So...what exactly are liquidated damages?
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)?
- Genuine: the amount is reflective of the loss that would be suffered as a result of the breach.
- 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 , 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 , the High Court reiterated the law separating penalties from liquidated damages.
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:
- the buyback sum did not include an amount for goodwill;
- there was no proportionality connected to the breach of Ringrow selling non-BP fuel; and
- the buyback provision was indiscriminate, in that it applied to a range of contractual breaches.
The High Court rejected all three arguments of Ringrow:
- in relation to goodwill, the court noted that it was an insignificant amount and was not possible to assess the amount lost.
- 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
- 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.
 Dunlop Pneumatic Co v New Garage  AC 79
 Ringow Pty Ltd v BP Australia Pty Ltd  HCA 71
Brian Ambler, Partner