The parties to a contract have an interest in quantifying and allocating risk and liability between them as clearly as possible. Often, commercial contracts utilise a suite of clauses which quantify, allocate, and set out the procedures for dealing with unusual risks that arise in the delivery of goods or services. One such clause is a liquidated damages clause, which obliges one party to pay a monetary amount to the other party when a specified event occurs. Such clauses usually apply to a breach of a specific term under the contract.
Liquidated damages can be understood in contrast to general damages, which are available to the parties to a contract at common law. General damages are calculated by a court based on the interests of the parties which ought to be protected, and the losses incurred by the non-breaching party as a result of a breach. Liquidated damages, on the other hand, are a quantification and pre-agreement of the amount payable by one party to the other (i.e., as a liquidated amount) upon the occurrence of a specified event under the contract, without the need for a court to prove or quantify the actual loss suffered.
Importantly, complex common law principles applied in the calculation of general damages such as causation, remoteness and mitigation are not applicable to liquidated damages. For this reason, it is common for the parties to a commercial contract to use a liquidated damages (LDs) clause to create a more certain method to determine their financial liability in the event of a breach of contract or failure to meet a primary stipulation.
Although liquidated damages provide greater commercial certainty for the parties to a contract regarding their financial liability in the event of a breach, their use is not without limitation by the Australian common law.
The doctrine of penalties is a common law doctrine used by courts to distinguish between contractual clauses which seek to compensate the losses of the party invoking it, and clauses which penalise the other party to the contract.
Given the purpose of an LDs clause is to specify a monetary amount that is payable under the contract upon the occurrence of a specific event, the doctrine of penalties is of particular relevance to the interpretation of these clauses. For the parties to a contract to ensure an LDs clause is enforceable, they must ensure it cannot be construed as a penalty.
The doctrine of penalties can be traced back to the English case of Clydebank Engineering and Shipbuilding Co Ltd v Don Jose Ramos Yzquierdo Y Castaneda [1905] AC 6 (Clydebank). In that case, the Spanish Government contracted with Clydebank (a shipbuilding firm) for the building of four torpedo-boat destroyers – costing £67,180 under one contract, and £65,650 under the other, for each vessel. Delivery was set at periods ranging between six months and 7.75 months from the date of contract. The contracts provided: ‘the penalty for late delivery shall be at the rate of £500 per week for each vessel’. Delivery was delayed by several months due to fears that the vessels would be sunk due to the ongoing Spanish-American war. As a result, the Spanish Government brought an action against Clydebank for payment of £500 for every week that each vessel was not delivered, being calculated from the original contracted delivery date.
It was held that the LDs clauses being relied upon were not penalties in these circumstances. Lord Chancellor Halsbury stated that courts had jurisdiction “to interfere at all in an agreement between the parties, (if the agreement is) unconscionable and extravagant, and one which no Court ought to allow to be enforced”.1 This principle is commonly referred to as ‘supervisory jurisdiction’, which permits courts to interfere with the parties’ freedom to contract, to the extent that a clause in the contract may be construed as a penalty.
Importantly, it was held that an LDs clause will be considered a penalty where the stipulated fee is “plainly excessive (in) nature … in comparison with the interest sought to be protected by that stipulation”.2
Clydebank established the basis for which English courts may intervene to read down a clause to a contract where it imposes a penalty upon the other party.
Ten years later, in the case of Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd [1915] AC 79 (Dunlop), the House of Lords would expand upon the approach adopted in Clydebank and outline the specific considerations a court must take into account when assessing whether an LDs clause constituted a penalty.
Dunlop concerned a contract between New Garage, a tyre reseller, and Dunlop a manufacturer of tyres. The contract required New Garage to not sell tyres to other customers for less than an agreed price specified in the contract. The contract between the parties also included the clause: “We [New Garage] agree to pay to the Dunlop Pneumatic Tyre Company, Ltd. the sum of £5 for each and every tyre, cover or tube sold or offered in breach of this agreement, as and by way of liquidated damages and not as a penalty." Dunlop discovered that New Garage were selling the supplies provided under the contract for an amount less the listed price, breaching the contract and entitling the appellants to liquidated damages, in accordance with the agreed clause.
