In England & Wales, tenancy deposits are governed by the Housing Act 2004, specifically Part 6, Chapter 4, sections 212-215C. References below are to that Chapter of the Act.
what if there is minor damage that the landlord would like legitimately to claim against this unprotected deposit?
That is possible. This is dealt with in two places. If the tenancy has ended and the matter has gone to court, section 214(3A) applies:
The court may order the person who appears to the court to be holding the deposit to repay all or part of it to the applicant within the period of 14 days beginning with the date of the making of the order.
In addition, section 215(2A) mentions that the prohibition against the landlord issuing a section 21 ("no fault") notice of eviction doesn't apply where:
the deposit has been returned to the tenant in full or with such deductions as are agreed between the landlord and tenant
(Though note that this is merely one of the requirements for a section 21 notice to be valid.)
Are they not entitled to claim damage or must they return the full deposit (or a multiple thereof) as penalty and then reclaim the damages through civil small claims etc?
The above quoted sections of the Act deal only with how much of the deposit is returned, not the penalty. As far as I can tell, either the landlord and tenant agree between themselves, or the court decides in the case where the tenant takes the matter to court.
Where are the statutory bases for these penalties
Section 214(4):
The court must order the landlord to pay to the applicant a sum of money not less than the amount of the deposit and not more than three times the amount of the deposit within the period of 14 days beginning with the date of the making of the order.
Note that this is a penalty payment, and is separate from the question of how much of the deposit has to be returned.
are there any defences for a landlord who did not comply with protection requirement?
Not as far as I can tell. The only discretion the court has is how much of a penalty to impose.
What other implications does failing to protect deposit have on tenancy situation and bilateral rights?
The main one, dealt with in section 215, is that the landlord cannot issue a section 21 notice until the deposit is either returned, or moved to an official deposit scheme. As far as I can tell, apart from that, the tenancy is unaffected (and indeed, landlords are not required to ask for a deposit at all, though most do).
To return to the title of the question: in this particular situation, the landlord is in a very weak negotiating position. If the landlord wants to make deductions and the tenant disagrees, the landlord risks being taken to court and being fined. It's up to the landlord if they really want to take such a risk.
