A recent case before the Court of Appeal of Western Australia,(1) involving the late completion of works, led the court to consider the enforcement of a liquidated damages clause.
The contract contained a liquidated damages provision which stipulated that if Speirs Earthworks Pty Limited was late in completing its works, then Landtec Projects Corporations Pty Limited would claim liquidated damages at a rate set out in the contract. According to Landtec, the rate was calculated by anticipating the loss of proceeds from the sale of the land that Landtec would suffer as a result of delays caused by Speirs.
Speirs was late in completing the works and Landtec sought to enforce the liquidated damages clause. Speirs argued that the provision was not a pre-estimate of the loss, but was in fact a penalty, on the basis that Landtec was required to satisfy a number of conditions before sub-dividing and selling the land, and that Landtec had not satisfied one of the conditions by the time that Speirs had reached practical completion.
The court held that the liquidated damages were not a genuine pre-estimate of the loss flowing from Speirs. It held that the sum was a penalty and "out of all proportion", on the basis that Landtec would suffer no financial loss as a result of the delay in practical completion by Speirs until the relevant condition was satisfied. Specifically, the court held that:
"the liquidated damages clause cannot be characterised as a genuine pre-estimate of the damages to which [Landtec] would be entitled under the general law. Delay in the performance of the [contract between Speirs and Landtec] was incapable of causing any relevant financial loss to [Landtec] until [the condition] was satisfied…..Thus, the sum stipulated is extravagant in amount in comparison with the greatest loss that could potentially be suffered by delay in practical completion under the [contract between Speirs and Landtec]."
The purpose of a liquidated damages clause or agreed damages clause is to fix the amount recoverable by one party if the other party has breached the contract, without the need to proceed to the courts to assess the damages payable for the breach. However, if the sum stipulated in the clause resembles a penalty (as opposed to a genuine pre-estimate of the loss likely to be suffered as a result of the breach), the clause may be unenforceable.
The test as to whether a pre-estimate is genuine is objective - that is, regardless of whether the parties were of the view that the sum was a genuine pre-estimate of the loss at the time of entering the contract, if the court determines that the sum is extravagant or unconscionable, it will not be considered a genuine pre-estimate.
From the early 14th century to the late 16th century, the law governing agreed damages clauses was harsh, with remedies going way beyond adequate compensation. During the late 16th and early 17th centuries, the courts of equity intervened to limit the amount recoverable to a sum that reflected the loss actually suffered by a party because of the breach. Further changes followed in the 18th and 19th centuries.
In a landmark decision in 1915, Lord Dunedin in Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd declared that an agreed damages clause would be considered a penalty and unenforceable if the sum stipulated was extravagant and unconscionable in comparison to the greatest loss that might conceivably be proved to have followed from the breach. If a clause is not a genuine pre-estimate of the damage, but an amount that is (by its nature) a punishment for non-observance of a part of the contract, then the court may not enforce it.
A number of cases followed that considered the distinction and in some instances imposed slightly different wording. For example, the High Court of Australia in AMEV-UDC Finance Ltd v Austin was of the view that a sum would be a penalty if there were a "degree of disproportion" sufficient to point to oppressiveness. To calculate the 'degree of disproportion', the sum stipulated in the clause and the loss likely to be suffered by the plaintiff must be taken into account, as well as the nature of the relationship between the parties.
Between the decisions in Dunlop and AMEV-UDC, a number of cases diluted the standard imposed by Dunlop. In a bid to restrict the parties' freedom to contract, the courts began to strike out clauses that contained sums merely greater than the amount that could possibly be awarded for breach of contract and restrained the parties from recovering more than the law provided.
However, the principles in Dunlop - confirmed in cases such as AMEV-UDC, Ringrow Pty Ltd v BP Australia Pty Ltd and State of Tasmania v Leighton Contractors Pty Ltd (and now in Speirs) - prevailed and remain the law in Australia. Therefore, the party resisting enforcement of the clause must demonstrate that the sum is extravagant, unconscionable and out of all proportion with the greatest loss that could conceivably be proven from the breach. However, the court will not intervene simply because a hard bargain has been driven. The court does not want to restrict the parties' freedom to contract and will intervene only to provide relief against a clause that is so oppressive or unconscionable that the clause is more penal than compensatory.
