The Andrews and Paciocco cases have generated a lot of publicity around the law of penalties. Many articles have been written urging suppliers and customers to reconsider key provisions in contracts to ensure they are not penalties.
But a recent case in Queensland (IPN Medical) has provided clear guidance when it comes to liquidated damages clauses.
The outcome in IPN Medical confirms that suppliers will have a hard task trying to prove that any pre-agreed amount should be struck out as a penalty.
On the flipside, the sting for customers is that valid liquidated damages clauses act as a limitation of liability. The trick is to make sure the liquidated damages clause protects all benefits of the bargain.
IPN MEDICAL V VAN HOUTEN
Dr Van Houten simultaneously sold his medical clinic to IPN Medical (Business Sale Contract) and was engaged by them as a medical practitioner on a 5-year service contract (Service Contract). The Service Contract was attached to the Business Sale Contract.
The Business Sale Contract provided that if Dr Van Houten breached the Service Contract and IPN Medical terminated that contract on the basis of that breach, he would have to pay for the remaining term of the Service Contract at a rate of $5,500 per month for the first 36 months and then $3,000 per month for the remainder.
Dr Van Houten breached the Service Contract after seven months, then alleged that this clause was void as a penalty.
IPN Medical made an alternative claim, alleging it had suffered a greater loss than the amount they were entitled to under the liquidated damages clause.
LIQUIDATED DAMAGES & THE PENALTY REGIME
In IPN Medical, the judge pointed out that there is a long line of cases that consider the application of the penalty regime to liquidated damages clauses. This is distinct from the extension of the penalty regime in the Andrews cases to circumstances where there is no underlying breach of contract.
The relevant question has long been “does the liquidated damages amount represent a genuine pre-estimate of loss”?
The recent Paciocco decision highlights that the “genuine pre-estimate of loss” test may be too strict or too vague. The real consideration should be whether the pre-agreed amount is “extravagant”, “unconscionable” or “oppressive”.
Justice Jackson applied this test in IPN Medical, finding that the clause was not a penalty because there was no evidence to suggest that the liquidated damages were “extravagant”, “unconscionable”, or had a “degree of disproportion sufficient to point to oppressiveness.”
LIQUIDATED DAMAGES AS A LIABILITY CAP
Justice Jackson dismissed IPN Medical’s alternative claim to disregard the liquidated damages clause because the pre-agreed amount in the contract was insufficient to compensate them for their loss. He noted that enforceable liquidated damages clauses act as a liability cap and that a party cannot ignore the agreed amount of damages and elect to claim a larger amount as damages for breach of contract at common law.
Because liquidated damages may limit your claim for loss, customers should ensure that the pre-agreed amount takes into account all benefits designed to be protected by the contract – ie, all reasons for which it enters into a contract and its intended outcomes (this is known as the “scope of the bargain”).
This may be wider than the immediate effect of breach.
In IPN Medical, Justice Jackson found that the performance of the Service Contract was critical to the benefit of the Business Sale Contract so the loss of the doctor’s services, as well as the goodwill and intellectual property acquired in the business sale, could be factored into the agreed damages.
WHAT IT MEANS FOR CONTRACT DRAFTING
IPN Medical’s application of the Paciocco appeal lends weight to the suggestion that Paciocco might be a go-to guide for lawyers on penalties for the near future. In a snapshot, the relevant threshold is high - one must prove extravagance or unconscionability.
For contract drafters, drafting an appropriate liquidated damages clause is a fine craft. Drafters must be careful to ensure that the pre-determined amount of liquidated damages is not so overstated as to be a penalty, but not so conservative as to deprive the beneficiary of their entitlement to compensation for loss.