An Overview on Liquidated Damages and Penalties in Australian Contract Law

When examining an agreed damages clause, the task for the Court is to determine whether an agreed damages clause “is penal, or alternatively, a liquidated damages clause” (Lanyon, 1996, p. 234). The benefits of an agreed damages clause is the absence from “having to prove loss” (Carter et al., 2017, p.12). Particularly, it reflects a “public interest to enforce an advance agreement” and to manage commercial risks by providing compensation for “probable losses” (Carter et al., 2017, p. 12; Paterson & Robertson, 2020, p. 990)

In recent years, there has been substantive discourse on the fundamental nature and scope of penalties. These issues and fundamental questions are “centuries old,” and can be traced as early as the 17^th century (Tiverios, 2017, p. 1). Exploring those same issues in this article, we address the frequently asked questions on liquidated damages and penalties in Australian Contract Law:

What is a penalty?

The penalty doctrine is “engaged when a clause imposes a detriment to secure performance or occurrence of another stipulation required by the contract” (Seddon & Bigwood, 2023, para 23.45). Further, the stipulation should be “out of all proportion to the interest in the contract performance that it purports to protect” (Paterson & Robertson, 2020, p. 601). The threshold requirement is not whether the amount is lacking in proportion, but whether the amount is out of proportion, extravagant or unconscionable within the context of the interest protected by the bargain (Paciocco v Australia and New Zealand Banking Group Ltd (2017) 333 ALR 569 [270]).

On one view, penalties are invalidated as a “matter of public policy because it represents unfair recovery in excess of justified reliance” (Lanyon, 1996, p. 238). Others suggest that a promisee should only recover damages “in accordance with ordinary damages principles”, and not in excess of that (Lanyon, 1996, p. 238). Notwithstanding these different views, penalties are, ultimately, a carve-out to a fundamental principle in contract law, namely, freedom of contract (Carter, 2017). This carve-out was expressed in the High Court decision of Ringrow Pty v BP Australia Pty Ltd (2003) 222 ALR 306 at paragraph [32]:

“Exceptions from that freedom of contract require good reason to attract judicial intervention to set aside the bargains upon which parties of full capacity have agreed. That is why, the law on penalties is, and is expressed to be, an exception from the general rule. It is why it is expressed in exceptional language”  

Similarly, in AMEV-UDC Finance Ltd v Austin (1986) 68 ALR 185 at 202, Mason and Wilson JJ expressed that the doctrine of penalties intersected between upholding the freedom of contract, and rebalancing the inequality in bargaining power between parties:

“The doctrine of penalties answers, in situations of the present kind, an important aspect of the criticism often levelled against unqualified freedom of contract, namely the possible inequality of bargaining power. In this way, the courts strike a balance between the competing interests of freedom of contract and protection of weak contracting parties…”

What are liquidated damages?

Principally, liquidated damages “provide for the payment of a genuine pre-estimate of loss” (Carter, 2018, p. 859). Its function is to “overcome the requirement of proof of loss (or damage) in a claim for damages” (Carter, 2018, p. 859). It represents an agreed sum “commensurate with the interest protected by the bargain” (Andrews v Australia and New Zealand Banking Group Pty Ltd (2012) 290 ALR 595 at 613).

In an alternative landscape, if a party was able to enforce a fixed sum that was more “significant beyond the monetised value of the underlying secured primary right”, then the enforcement’s function would be transformed into a “punitive operation” (Tiverios, 2017, p. 17). From a public policy perspective, this would be an “unjustifiable burden” on the promisor (Tiverios, 2017, p. 17).

What is the doctrine of penalties? 

In Andrews v Australia and New Zealand Banking Group Ltd (2012) 290 ALR 595 (“Andrews”), the orthodox principles surrounding penalties was broadened (Peden, 2019). A contract term may be a “penalty if it secures a primary stipulation, even though that stipulation is not a contractual promise” (Paterson & Robertson, 2020, p. 597). That is, a right to a fixed sum that secures “the performance of some other contractual ‘requirement’ or ‘stipulation’” (Tiverios, 2017, p. 10). This approach transforms a penal clause as a “security right” (Tiverios, 2017, p. 15). If a contract clause is viewed by the Court as a security right, then the Court may “restrain the exercise of that collateral right to ensure it is only enforced to the extent necessary” (Tiverios, 2017, p. 18).