In this case, the House of Lords ruled that the LDs clause being relied upon was not a penalty. In his judgement, Lord Dunedin set out the test for where a sum agreed between parties as a forecast of loss will not constitute a penalty if it is a genuine pre-estimate of damage. His Honour stated that the clause will constitute a penalty where it is not “a genuine covenanted pre-estimate of damage” and where the sum stipulated is “extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved to have followed from the breach”.3
Importantly, His Honour also clarified that:
“It is no obstacle to the sum stipulated being a genuine pre-estimate of damage, that the consequences of the breach are such as to make precise pre-estimation almost an impossibility. On the contrary, that is just the situation when it is probable that pre-estimated damage was the true bargain between the parties".4
This method of determining whether an LDs clause constitutes a penalty is commonly described as the ‘mechanical approach’, and was adopted (with some modification) in Australia for some time following the decision of Malouf (WT) Pty Ltd v Brinds Ltd (1981) 52 FLR 442.
An example of Australian courts following Lord Dunedin’s test in Dunlop can be found in the High Court case of Ringrow Pty Ltd v BP Australia Pty Ltd [2005] HCA 71 (Ringrow). In that case, Ringrow entered into contracts with BP to buy a service station. The first contract restricted Ringrow to only purchase fuel from BP, and the second contract provided BP with an option to buy-back the service station in the event the first contract was terminated. At various times, Ringrow purchased fuel from a supplier other than BP, breaching the first agreement.
Proceedings led to a High Court appeal, in which Ringrow asserted the option allowing BP to buy-back the service station was void and unenforceable as a penalty. The High Court affirmed the approach adopted by Lord Dunedin in Dunlop, ruling that an LDs clause, in this case being the option to buy-back the service station following the breach of the first contract, did not constitute a penalty.
The High Court determined this on the basis that the difference in value of the loss suffered by BP through the breach of the fuel exclusivity agreement, and the value to be reclaimed by BP through exercising the buy-back option was “not extravagant and unconscionable”, and did not demonstrate “a ‘degree of disproportion’ sufficient to point to oppressiveness”.5 References to extravagance, unconscionability, and disproportion to the loss suffered can all be traced back to Lord Dunedin’s test in Dunlop.
In recent years, however, the High Court has adopted what is referred to as an ‘equitable approach’ to the doctrine of penalties, expanding the application of the doctrine to clauses which provide for the payment of money upon the occurrence of events other than breach of contract.
The most significant case which adopted the ‘equitable approach’ referred to above was Andrews v Australia and New Zealand Banking Group Limited (2012) 247 CLR 205 (Andrews). In that case, the High Court considered whether certain types of fees charged by ANZ (which were not charged upon breach of contract, nor upon the occurrence of an event which the customer had an obligation to avoid) could be characterised as penalties. The applicants argued the fees were ‘out of all proportion’ to the loss or damage which might have been sustained by ANZ by reason of the occurrence of those events.
The observations by Mason and Deane JJ in Legione v Hateley6 were reiterated by the High Court, specifically that a ‘penalty’ is a punishment for non-observance of a ‘primary contractual stipulation’. The High Court in Andrews continued that a penalty is a ‘collateral stipulation’ as security for the ‘primary stipulation’.7 The High Court expanded upon this, further stating that a primary stipulation (for which the penalty is collateral) does not need to only apply to a breach of the agreement, and that it may also apply to an event which the offending party is under “responsibility or obligation”8 to avoid:
“It should be noted that the primary stipulation may be the occurrence or non-occurrence of an event which need not be the payment of money. Further, the penalty imposed upon the first party upon failure of the primary stipulation need not be a requirement to pay to the second party a sum of money.”9
Importantly, the High Court also set out several limitations on the application of the doctrine of penalties in Andrews. These limitations were:
Following the High Court’s broadening of the application of the doctrine of penalties, and the adoption of a more ‘equitable approach’ in Andrews, another subsequent High Court decision would go on to further diverge from the traditional ‘mechanical approach’ to determining the enforceability of an LDs clause.
