer has been surprised that the courts of equity ever countenanced it ..."

[18] Whatever the position under English law, in my view under Scots law the rules relating to penalties do not apply to deposits. Accordingly, the pursuer is entitled to decree of payment. In the circumstances of this case, that approach accords with business common sense. The original sale contract linked payment and performance. If the business did not reach its financial targets, the pursuer would pay Mr McCallion a reduced sum. There was a further protection available to the pursuer. If he breached his obligations, then it could rely on the principle of mutuality to withhold payment. A forfeiture provision was therefore unnecessary.

[19] The amendment agreement materially changed the position. It accelerated Mr McCallion's entitlement to the deferred consideration. But clause 3.7.2 provided the necessary counterpart. He had to repay the full amount within 10 days if he breached the restrictive covenant. The purpose of clause 3.7.2 was to retain and reinforce the link between payment and performance.

Conclusion

[20] I hold that the defender's challenge fails. I shall put the matter out for a hearing to determine further procedure in both actions. Meantime I shall reserve all questions of expenses.