In summary, the High Court described this reformulated approach at paragraph [10]:

…a stipulation prima facie imposes a penalty on a party if, as a matter of substance, it is collateral (or accessory) to a primary stipulation in favour of a second party and this collateral stipulation, upon the failure of the primary stipulation, imposes on the first party an additional detriment, the penalty, to the benefit of the second party. In that sense, the collateral or accessory stipulation are described as being in the nature of a security for and in terrorem of the satisfaction of the primary stipulation. If compensation can be made to the second party for the prejudice suffered by failure of the primary stipulation, the collateral stipulation and the penalty are enforced only to the extent of that compensation.

Further, the High Court stated at paragraph [11] that the penalty rule may not apply if there was an impossibility to compensate in monetary terms:

…the penalty doctrine is not engaged if the prejudice or damage to the interests of the second party by the failure of the primary stipulation is insusceptible of evaluation and assessment in money terms . It is the availability of compensation which generates the “equity” upon which the court intervenes; without it, the parties are left to their legal rights and obligations.

This statement was similarly mirrored by Kiefel J in the later High Court decision of Paciocco v Australia and New Zealand Banking Group Ltd (2017) 333 ALR 569 (“Paciocco”) at paragraph [26]:

The aspect of Dunlop which assumes particular importance in this case is the recognition that a sum stipulated for payment on default may be intended to protect an interest that is different from, and greater than, an interest in compensation for loss caused directly by the breach of contract…It has already been observed that equity recognise that there may be injury to interests for which compensation cannot be made and to which the doctrine of penalties cannot be applied to provide relief.

Overall, the High Court’s views in Andrews was questioned as “reviving or reconsidering the operation and scope of the penalty doctrine” (Peden, 2019, p. 263). Carter highlights that “any decision which broadens the reach of the penalty concept must be controversial” (Carter et al., 2017, p. 101). Ultimately, the reformulated principles depart from the orthodox approach in the United Kingdom. For example, Paterson and Robertson (2020) highlights the critique made in the English Supreme Court decision of Cavendish Square Holdings BV v Makdessi [2016] 2 All ER 519 (“Canvendish”). In Cavendish at 542, the High Court’s reformulation was criticised as encroaching on the governing principle relating to freedom of contract between parties:

The High Court’s decision does not address the major legal and commercial implications of transforming a rule for controlling remedies for breach of contract into a jurisdiction to review the content of the substantive obligations which the parties have agreed….The potential assimilation of all of these clauses imposing penal remedies…would represent the expansion of the courts’ supervisory jurisdiction into a new territory of uncertain boundaries, which has hitherto been treated as wholly governed by mutual agreement

Notwithstanding these controversies, the High Court in Paciocco explained that Australia was not necessarily bound to follow United Kingdom’s approach on penalties at paragraph [7] (Paterson & Robertson, 2020):

The countries of the common law world have a shared heritage which they owe to the unwritten law of the United Kingdon. That shared heritage offers the undoubted advantage, but does not import the necessity, of development proceeding on similar lines

What was the orthodox approach on penalties and liquidated damages?

Prior to the decision in Andrews and Paciocco, the traditional doctrine on penalties was “was limited to promises to confer benefits activated by breach of contract or discharge for breach” (Carter at al., 2017, p. 12). The doctrine’s purpose was to assess genuineness, good faith, and discipline, rather than “accuracy (Carter et al., 2017). Others similarly agree that the traditional approach was “fashioned by good faith, or honesty” (Peden, 2019, p. 265).

