Contractual provisions designed to protect the parties to a contract as the result of an unforeseeable or unavoidable event.
Liquidated Damages and Penalties
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Liquidated damages clauses can be found in pretty much any commercial contract that you come across. They 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 breach. However, in some circumstances, these clauses might not always be enforceable.
What are Liquidated Damages?
Liquidated damages are essentially an amount of money that has been agreed upon by the parties to a contractual agreement at the time of entering into the agreement that can be recovered in the event that one party breaches the agreement, and the breach leads to the other party suffering loss or damage in some way. The amount of the liquidated sum is supposed to reflect the best estimate of actual damages when the parties sign the contract.
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. Where a contract provides for payment in response to breach with the goal of punishing the breaching party, that provision is referred to as a penalty provision. There can sometimes be confusion regarding 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 are clauses or sections in contracts that can also be referred to as ‘agreed remedies’, ‘stipulated damages’, ‘pre-estimated damages’ or by other nomenclatures. 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 employer a specified sum for each day, week or month during which the delay continues. Liquidated damages clauses are useful in construction and other commercial contracts because they provide a barrier of certainty for all parties involved in the contract if a breach of contract were to occur.
Advantages of Liquidated Damages
There are several commercial and practical benefits of including liquidated damages clauses in contractual agreements, including:
- Providing certainty by allowing the parties to determine more precisely their rights and liabilities consequent upon 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”. 1
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”. 2
What are Penalties and 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; and
- If the amount fixed was more than likely intended to deter the other party in order to refrain 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 provision.
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 ,3 the Court set out certain 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.
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 us 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 as this can provide a sense of undertaking of what is at stake if that aspect of the contract is breached.
For when you need Assistance
Liquidated damages clauses are a complex area of law. Here are some key things to take out 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, or if you have any questions about anything contained in this article, contact our team at Gibbs Wright Litigation Lawyers today for an obligation-free and confidential consultation about your matter to explore your legal rights and options.
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