Is your liquidated damages clause really a penalty?

It is common for drafters of liquidated damages clauses in commercial contracts to run a fine line between a genuine pre-estimate of damages and a penalty.  The case of Paciocco v Australia and New Zealand Banking Group Limited [2014] FCA 35 (Paciocco) provides some guidance on when a liquidated damages clause can be enforced.

What is a liquidated damages clause?

A clause for liquidated damages will require one party to pay the other party compensation for a breach of contract.  The term “liquidated” means the amount of compensation is designated or ascertainable.

The amount of compensation that a party should be required to pay, should be a genuine estimation of the loss that would result from a breach of contract.

When is a liquidated damages clause enforceable?

In Andrews v Australia and New Zealand Banking Group Ltd [2012] HCA 30 (Andrews), it was held that when the contract requires the payment of compensation that is non-proportional to the pre-estimated loss it may be found to be a penalty clause and therefore unenforceable.

Are penalty clauses limited to a breach of contract?

To constitute a penalty clause a breach of contract is necessary at law but not in equity.  In the matter of Pioneer Energy Holdings Pty Ltd [2013] NSWSC 1134 (Pioneer) the Supreme Court of New South Wales found that a penalty clause could exist without a breach of contract if the fee was collateral to the performance of a primary obligation.  In this case, upon the failure of one party to fulfil their primary obligation an additional detriment is imposed on them.  This situation is distinct from a situation where the fee is for the provision of further service.

When will a liquidated damages clause be enforced?

In Paciocco the Court further outlined the circumstances in which a clause will be determined to be a clause for liquidated damages or a penalty.  The question whether a sum stipulated is a penalty or liquidated damages is a question of construction to be decided upon the terms and inherent circumstances of each particular contract, judged as at the time of the making of the contract, not as at the time of the breach. 

To assist this task of construction, various tests have been suggested, which may prove helpful, or even conclusive, including:

  • a clause will be held to be a penalty if the sum stipulated is for an extravagant and unconscionable amount in comparison with the greatest loss that could conceivably be proved to have followed from the breach; and
  • a clause will be held to be a penalty if the breach consists only in not paying a sum of money, and the sum stipulated is a sum greater than the sum which ought to have been paid.

It is no obstacle to the sum stipulated being a genuine pre-estimate of damage, that the consequences of the breach are such as to make a precise pre-estimation almost an impossibility.  On the contrary, that is just the situation when it is probable that pre-estimated damage was the true bargain between the parties.

Identifying penalties

A penalty punishes a party by requiring them to pay a sum that is unconscionable or non-proportional to the loss that would have been suffered.  In Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd [1915] AC 79 (Dunlop) Lord Dune provided recommendations to assist in the identification of penalty clauses, these include:

  • the effect of the clause rather than the wording used;
  • whether the clause is a threat or a bona fide pre-estimate of damages;
  • the construction of the clause in relation to the context of the contract as a whole;
  • whether the amount is “extravagant and unconscionable” it may be presumed to be a penalty; and
  • if the payment is of a single sum, whether the amount is proportionate for a serious breach or proportionate for a trivial breach.

If a clause is a penalty then it is void and therefore unenforceable.

Takeaways

When drafting a liquidated damage clause estimate to the best of your ability what the value of damage will be if the contract is breached by a party.  Should the liquidated damage being sought purusant to a clause be higher than the estimation of damage it is unlikely the clause will be enforcable.

Further References

Cases

Andrews v Australia and New Zealand Banking Group Ltd [2012] HCA 30   

Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd [1915] AC 79

In the matter of  Pioneer Energy Holdings  Pty Ltd [2013] NSWSC 1134

Paciocco v Australia and New Zealand Banking Group Limited [2014] FCA 35

Legislation

Corporations Act 2001 (Cth)

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Further information

If you need assistance regarding the duties owed by directors, please telephone us for an obligation free and confidential discussion.

 


Matthew Robinson
LL.B.,GDLP.,MQLS
Senior Associate
Telephone: (07) 3221 0013
e: mrobinson@dundaslawyers.com.au

Disclaimer

This article is not legal advice. It is general comment only.  You are instructed not to rely on the commentary unless you have consulted one of our Lawyers to ascertain how the law applies to your particular circumstances.

 

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