The case of Paciocco v Australia and New Zealand Banking Group Limited (2016) 258 CLR 525; [2016] HCA 28 (Paciocco) concerned a class action case against ANZ’s ‘Exception Fees’ led by Mr Paciocco and his company (the appellants). The Exception Fees charged by ANZ were late payment fees, over limit fees, honour and dishonour fees and non-payment fees. The appellants asserted that the terms which permitted ANZ to charge these fees amounted to penalties, and were thus unenforceable.
The High Court held that the fees charged by ANZ were necessary so as to protect ANZ from potential costs arising from late payments, which reflect damage to its financial system. Justice Kiefel, in a significant revision to the ‘genuine pre-estimate’ standard originally espoused by Lord Dunedin in Dunlop, held that:
“The conclusion to be reached, after all, is whether the sum is "out of all proportion" to the interests said to be damaged in the event of default.”11
Justice Kiefel applied the test and found that the sums of $20 and $35 were “not out of all proportion to the interests [of ANZ] identified”12
While the test adopted by the High Court in Paciocco significantly deviates from the ‘genuine pre-estimation’ test outlined by Lord Dunedin in Dunlop, it is important to note that it does not extinguish the validity of this test in the long-developed line of case law surrounding the doctrine of penalties. Australian Courts, following Paciocco, simply have an additional test which they can apply when determining whether an LDs clause will be considered a penalty.
The decision in Paciocco can be summarised as an endorsement by the High Court that liquidated damages will not be considered penalties if they are in proportion to the interests they seek to protect, regardless of whether they are set at an amount which is beyond the loss or damage actually suffered by the party invoking the clause.
Government procurement and legal teams may experience great difficulty in pre-estimating loss under contracts for the delivery of major projects. Due to the predominantly non-commercial nature of government’s ordinary course of business, unless an LDs clause is tied directly to loss suffered by the Government party under another related arrangement, the exercise of pre-estimating loss, or seeking to calculate an amount proportional to the interest being protected, is often very difficult. This is not to say however, that because of this imprecision and difficulty, LDs clauses used in government contracts will by definition be unenforceable.
In the appeal case of State of Tasmania v Leighton Contractors Pty Ltd13 (Leighton), the Tasmanian Supreme Court approved a primary judge’s view that a pre-estimate of loss suffered by the government party in a roadbuilding project consisted of administrative work hours that were extremely high and ultimately speculative.14 Despite this fact, the LDs clause utilised in the roadbuilding project contract in Leighton was held not to be a penalty.
In their judgement, the Court in Leighton held that:
Importantly, the Court further noted that government may suffer both:
Despite the largely financially unquantifiable nature of ‘loss of public utility or access to infrastructure’, it is important to note that governments are not prohibited from incorporating such losses into the scope of an LDs clause, provided they are a genuine pre-estimate of the loss, or at the very least, not out of all proportion to the interest they are protecting.
When drafting an LDs clause in a government contracting context, the government party should take into account a few practical considerations and common law limitations.
Before proposing to incorporate an LDs clause into a contract, the government party should:
Once these activities have been completed, the government party should have a clear understanding of the scope of the proposed LDs clause, allowing it to draft a clause with precision.
The language of a proposed LDs clause must be sufficiently precise to ensure both parties understand:
While the Australian common law regarding the doctrine of penalties does not support the proposition that an LDs clause is less likely to be construed by a court as a penalty if it includes express language that it ‘does not constitute a penalty’, or represents a ‘genuine pre-estimation of loss’, it is generally assistive to incorporate such language into the contract to ensure the parties understand that the intention behind its incorporation is not punitive in nature.
