Liquidated damages and penalties

The purpose of liquidated damages is to represent a reasonable approximation of losses in situations where actual damages are difficult to ascertain. Generally, liquidated damages are meant to be compensatory rather than punitive. This is why the amount of compensation that a party is required to pay in a liquidated damages clause should be a genuine estimation of the loss that would result from a breach of contract. Where a contract provides for payment in response to a breach with the goal of punishing the breaching party, that provision is referred to as a penalty provision. There can sometimes be confusion about whether a clause is a liquidated damages clause or a penalty provision. Each of these provisions will be discussed in more detail below.

What are liquidated damages clauses?

Liquidated damages clauses can be found in almost every commercial contract. These clauses aim to create certainty between the parties to the contract about a sum that must be paid by one party to the other in the event of a breach. The court recognises the advantages of these liquidated damages clauses for both parties, and maintains a general view that these clauses should be upheld, particularly in a commercial context where parties are seen as free to apportion the risks between them. However, in some circumstances, these clauses might not always be enforceable.

Liquidated damages clauses or sections in contracts can also be referred to as “agreed remedies”, “stipulated damages”, “pre-estimated damages” or other names. Such clauses are frequently included in any contract that requires payment for services, such as employment contracts, IT development contracts and, most commonly, construction contracts.

Most construction contracts will include a clause that typically provides that, if completion is delayed by reason of the contractor’s breach, the contractor will be liable to pay the purchaser a specified sum for each day, week or month that the delay continues. Liquidated damages clauses are useful in construction and other commercial contracts because they provide certainty for all parties involved if a breach of contract were to occur.

Key elements of a liquidated damages clause

There are numerous key components of a liquidated damages clause, including:

• practical completion: the critical term of the clause meaning that each major stage has been finalised except for minor omissions or defects;
• date for practical completion: the date that the contractor has promised practical completion, which may be a fixed date, number of days from the contract date or triggered by a particular event;
• date of practical completion: the date practical completion is actually reached, requiring proof that practical completion has been reached; and
• applicable rate: the rate of liquidated damages generally specified as a fixed sum per time period, payable between the date for practical completion and the date of actual completion.

It is important that the liquidated damages clause for practical completion outlines the requirements clearly, which can be objectively assessed. Furthermore, the date for practical completion must be clear, or the process to determine the date must be obvious, or determined to be an easily recognised event.

Advantages of liquidated damages

There are several commercial and practical benefits of including liquidated damages clauses in contractual agreements, including:

• alleviating the parties of the time and expense of dispute resolution and/or court action in the event of a breach;
• providing the benefit of being able to deal with minor breaches in a long-term contract, facilitating a continued commercial relationship between parties;
• providing certainty by allowing the parties to determine more precisely their rights and liabilities in the event of a breach;
• limiting disputes between the parties about how loss suffered as a result of breach should be calculated;
• establishing a limit of liability for certain breaches of the contract;
• encouraging contractual compliance; and
• quantifying risk allocation.

What are penalties?

The term “penalty” was defined in the case of Legione v Hately (1983) by Mason and Deane JJ as:

“A penalty, as its name suggests, is in the nature of punishment for non-observance of a contractual stipulation; it consists of the imposition of an additional or different liability upon the breach of the contractual stipulation.”

In the case of Ringrow v BP Australia Pty Ltd (2005), the High Court stated:

“The principles of law relating to penalties require only that the money stipulated to be paid on breach or the property stipulated to be transferred on breach will produce for the payee or transferee advantages significantly greater than the advantages which would flow from a genuine pre-estimate of damage.”

How do they relate to liquidated damages?

The distinction between the terms “penalty” and “liquidated damages” is:

• where the amount is fixed and a genuine pre-estimate of the loss in case of breach, it should be referred to as liquidated damages; compared with
• if the amount fixed was more than likely intended to deter the other party from committing a breach, or to grant the other party a significantly greater advantage than would be afforded under a genuine pre-estimate, it should be referred to as a penalty.

The importance of the distinction between these two terms relates to enforceability. If a liquidated damages clause is found to be a penalty provision, it will be unenforceable by the party seeking to impose it. This is known as the penalty doctrine.

Distinguishing liquidated damages from penalties

In the case of Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Ltd [1915], the court set out rules for distinguishing a liquidated damages clause from a penalty provision:

• If the sum is unconscionable, excessive or extravagant in comparison to the greatest loss conceivable from the breach, it is a penalty;
• If the breach of the contract arises only through the failure to pay money, and the amount payable under the relevant clause in the contract is greater than the sum that ought to have been paid, it is a penalty;

• There is a presumption that a clause is a penalty when a single lump sum is made payable by way of compensation on the occurrence of one or more or all of several events, some of which may result in serious damage and some of which may result in trifling damage; and
• If the consequences of the breach are difficult or impossible to estimate, it does not mean it is a penalty. Rather, in such circumstances, there is a presumption that it is a liquidated sum clause.

When is a liquidated clause enforceable?

If a liquidated damages clause is found to be a penalty, it will be unenforceable by the party seeking to impose it. Even where the liquidated damages clause is unenforceable because it is a penalty, the clause may still operate as a basis to seek general damages. This situation might be the case where the liquidated damages clause is expressly confirmed as the sole remedy for the breach.

The courts generally require that the parties involved make the most reasonable assessment possible for the liquidated damages clause at the time the contract is signed, because this can provide a sense of what is at stake if that aspect of the contract is breached.

In Andrews v Australia and New Zealand Banking Group Ltd [2012] FCA 59, 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.

The Queensland Supreme Court case of Grocon Constructors (Qld) Pty Ltd v Juniper Developer No 2 Pty Ltd is an example of a court determining whether a liquidated damages clause contained in a construction contract is a penalty or not. Juniper contracted Grocon to build a four-part development. Grocon sued Juniper for unpaid work and delay costs, and Juniper countersued for liquidated damages. The liquidated damages clause was triggered by Grocon’s failure to reach practical completion by the specified date under each part of the project.

The court found that the liquidated damages clause was not a penalty and that for it to be a penalty, the clause must be judged “extravagant or unconscionable in amount”, or out of all proportion, rather than only lacking in proportion. The court upheld the liquidated damages clause in a design and construct contract, rejecting the argument that it was an unenforceable penalty.

For when you need help

Liquidated damages clauses are a complex area of law. Here are some key things to take from this article:

• Liquidated damages clauses should be a fair representation of losses in situations where actual damages are difficult to ascertain;
• If not drafted correctly, liquidated damages clauses could be found to be a penalty; and
• Penalty provisions are generally not enforceable.

If you are a party to a contract dispute involving a liquidated damages clause,  contact our team at Gibbs Wright Litigation Lawyers today for an obligation-free and confidential consultation.