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So...what exactly are liquidated damages?

Newsletter Article 13 August 2010

They are essentially a fixed sum that accrues to a party as a means of compensation following a breach of a contract. Most commonly they occur as a result of breach to deliver a good or service on time (i.e., late performance) however, liquidated damages can also be used for other breaches.

One of the principle requirements of a liquidated damages clause is that it does not venture into the realm of a penalty – which would make that clause void and unenforceable.

What does this mean for you?

When dealing with contracts that contain liquidated damages clauses, it is important you consider the following:

Are the damages a genuine, pre-agreed estimate (liquidated damages)?

  1. Genuine: the amount is reflective of the loss that would be suffered as a result of the breach.
  2. Estimate: this estimate is to be calculated at the time of contracting – thus, if no damage actually occurs following a breach, liquidated damages are still payable.
  • Some factors that the Court will examine to determine if a clause is a penalty, and therefore invalid include whether the amount is unconscionable, or extravagant [1], i.e., if the damages are so disparate that they are oppressive.

Ultimately, the question of validity is a matter of construction based on the terms and circumstances of each contract.

Practical measures to take

  • Ensure you keep records of how the liquidated damages were calculated.
  • Consider the formula used to calculate the liquidated damages.Remember the amount is based on the time of making the contract.

What has the Australian High Court said?

In Ringrow [2], the High Court reiterated the law separating penalties from liquidated damages.

Facts

BP sought to exercise an option to buy back a BP service station independently owned by Ringrow – following a discovery that Ringrow breached the contract by selling non-BP fuel. Here, the liquidated damages was said to be BP’s ability to exercise the option. Ringrow however, argued that this buyback provision was a penalty as it had exceeded a genuine, pre-agreed estimate of the damage suffered as a result of Ringrow’s breach.

Ringrow argued that the buyback provision equated to being a penalty because:

  1. the buyback sum did not include an amount for goodwill;
  2. there was no proportionality connected to the breach of Ringrow selling non-BP fuel; and
  3. the buyback provision was indiscriminate, in that it applied to a range of contractual breaches.

The High Court rejected all three arguments of Ringrow:

  1. in relation to goodwill, the court noted that it was an insignificant amount and was not possible to assess the amount lost.
  2. In relation to the doctrine of proportionality, the Court noted that the significant factor is that the liquidated damages are not significantly greater or out of proportion with a genuine pre-estimate of damage, not disproportionality between one party’s commercial interests and the promise extracted from them; and
  3. the fact that it was indiscriminate was not enough to lead to disparity.

The Court thus, emphasised that mere disparity is not sufficient – rather, the damages must be out of all proportion to the loss suffered.

[1] Dunlop Pneumatic Co v New Garage [1915] AC 79
[2] Ringow Pty Ltd v BP Australia Pty Ltd [2005] HCA 71


Brian Ambler, Partner
Sydney

Newsletter Article 13 August 2010
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