The doctrine of penalties - when are liquidated damages unenforceable?



The courts will generally enforce a liquidated damages clause even if it has results that (with the benefit of hindsight or based on the facts as at the date the clause is enforced) are 'unfair' for either party. This is because parties will be required to stand by the bargain (as set out in the contract) that they have made.

However, as a matter of policy, the courts will not enforce a bargain that amounts to a penalty. The onus of proving that the clause is a penalty rests on the person trying to resist the application of liquidated damages.

The key indicators of a penalty are:


  • where the liquidated damages amount is 'extravagant and unconscionable' in comparison to the loss anticipated as at the date of contract to arise from the breach;
  • when the liquidated damages clause makes the same sum payable on the occurrence of one, or all, of several events. Some of these may cause serious damage and others trifling damage (see Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd [1915] AC 79, an English case which has been approved in Ringrow Pty Ltd v BP Australia Pty Ltd (2005) 222 ALR 306).

In evaluating whether liquidated damages are 'extravagant and unconscionable', two relevant factors are:

  • the degree of disproportion between the stipulated liquidated damages and the loss likely to be suffered by the claimant; and
  • the nature of the relationship between the contracting parties (eg relative bargaining power, sophistication etc).

CASE STUDY



Ringrow Pty Ltd v BP Australia Pty Ltd

(2005) 222 ALR 306



Facts


  • Ringrow entered into an agreement with BP for the purchase of a service station.
  • A collateral agreement required Ringrow to purchase fuel from BP exclusively and enabled BP to buy back the service station if there was a breach of this agreement.
  • Ringrow bought and on-sold fuel from an alternative supplier and BP attempted to exercise this option.
  • Ringrow claimed the option was a penalty and therefore void and unenforceable.

Result


  • The court held that liquidated damages would be valid unless the amount stipulated was 'out of all proportion' with the loss likely to be suffered.
  • It was held that there must be an extravagant or unconscionable difference between the liquidated damages and the general damages that would have been paid on breach for there to be a degree of disproportion that points to oppressiveness amounting to a penalty.
  • The fact that the agreement could be terminated for minor or technical breaches did not trigger the penalty doctrine.

In deciding whether or not a liquidated damages clause is enforceable, or void as a 'penalty', the Australian courts have broadly applied the 'Dunlop' test, i.e. does the clause represent a genuine pre-estimate of the loss that would be incurred by one party where the other party had committed a particular breach of the contract (for example, in the event of delayed completion). That is, the clause reflects the negotiated level of risk that the parties agreed to bear upon breach of the contract.

However, it is not essential to be able to demonstrate that the rate for liquidated damages is a genuine pre-estimate of loss. The fact that actual damage would be difficult to prove is not, of itself, an indication that liquidated damages will be penal. This is a circumstance where a liquidated damages provision could be considered by the courts to be appropriate.

In Australia, the High Court ruled in 2012 that a contractual 'breach' is no longer a prerequisite to whether or not a clause is a penalty (Andrews v Australia and New Zealand Banking Group Pty Ltd [2012] HCA 30.

While the case is of importance for provisions of a contract that may operate other than as a result of breach, most liquidated damages clauses (whether time or performance related) are triggered by a breach on the part of the contractor, being a breach of an obligation either to complete the works by a nominated date or to a guaranteed standard of performance. These clauses are only enforceable if they do not operate as a penalty.

The mere fact that actual damage is complex and difficult to prove is not, of itself, an indicator that a liquidated damages clause must be a penalty.

The assessment of whether the rate of liquidated damages is a genuine pre-estimate of the loss likely to be suffered, or operates as a penalty, is to be made with regard to the knowledge of the parties at the time the parties entered into the contract, rather than using the benefit of hindsight (
Esanda Finance Corporation v Plessnig (1989) 166 CLR 131).

The test as to whether a clause is penal remains that the stipulated rate of liquidated damages must not be 'extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved to have followed' from the event (
Dunlop Pneumatic Tyre Co Ltd v New Garage Motor Co Ltd [1915] AC 79).


If liquidated damages are unenforceable



If a liquidated damages provision is found to be a penalty, it is 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 cap on general damages. This may occur where the liquidated damages clause is expressly confirmed as the sole remedy for the breach.

There is no clear case law that explicitly addresses this issue. Caution is therefore required by a contractor in deciding whether or not to assert that a liquidated damages provision is a penalty.

It is potentially possible for parties to agree on a calculation of liquidated damages for certain components of loss and provide that general damages will otherwise apply. However, it is unlikely that a contractor will agree to such a provision.


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