For historical purposes, the orthodox approach on distinguishing between penalties and liquidated damages was set out in the English decision of Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd [1915] AC 79 (“Dunlop”). In that decision, Lord Dunedin stated the following principles:

(i) Though the parties to a contract use the words, penalty, or liquidated damages, may prima facie be supposed to mean what they say, yet the expression used is not conclusive. The court must find out whether the payment stipulated is in truth a penalty or liquidated damages…

(ii) The essence of a penalty is a payment of money stipulated as in terrorem of the offending party; the essence of liquidated damages is a genuine covenanted pre-estimate of damage

(iii) The question whether a sum stipulated is penalty or liquidated damages is a question of construction to be decided upon the terms and inherent circumstances of each particular contract, judged of as at the time of the making of the contract, not as at the time of the breach

(iv) To assist this task of construction, various tests have been suggested, which if applicable to the case under consideration may prove helpful, or even conclusion. Such are:

(a) It will be held to be a penalty if the sum stipulated for is extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved to have followed from the breach

(b) It will be held to be a penalty if the breach consists only in not paying a sum of money, and the sum stipulated is a sum greater than the sum which ought to have been paid

(c) There is a presumption (but no more) that it is a penalty when “a single lump sum is made payable by way of compensation, on the occurrence of one or more or all of several events, some of which may occasion serious and others, but trifling damage”.

The principles explored in Dunlop were affirmed in the High Court decision of Ringrow Pty Ltd v BP Australia Pty Ltd (2003) 222 ALR 306.  The High Court said at paragraph [12]:

The formulation has endured for 90 years. It has been applied countless times in this and other countries….It is therefore proper to proceed on the basis that Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd continues to express the law applicable in this country, leaving any more substantial reconsideration than that advanced, to a future case where reconsideration or reformulation is in issue

With the advent of Andrews and Paciocco, Seddon & Bigwood (2023) describe the orthodox principles as no longer holding its status as “the holy writ”, but are rather now,  the “starting point” and adopt “more in the nature of guidelines” for legal analysis (para [23.45]). Others share a different view, and describe the orthodox model as being “dismantled” and “reduced almost to vanishing point” (Carter et al., 2017, p. 4)

What is the difficulty with calculating genuine pre-estimate of loss?

Seddon & Bigwood (2023) describe that an agreed damages clause is not a genuine pre-estimate if ‘’it must necessarily exceed by a wide margin the greatest loss’ that can be suffered as a result of the breach in question” (para 23.45).  On the estimation of a genuine pre-estimate of loss, Lord Dunedin in Dunlop stated at 742, 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

This concept of imprecision was also adopted in Andrews. In Andrews, notwithstanding, the imprecision of the pre-estimate of damages, the Court stated at paragraph [75] that:

…even if the sum agreed appeared imprecise as pre-estimate of damage… the critical issue, determined in favour of the appellant, was whether the sum agreed was commensurate with the interest protected by the bargain

How is a contract term characterised as a penalty or liquidated damages?

Whether an agreed damages clause is a penalty, or liquidated damages is determined at the time when “a contract was entered into” (Carter, 2018, p. 860). The legal inquiry is a question on substance, rather than form (Carter, 2018, p. 860). Therefore, the court is not “bound by the parties’ express intention” (Carter et al., 2013, p. 100). Tiverios (2017) describes this interpretative approach as “determining whether A’s right is properly characterised….depends on interpretation, being the objective linguistic meaning of the contract” (p. 12). Particularly, In Dunlop, the timing requirements was stated as:

The question whether a sum stipulated in penalty, or liquidated damages is a question of construction to be decided upon the terms and inherent circumstances of each particular contract, judged of as at the time of the making of the contract, not as at the time of the breach…

When determining whether a term is penal in character, the court is “entitled to consider the genesis of the clause and the nature of the relationship between the parties” (Seddon & Bigwood, 2023, para 23.45). Particularly, the construction is adopted from the “view of an ordinary member of the public” (Carter et al., 2017, p. 14).

Bibliography

Related Entries

Implied Terms | Enforceable Contract | Frustration | Legally Binding Agreement | Termination | Express Terms | Consideration | Intention to Create Legal Relations | Offer and Acceptance | Certainty | Repudiation | Privity | Classification of Terms | Contract Law (Theories) | Causation | Remoteness | Damages |

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Authored by:
Ben Franklin, Managing Partner (LIV Accredited Specialist – Property Law), & Matthew Tran, Lawyer.