Damages in contracts considered penalty clauses or enforceable liquidated damage
Posted on 14 April 2023
Daniel Albert
Understanding when agreed damages in contracts are considered penalty clauses or enforceable liquidated damages.
Agreed damages clauses are a common feature of many contracts. They are used to establish the amount of compensation that one party (the defaulting party) must pay to the other party (the aggrieved party) in the event of a breach of contract. However, not all agreed damages clauses are enforceable. In some cases, they may be considered penalty clauses and, therefore unenforceable.
The distinction between penalty clauses and liquidated damages clauses is important because it can affect the remedies available to the aggrieved party in the event of a breach of contract. If the agreed damages clause is a penalty clause, the aggrieved party may only be entitled to recover actual damages suffered, which can be difficult to prove in court. On the other hand, if the agreed damages clause is a liquidated damages clause, the aggrieved party may be entitled to recover the amount specified in the clause without the need to prove actual loss or damage suffered.
In Queensland, the law on agreed damages clauses is based on the common law. Elements which indicate whether a provision is an unenforceable penalty clause include where[1]:
- The agreed amount is disproportionate and excessive compared to the actual loss suffered as a result of the breach. The amount should not be so large that it acts as a deterrent or a threat (known as “in terrorem”). This is the primary test, and the absence of a pre-agreed estimate does not automatically mean the clause is a penalty[2].
- The breach relates solely to non-payment of a sum of money, and the damages agreed upon exceed what would be considered reasonable compensation.
- A single lump sum is payable as compensation for one or more events, some of which may result in significant damage, while others may lead to insignificant damage.
In such cases, the agreed damages clause will be unenforceable as it will be seen as a punishment rather than compensation for the actual loss or damage suffered. On the other hand, if the agreed damages clause reflects a genuine pre-estimate of the loss or damage that the aggrieved party is likely to suffer as a result of the breach, it will be enforceable. Such clauses are referred to as liquidated damages clauses.
The Australian High Court has provided further clarity on the criteria used to determine if a clause constitutes a penalty clause. According to the court, the key factor is whether the clause imposes a disadvantage on the party in breach that is excessive in relation to the legitimate interest of the innocent party in fulfilling the primary obligation. Additionally, the court has emphasized that determining whether a clause is a penalty clause is a matter of interpretation, which requires a holistic assessment of the entire contract.[3]
The distinction between penalty clauses and liquidated damages clauses is not always clear-cut. In some cases, it can be difficult to determine whether an agreed damages clause is a penalty clause or a liquidated damages clause. This is particularly the case where the agreed damages clause is not a fixed sum but rather a formula that takes into account various factors.
One factor that can be relevant in determining whether an agreed damages clause is a penalty clause or a liquidated damages clause is whether the clause provides for payment of an amount that is payable on a breach of a primary obligation, such as a payment of money. If the payment is designed to deter the defaulting party from breaching the primary obligation, it may be considered a penalty clause. On the other hand, if the payment is designed to compensate the innocent party for the loss suffered as a result of the breach, it may be considered a liquidated damages clause.
Another factor that can be relevant is whether the agreed damages clause provides for payment of an amount that is fixed or whether it takes into account various factors, such as the nature and extent of the breach and the resulting loss or damage suffered by the aggrieved party. If the clause provides for payment of a fixed amount, it may be considered a penalty clause. On the other hand, if the clause takes into account various factors, it may be considered a liquidated damages clause.
CASE LAW:
There have been several cases in Queensland that have dealt with the issue of penalty clauses versus liquidated damages clauses. One such case is Andrews v ANZ Banking Group Ltd [2012] QSC 39. In this case, the court found that a clause in a loan agreement that required the borrower to pay a fee of $15,000 in the event of a breach of the agreement was a penalty clause. The court held that the fee was not a genuine pre-estimate of the loss or damage that the lender was likely to suffer as a result of the breach, but rather a deterrent to the borrower to comply with the agreement. As a result, the clause was unenforceable as a penalty.
Another case is Paciocco v Australia and New Zealand Banking Group Ltd [2016] HCA 28. In this case, the High Court of Australia considered whether various fees charged by ANZ Banking Group to its credit card customers were penalty fees. The court held that late payment fees and over-limit fees were penalty fees as they were not a genuine pre-estimate of the loss or damage suffered by ANZ Banking Group as a result of the breach by the credit card customers. On the other hand, the court held that a fee charged for exceeding the credit limit was not a penalty fee as it was a genuine pre-estimate of the loss or damage that ANZ Banking Group was likely to suffer as a result of the breach.
These cases illustrate the importance of ensuring that agreed damages clauses are carefully drafted to avoid them being considered penalty clauses. It is also important to note that the law on penalty clauses is not limited to agreed damages clauses but also applies to other types of clauses, such as clauses imposing liquidated damages for delay or clauses providing for the forfeiture of a deposit.
In conclusion, the distinction between penalty clauses and liquidated damages clauses is an important one that can have significant implications for parties to a contract. In Queensland, the law on agreed damages clauses is based on the common law, and the courts will look to the contract as a whole to determine whether an agreed damages clause is a penalty clause or a liquidated damages clause. Parties to a contract should ensure that agreed damages clauses are carefully drafted to reflect a genuine pre-estimate of the loss or damage that the aggrieved party is likely to suffer as a result of a breach. If in doubt, legal advice should be sought to ensure that the clause is enforceable and will provide the intended remedy in the event of a breach.
[1] See Amev-Udc Finance Ltd v Austin (1986) 162 CLR 170 and Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd [1915] AC 79.
[2] See Paciocco v Australia and New Zealand Banking Group Limited [2016] HCA 28 (27 July 2016).
[3] Paciocco v Australia and New Zealand Banking Group Ltd [2016] HCA 28.
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