Unlike the United States and China, where victims of a breach of contract may be entitled to damages exceeding their actual loss, Australian contract law adheres to the principle of “restitutio in integrum.” This principle, as established in Livingstone v Rawyards Coal Co (1880) 5 App Cas 25, Lord Blackburn at 39, and affirmed in Haines v Bendall (1991) 172 CLR 60 at 63 and Arsalan v Rixon [2021] HCA 40 at [25], holds that damages should be assessed to represent no more and no less than a plaintiff’s actual loss. In this context, liquidated damages clauses hold significant importance

1. What are liquidated damages and liquidated damages clauses?

Liquidated damages refer to a sum of money agreed upon by contracting parties at the time of entering into a contract, which can be recovered by one party if the other breaches the contract, resulting in loss or damage. The agreed sum should reflect the best estimate of actual damages at the time of signing the contract. For example, in a construction contract, a liquidated damages clause might stipulate that the contractor will pay the employer a specified sum for each day, week, or month of delay in completion caused by the contractor’s breach.

2. Why are liquidated damages clauses important?

Liquidated damages clauses offer several benefits, including: (1) certainty and predictability about the financial consequences of a breach; (2) avoiding costly and time-consuming litigation; (3) incentivising performance; (4) addressing situations where actual damages are difficult to quantify; (5) enabling faster resolution of disputes; and (6) allowing parties to allocate risks and costs in accordance with the principle of freedom of contract. These benefits make liquidated damages clauses a valuable tool in commercial contracts.

3. The penalty trap and the risk of unenforceability

However, if a liquidated damages clause is found to be a penalty, it will be unenforceable. As defined in Legione v Hately (1983), a penalty is “in the nature of punishment for non-observance of a contractual stipulation.” Courts are reluctant to enforce penalty clauses to prevent unfairness and oppression in contracts. When drafting liquidated damages clauses, parties should attempt to calculate a reasonable pre-estimate of the loss that may arise from a breach and avoid rates that could be perceived as penalising the breaching party.

Case law principles that may assist in determining whether a clause is a penalty include:

• Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Ltd [1915]: If the sum is unconscionable, excessive, or extravagant compared to the greatest conceivable loss from the breach, it is a penalty.
• Andrews v Australia and New Zealand Banking Group Ltd [2012] FCA 59: A clause requiring non-proportional compensation to the pre-estimated loss may be found to be a penalty.
• Grocon Constructors (Qld) Pty Ltd v Juniper Developer No 2 Pty Ltd: For a liquidated damages clause to be a penalty, it must be “extravagant or unconscionable in amount,” or out of all proportion, not merely lacking in proportion.
• Beil v Mansell (No. 2) [2006] 2 Qd R 499: A penalty may be found where the liquidated damages payable by a contractor for delay are exceptionally high compared to similar contracts.

In conclusion, liquidated damages clauses are instrumental in Australian contract law, ensuring certainty, promoting performance, and distributing risks effectively. However, parties must be careful to draft these clauses as genuine pre-estimates of loss to avoid the penalty trap and the risk of unenforceability. By understanding the principles established in key cases and adhering to the concept of “restitutio in integrum,” contracting parties can effectively utilize liquidated damages clauses while minimising the risk of their being found unenforceable.

Reference:

• Haines v Bendall (1991) 172 CLR 60
• Livingstone v Rawyards Coal Co (1880) 5 App Cas 25
• Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Ltd
• Andrews v Australia and New Zealand Banking Group Ltd [2012] FCA 59
• Grocon Constructors (Qld) Pty Ltd v Juniper Developer No 2 Pty Ltd
• Beil v Mansell (No. 2) [2006] 2 Qd R 499