Liquidated damages clauses in contracts – what you need to know

Liquidated damages clauses in contracts – what you need to know

It is fairly common for contracts to include a clause which says that in the event of ABC occurring, Party A has to pay Party B $XYZ amount of money. For example, a clause may specify that a certain amount of money is payable upon a contract being cancelled or only part performed. In legal terms, these types of clauses are known as liquidated damages clauses.

The court will of course recognise that liquidated damages clauses provide advantages in terms of certainty for both parties in a commercial contract. This recognition, when combined with the principle of freedom of contract, has led to a general view on the courts’ part that liquidated damages clauses should ordinarily be upheld. In other words, the party seeking to rely on the liquidated damages clause starts from the point that the clause in question will be enforceable.  

However, a liquidated damages clause which constitutes a penalty will not be enforceable. Therefore, a party seeking to defend a claim will need to satisfy the court that the clause in question is in fact, a penalty. Working out what constitutes a penalty is not an exact science and ultimately requires a subjective judgment to be made about fairness. 

The purpose of the ‘penalty rule’ is to prevent a claimant from claiming money (or another remedy) which bears little or no relation to the loss actually incurred. It examines the fairness of the remedy and not the fairness of the deal as a whole. The primary test is whether the remedy is disproportionate to the legitimate interest it was designed to protect. In practice, this will involve a value judgement by the court and the first step in that process is identifying the legitimate interest which the clause is designed to protect.

For example, the policy position underpinning a payment pursuant to a cancellation clause may be that to enable effective planning for product or service delivery, there may be a requirement for certainty to enable the supplier to in turn place orders themselves for component products or services which they require to fill an order, and which may incur direct cost to the supplier. By extension, the reasonableness of the amount of any cancellation fee in this example is likely to be underpinned by the actual costs incurred by the supplier at the point in time of the cancellation occurring.

The next step in determining whether a liquidated damages clause is in fact a penalty (and by extension unenforceable) is to look at the remedy. This is done on a case-by-case basis and if the party defending the claimcan satisfy the court that the amount claimed can reasonably be regarded as being disproportionate to the claimant’s interest in enforcing it, then the clause will be unenforceable.

The key takeaway from the above is that there is often a clear risk to both sides in arguing over a liquidated damages clause in court. It is for this reason, that these types of claims tend to be resolved by a compromise settlement where possible. By extension, a party seeking to enforce a liquidated damages clause should be realistic that it may well expect to settle for a lesser amount than the clause itself would otherwise have delivered. The claimant should also be prepared to provide evidence of the actual costs incurred up until the point in time of the cancellation, as that evidence will often inform the other party and should encourage a settlement without the need for a court proceeding.

In any event, if you’ve read this far and still have queries or if you think that you may need some help with your matter, then now is probably the time to get in touch. Austral Legal can help and we offer an initial discounted 30-minute SmartMove appointment for $80 (by phone or in person). Beyond that initial appointment we will usually be able to offer you a fixed fee for any further work which may be required, so that if you choose to go-ahead with our services, you will know what your legal costs will be up front. Bookings can be made online through our website or by phoning the office on 08 9745 9550.