Liquidated damages are a fixed amount of money, established at the formation of the contract, usually due and payable upon breach, as a reasonable pre-estimate of costs and expenses incurred by the non-breaching party.
However, these liquidated damages are not to be a penalty for the breach.
In commercial litigation or civil litigation, if a Court determines that the clause seeks to penalise the breaching party then it may be void and unenforceable.
It is important that these clauses are drafted correctly and are a genuine pre-estimate of the costs likely to be incurred because of the particular breach.
This article will explain the difference between liquidated damages and penalties.
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Liquidated Damages and Penalties
Historically, Lord Dunedin in Dunlop Pneumatic Tyre Company, Limited v New Garage And Motor Company Limited said at 4:
It will be held to be penalty if the sum stipulated for is extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved to have followed from the breach. [sic].
This decision followed Lord Halsbury in Clydebank Engineering and Shipbuilding Co. Limited v Don Jose Ramos Yzquierdo y Castaneda. But how has this question been treated in Australia?
In Legione v Hateley [1983] HCA 11 the High Court defined penalty as:
A penalty, as its name suggests, is in the nature of a punishment for non-observance of a contractual stipulation; it consists of the imposition of an additional or different liability upon breach of the contractual stipulation.
Freedom to Contract Liquidated Damages
“Freedom of contract” is the freedom of persons to be able to enter into contracts without overbearing or draconian outside interference and restrictions. This is of course qualified by minimum wage laws, workplace relation laws etc. but on the whole, adults with capacity to enter into a legal contract, can do so.
In some instances, the Courts are hesitant to intervene in person’s freedom to contract. There has been criticism of the doctrine of penalties. The arguments from a freedom of contract perspective is that if the parties legally entered into the contract, including a liquidated damages clause, then that should be enforceable and the Court should have nothing to say.
However, generally common law contract law does not allow:
- Punitive private damages for breach of contract; and
- Unconscionability.
Liquidated Damages in Australia
The High Court of Australia in Ringrow Pty Ltd v BP Australia Pty Ltd (2005) 222 ALR 306 confirmed:
It is therefore proper to proceed on the basis that Dunlop Pneumatic Tyre Company, Limited v New Garage And Motor Company Limited continues to express the law applicable in [Australia].
This means that in Australia a sum for liquidated damages is a penalty if it is:
- extravagant and unconscionable;
- not a genuine covenanted pre-estimate of damage; and
- a sum greater than the sum which ought to have been paid.
The Court also added that a sum for liquidated damages is not enforceable if it is “out of all proportion”.
The High Court of Australia confirmed the traditional approach of assessment of whether liquidated damages are a penalty subsequently in Andrews v Australia and New Zealand Banking Group Ltd [2012] HCA 30 and more recently in Paciocco v Australia and New Zealand Banking Group Limited [2016] HCA 28.
Liquidated Damages in Queensland
The High Court cases have been followed in the Supreme Court of Queensland. In IPN Medical Centres Pty Ltd v Van Houten & Anor [2015] QSC 204 Jackson J said:
the question of extravagance and unconscionability by reference, as Lord Dunedin said in Dunlop, to the greatest loss that could conceivably be proved to have followed from the breach, is to be understood as reflecting the obligee’s interest in the due performance of the obligation.
In PT Thiess Contractors Indonesia v PT Arutmin Indonesia [2015] QSC 123 the Court said:
The … description of the disproportion varies in expression in the cases, but for present purposes “extravagant”, “exorbitant”, “oppressive”, “inordinate” and “unconscionable” can be seen to be broad synonyms: see Ringrow at 667-669. The question is to be assessed as at the time of entry into the contract.
Conclusion
A liquidated damages clause will only be unenforceable if the clause is deemed to be:
- extravagant and unconscionable;
- not a genuine covenanted pre-estimate of damage at the time of making the contract;
- a sum greater than the sum which ought to have been paid; and
- out of all proportion.
If you have a liquidated damages clause in your contract which is a reasonable pre-estimate of the damages caused; or expenses paid as a result of a breach, and not extravagant, unconscionable or blown out of all proportion – these is a good chance that the Court will not intervene.
Evidence of all reasonable costs should be tendered in order to satisfy these requirements.
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