Peter Lamont, Associate
The issue of Liquidated Damages and Penalty Clauses has been commonly litigated and the courts are often confronted with the question of whether the Liquidated Damages Clause is a penalty. Surprisingly, the 1915 decision in the case of Dunlop Pneumatic Tyre Co Ltd -v- New Garage and Motor Co Ltd still remains the starting point for any answer to this question. The pre-eminent principle that emerged from this case is the notion of 'genuine pre-estimate' and the Dunlop case has stood the test of time and remains the leading authority on this issue.
What is a genuine pre-estimate?
If forced to litigate on the issue of whether or not parties have agreed on a reasonably accurate preestimate of loss or damage, the key determining factor will be whether the estimate agreed upon is regarded as liquidated damages or a penalty. It is at this point where the parties are free to agree upon the genuine pre-estimate, and the courts will only get involved where the amount involved goes so far beyond a genuine pre-estimate of loss that it is considered out of all proportion, extravagant or exorbitant.
More recently, the concepts of terms like 'quite extravagant', 'quite exorbitant', 'totally disproportionate', 'not a genuine pre-estimate' and 'unconscionable' were considered in a 2005 Tasmanian Supreme Court case involving the State of Tasmania and Leighton Contractors Pty Ltd. The issues that emerged from this case were essentially these:
"The terms encapsulate the following propositions:
- A comparison between the sum provided for in the event of a breach and the greatest loss which could conceivably be proven in the light of the total amount of the contract as a whole;
- A comparison between the sum provided and the nature of the breach. If any breach activates the operation of a damages term irrespective of its import, then it might more readily be regarded as a penalty;
- Equivalence of bargaining power at the time of agreement or whether one party was subject to unreasonable pressure in performance;
- The potential outcomes to which the clause was directed;
- The means, if any, used in the compilation of the sum provided; and
- The import of the contract provision for damages to be considered at the time of the making of the contract, not as at the time of the breach."
It is important to remember the fact that no loss has actually been suffered is irrelevant when deciding whether a liquidated damages clause amounts to a genuine pre-estimate of any loss that might be suffered.
What is a penalty clause?
It is often the case where parties intend on agreeing upon a liquidated damages clause, and in fact the pre-estimate becomes extravagant and unconscionable effectively rendering it a penalty.
When considering whether your clause might actually be a penalty, revert back to the terms, 'quite extravagant', 'unconscionable', 'exorbitant' and do your own objective assessment.
Usefulness for the contractor
An effective, well thought out and properly considered liquidated damages clause can provide a cap on the liability of a contractor.
As a minimum, the liquidated damages clause can make a tendering process more certain from the pricing perspective, insofar as the contractor knows the liability that will result from delay and can allocate risk accordingly.
Recommendations
It seems obvious, but I do need to say this regularly to clients and that is, 'don't pluck a figure from the air'. The concept of 'genuine pre-estimate' needs to override all considerations when dealing with liquidated damages clauses. The loss to be suffered needs to be genuine.
If you are a contractor, ask for evidence of the genuine pre-estimate prior to agreeing to the operation of the clause, and if you are a principal be prepared to provide documentary evidence or whatever extrinsic material available to prove that the genuine pre-estimate is genuine.
Liquidated damages clauses can be the contractor's friend if the concept for 'genuine pre-estimate' is explored thoroughly at the outset. Make sure you agree to the figure on the basis that comprehensive discussion on the point has occurred with the principal to avoid disputes down the track.
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The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.