If the government party ensures that these matters are addressed in the proposed LDs clause, the clause is more likely to be enforceable, and is more likely to be considered a reasonable protection of the government party’s interests in the performance of the contract.
Arguably the most important considerations for the government party to take into account when proposing to incorporate an LDs clause into a contract are the commercial consequences for both the government party and the contractor arising from the use of an LDs clause, and how this may affect the contractor’s financial capacity, and capability to perform their remaining obligations under the contract.
As this article has demonstrated, LDs clauses are not construed as penalties by default when they are invoked by government parties to protect broad forms of direct and indirect losses arising from a contractor’s failure to meet a primary stipulation, and when they either represent a genuine pre-estimate of those losses, or are not out of proportion to the interest being protected by the clause.
Notwithstanding this fact, just because an LDs clause will typically not be construed as a penalty by default in those circumstances, does not mean that its invocation will be without commercial consequence for the relationship of the contracting parties, and the prospect of the government party receiving the benefit of the full performance of the contract.
Before incorporating an LDs clause into a contract, the government party should consider the extent to which imposing an obligation on the contractor to pay liquidated damages under the circumstances would affect the contractor’s financial stability, or their capacity to perform the remainder of the contract.
Relevant factors to consider may include the financial viability of the supplier, their insurance coverage, the size of their customer base, and whether there is genuine competition in the market. Ultimately is important to consider if the contractor has the capacity to absorb the proposed LDs. If the risk of performance issues arising if the Commonwealth enforced an LD clause exceeds the benefit that would be received as LDs, then it may not be worth drafting into a contract. As an alternative if the circumstances allow, an LD clause may be included, but the Government’s decision to enforce it could be discretionary.
LDs are a powerful contractual mechanism to incentivise the contractor to perform specific obligations, but they must be proportional to the interest being protected to ensure they are legally enforceable, and also commercially proportional to the specific circumstances of the commercial bargain.
Government parties should not seek to use LDs to protect themselves from all possible forms of loss, or calculate the highest proportionally quantifiable LDs amount agreed for each form of loss, if doing so would undermine the commercial efficacy of the contractual relationship. Minimising liability and risk under commercial contracts is important, but doing so should not come at the expense of securing performance of the contract in full without issue, dispute, or default.
If you have any questions or require detailed advice on a particular liquidated damages clause that may be relevant for your organisation, please feel free to reach out to our team for support.
1 Clydebank Engineering and Shipbuilding Co Ltd v Don Jose Ramos Yzquierdo Y Castaneda [1905] AC 6 at 10.
2 Kiefel J in Paciocco [35] referring to Clydebank Engineering
3 Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd [1915] AC 79 at 86-87.
4 Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd [1915] AC 79 at 87-88 (4(d)).
5 Ringrow Pty Ltd v BP Australia Pty Ltd (2005) 224 CLR 656 at 666.
6 (1983) 152 CLR 406 at 445.
7 Andrews v Australia and New Zealand Banking Group Limited (2012) 247 CLR 205 at 216.
8 Paciocco v Australia & New Zealand Banking Group Ltd [2016] HCA 28 [119].
9 Andrews v Australia and New Zealand Banking Group Limited (2012) 247 CLR 205 at 217.
10 [1966] 2 NSWR 717 at 723-724.
11 Paciocco v Australia & New Zealand Banking Group Ltd [2016] HCA 28 [57].
12 Paciocco v Australia & New Zealand Banking Group Ltd [2016] HCA 28 [68].
13 [2005] TASSC 133.
14 State of Tasmania v Leighton Contractors Pty Ltd [2005] TASSC 133 [11].
15 State of Tasmania v Leighton Contractors Pty Ltd [2005] TASSC 133 [38].
16 State of Tasmania v Leighton Contractors Pty Ltd [2005] TASSC 133 [31].
Rory Alexander – Managing Director
James Evans – Senior Associate
