Chapter 12 The doctrine of penalties - when are liquidated damages unenforceable?
The courts will generally uphold 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, the courts will not enforce a liquidated damages clause that amounts to a penalty. This is an exception to the principle that the law of contract preserves the freedom of parties, with no relevant disability, to agree upon the terms of their commercial relationships.
Where the clause alleged to be penal requires the defaulting party to transfer property as money’s worth (as opposed to pay a liquidated sum), courts will inquire as to the difference between the price paid on re-transfer and the market value of the property: Ringrow Pty Ltd v BP Australia Pty Ltd (2005) 222 ALR 306.
Ringrow Pty Ltd v BP Australia Pty Ltd (2005) 222 ALR 306
- 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 gave BP the right to buy back the service station (and obliged Ringrow to transfer it) if there was a breach of this agreement.
- Ringrow bought and on-sold fuel from an alternative supplier in breach of the agreement
- BP gave notice of the breach, followed by a notice of termination and notice of its intention to exercise its right to buy back the service station.
- Ringrow claimed the option was a penalty and therefore void and unenforceable.
- Ringrow contended that the exercise of the option was indiscriminate and oppressive as it was enforceable for minor breaches of the agreement.
- The High Court dismissed Ringrow’s appeal.
- The law of penalties, in its standard application, is attracted where a contract stipulates that on breach the contract-breaker will pay an agreed sum which exceeds what can be regarded as a genuine pre-estimate of the damage likely to be caused by the breach (relying on Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd  AC 79).
- The comparison between the agreed sum and the genuine pre-estimate must be an extravagant or unconscionable to be classified as penal. The degree of disproportion must be such that it points to oppressiveness.
- The fact that the agreement could be terminated for minor or technical breaches did not of itself trigger the penalty doctrine.
As mentioned above, 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, ie 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.
In 2012, the High Court in Andrews v Australia and New Zealand Banking Group Ltd (2012) 247 CLR 205 revisited the doctrine and held it could be applied where a pre-stipulated sum was payable upon an event that did not amount to breach of contract. This correctness of this position was confirmed four years later by the Court’s decision in Paciocco v Australia and New Zealand Banking Group Ltd (2016) 258 CLR 525.
Though neither case dealt with the enforceability of liquidated damages clauses in the context of construction contracts, they provide important guidance on when such clauses will be considered penal.
Andrews v Australia and New Zealand Banking Group Ltd (2012) 247 CLR 205
- Andrews, the lead plaintiff in a class action, alleged that certain fees charged to him by the respondent bank were void or unenforceable as the terms and conditions relating to the fees were penalties.
- These fees were:
- late payment fees on consumer credit card accounts
- honour, dishonour and non-payment fees charged to consumer and business deposit accounts; and
- over limit fees on consumer credit card accounts
At first instance, the trial judge held that the honour, dishonour, non-payment and over limit fees could not be penalties as the obligation to pay these fees was not triggered by a customer’s breach of contract.
- The High Court allowed the appeal against the trial judge’s decision.
- The doctrine of penalties is not limited to providing relief only in cases where the stipulated sum becomes payable upon breach of contract but extends to provisions applying where a party does not observe a contractual stipulation.
- In determining whether a sum payable under a contract is a penalty, it must be possible to undertake a comparison of the sum payable and the damages to the interests of the innocent party caused by the non-fulfilment of the contractual stipulation.
Paciocco v Australia and New Zealand Banking Group Ltd (2016) 258 CLR 525
- Paciocco, the lead plaintiff in a class action, held consumer credit card accounts with the ANZ bank.
- The terms of each account included a provision entitling the bank to charge fees for late payments when the account was in debit and the minimum monthly repayment not made on or before the due date for payment.
- The central issue was whether these fees charged by the bank to its customers for payments which were late, and thus in breach of the loan contract, penalties?
- A contractual term will not be a penalty if it protects the legitimate commercial interests of the non-defaulting party.
- A liquidated damages provision does not have to actually represent a genuine pre-estimate of the loss in the sense that the parties have attempted to calculate the loss which would foreseeably arise from the non-performance of a term or breach of the contract.
- The distinction drawn between liquidated damages clauses and penalty clauses in Dunlop is ‘useful’ it ‘should not be understood as a limiting rule’.
- The essential inquiry is whether the amount alleged to be a penalty is ‘out of all proportion to the interests of the party which it is the purpose of the provision to protect’.
- In undertaking this inquiry, the court is not limited to considering only those losses which are or might be recoverable for breach of the relevant contract, but also any detriment to other commercial interests which the non-defaulting party has legitimately sought to protect.
- In this case, the bank had a legitimate interest in receiving timely payments of credit.
- Accepting that late payments of credit card payments impacted the bank’s operational, provisioning and regulatory capital costs, the court determined that the fees were not ‘out of all proportion’ and were not a penalty.
The practical effect of the Paciocco case is that the ability to successfully challenge a liquidated damages clause on the ground that the sum it stipulates is penal is limited. This is because the quantum of the sum need not only reflect a genuine pre-estimate of damages in order to escape the application of the doctrine of penalties, but can additionally reflect the detriment caused by a party’s non-performance to the broader commercial interests the counterparty might have.
If liquidated damages are unenforceable
If a liquidated damages clause 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 stated to be the sole remedy for the breach.
There is no clear case law which 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.