Drafting liquidated damages clauses to avoid the doctrine of penalties

30 September, 2016

At Access Law Group, it is our experience that organisations often encounter difficulties when they attempt to enforce liquidated damages clauses in their contracts. A recent High Court decision has shed some light on when a liquidated damages clause may be deemed to be invalid as a penalty.

The matter of Paciocco v Australia and New Zealand Banking Group Ltd (“Paciocco) concerned a late payment fee charged by the ANZ Bank on consumer credit card accounts. The appellants alleged that the late payment fee was unenforceable as a penalty.

As set out in Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd [1915] AC 79, the essence of a penalty is “a payment of money stipulated as in terrorem of [to threaten] the offending party”.

Justices Mason and Deane in Legione v Hateley (1983) 152 CLR 406 held that “a penalty…is in the nature of a punishment for non-observance of a contractual stipulation; it consists of the imposition of an additional or different liability upon breach of the contractual stipulation”.

A penalty is therefore an amount of money to be paid upon breach that acts as a “threat” to ensure compliance, or to punish non-compliance, as opposed to compensating a party for its loss. As a comparison, liquidated damages are “a genuine covenanted pre-estimate of damage”.

However, it is often difficult, if not impossible, for a party to a contract to accurately forecast loss or damage caused by a party’s breach. This is because, in drafting a liquidated damages clause, a party will often be seeking to protect its interests beyond merely the performance of the contract.

In these cases, where damage to a party’s interest is “extremely complex, difficult, and expensive” to quantify, the Court has held that it is reasonable for parties to agree as to the amount to be paid upon breach, unless that amount is “extravagant”, “unconscionable”, “exorbitant”, or “out of all proportion” to the party’s interests according to the circumstances of the case.

In Paciocco, the ANZ argued that the costs occasioned by late payments was very difficult to calculate, considering the various costs, risks and liabilities associated with late payment that it had to take into account in the course of doing business.

In finding that the late payment fee was not a penalty, the Federal Court held that loss should be determined by looking “at the greatest possible loss on a forward looking basis” with reference to “the economic interests to be protected”. On that basis, the late payment fee was found to not be out of all proportion to the commercial interests of the ANZ in avoiding the costs associated with late payment. Having regard to the circumstances, including the ANZ’s interests and the ANZ’s relationship with the customer, the High Court affirmed the Federal Court’s decision.

The High Court has affirmed that penalties remain unenforceable, but has given a strong indication that regard should be taken to the range of interests, including actual recovery costs, regulatory costs and liquidity requirements that a party seeks to protect, and not merely the interest in performance of the contract.

In determining amounts to be stipulated in liquidated damages clauses, organisations should ensure that they turn their minds to the legitimate impact to their commercial interests in the event of a breach of the contract. Liquidated damages clauses should be drafted in such a way as to make as clear as possible that the amount stipulated is a genuine pre-estimate of the loss that would be incurred upon breach.

Our team at Access Law Group is experienced in drafting liquidated damages clauses, and would be happy to assist in quantifying your organisation’s interests that may be effected by a breach of contract.