Determining whether clause is genuine pre-estimate of loss
In determining whether a sum is a genuine pre-estimate of the loss or a penalty, Dunlop sets out that the court will consider the following:
- If the sum is an extravagant or unconscionable amount in comparison to the greatest amount that could conceivably be proved to have followed from the breach, the sum will be a penalty.
- If the sum to be paid under the liquidated damages clause is greater than the sum which ought to be paid, this will be a penalty (ie, where B must pay A A$100, but if B does not pay A A$100 then A is entitled to liquidated damages in the sum of A$1,000, this would be considered a penalty).
- If a single lump sum is made payable for the occurrence of one or several events, where some of the events are serious and others trivial, there is a presumption that the parties intended the sum to be penal. However, if it can be shown that the damages caused by the breach are of an uncertain nature, the presumption will be rebutted. For example, a clause says that B must do X, Y and Z; if B does not do X, Y and Z, B must pay liquidated damages of A$10,000 a day to A. However, what if B only does X and Y, but not Z and still has to pay A$10,000 a day to A? It is up to A to show that the individual damages are so uncertain that they cannot be calculated separately, and that the overall total sum of A$10,000 for one or more breaches is a genuine pre-estimate regardless of whether there is one or more breaches. However, if A can calculate the individual loss for each of X, Y and Z (ie, if X is not done, but Y and Z are, the damages would be A$5,000; if X and Y are done, but not Z, the damages would be A$7,500), then A will be unable to rebut the presumption because the clause will not represent a genuine pre-estimate of the loss.
- Difficulty in quantifying losses that flow from the damages will not prevent a party from claiming damages.
The tests established by Dunlop have endured for 90 years and Speirs confirms that Dunlop remains the law applicable in Australia.
Factors to consider
The court will look at the individual circumstances of each particular contract at the time the parties entered into the contract (not when the breach occurred).
The Full Court of the Supreme Court of Tasmania in Leighton stated that a number of terms have been used in different cases to set the test of what will constitute a penalty. In addition to the above words 'extravagant', 'unconscionable' and 'out of all proportion', in Multiplex Constructions Pty Ltd v Abgarus Pty Ltd the court used "greater and unreasonably or inequitably so" and "true damages reasonably assessed". The Full Court of the Supreme Court of Tasmania has stated that the terms as a whole require the court to consider:
- the comparison between the sum provided for in the event of the breach and the greatest loss which could conceivably be proven in light of the total amount of the contract as a whole;
- the comparison between the sum provided and the nature of the breach;
- the equivalence of bargaining power at the time the agreement was entered into or whether one party was subject to unreasonable pressure in performance;
- the potential outcomes to which the clause was directed; and
- the means used to calculate the sum.
The High Court in Multiplex (referred to in Speirs) also held that where negotiations between contracting parties lead to the insertion of a liquidated damages clause, it will be relevant and admissible in the determination as to whether a clause is a penalty.
Leighton provides a practical application of the above considerations. In this case, the court found that:
- the parties were both well resourced and negotiated on an equal footing;
- the amount of liquidated damages was proposed by the State of Tasmania following careful consideration with its lawyers;
- the amount was calculated by reference to a list of potential expenses, and the State of Tasmania could produce considerable calculation details; and
- the amount was divided into specific items, with a cost beside each individual item.
Leighton illustrates that the court will consider the circumstances surrounding the parties at the time the contract is entered into. However, whether the parties intended the sum to be a penalty or genuine pre-estimate will have no bearing on the court's decision. Whether it is a genuine pre-estimate appears to be determined by looking at the specific calculations and how the parties derived that specific figure. If, after looking at that calculation, the figure is extravagant or unconscionable, then the court will intervene. This test upholds the concept that parties will be given freedom to determine their rights and liabilities, with the court stepping in to protect the parties from unfair outcomes.
Formulating or reviewing liquidated damages clause
Courts do not like to interfere with the contractual freedom of parties and will be reluctant to step in and intervene in business dealings between large organisations. Equally, the courts are not there to help remedy a bad bargain. Organisations must protect their own interests by seeking legal advice on the specific terms of a liquidated damages clause before accepting it.
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