Often, businesses include a term in their contracts that require the other contracting party to pay a certain amount of money in the event that they breach an obligation under the contract. Or, on the other occurrence of an event that would cause the business to suffer some loss or damage. Businesses often include such provisions, known as liquidated damages clauses. The aim is to protect their position in the transaction contemplated under the contract. However, they may not always be valid and enforceable. This article explores in what circumstances a court will enforce liquidated damages and what provisions constitute penalties.
Liquidated Damages
The provisions described above are known as liquidated damages clauses (i.e. agreed damages clauses). You can commonly find them in construction contracts, but they also often appear in various other commercial contracts.
Liquidated damages often express a specific lump sum or a formula to identify the quantum of damages payable upon the happening of a certain event. This event is usually a breach under the contract. However, for such clauses to be enforceable, the quantum of damages that you provide must reflect a genuine pre-estimate of loss suffered by you or your business if the other party breaches its contractual obligations.
Penalties
Liquidated damages are enforceable as long as they do not constitute a penalty. Penalties are provisions that require the payment of money ‘in terrorem’ of the breaching party. This means by way of a legal threat or intimidation. These provisions are void and unenforceable for all purposes.
Typically, a liquidated damages clause is capable of being a penalty. This occurs when it is triggered either on:
- a party’s breach of the contract; or
- to secure a party’s compliance with another contractual obligation.
A court would find a liquidated damages clause is a penalty if:
- the sum is extravagant and unconscionable in amount. This is in comparison to the greatest loss you could conceivably prove to have suffered following a breach of the subject contract; or
- a single lump sum is payable on the occurrence of one or more events, some of which may cause your business significant loss or damage and the other events, minimal.
It All Comes Down to Drafting
Whether or not a liquidated damages clause is enforceable will ultimately depend on its drafting, taking into account the surrounding circumstances of the contract. When drafting a liquidated damages clause, you should follow and consider the following:
- clearly express the actual amount payable or the formula in which parties are to calculate damages. Also, include the basis for such amounts or formula;
- it may be difficult to pre-estimate the loss you will suffer as a result of a specific breach. Therefore, it will also be appropriate to look at your business’ legitimate interests as a whole. You should consider those that a breach under the contract may affect. For example, the impact on operational costs and other objectives of the business as a whole. Ensure that the sum payable is in proportion to your interest that the clause is to protect;
- expressly state that the liquidated damages identified is a ‘genuine pre-estimate of loss’ in the event that the other party breaches an obligation under the contract. Also, ensure that the objective is to compensate you and your business. This is in opposition to intimidating the other party into compliance or punishing them on account of their breach;
- the amount payable must be referrable to the seriousness of the breach. Avoid one lump sum payable on the occurrence of multiple events and varying degrees of breaches under the contract; and
- expressly state that the parties have had the opportunity to obtain legal advice and consider the liquidated damages clause before entering into the contract.
Key Takeaways
Liquidated damages are contractual tools. They can protect your business’ interest in the event of a breach or occurrence of some specified event. These clauses are only enforceable if the amount payable is referrable and proportionate to the damage you will likely suffer. Suppose the amounts are otherwise extravagant or disproportionate and appear as a device to punish or otherwise threaten the other party into compliance. In that case, such clauses are likely to be construed as penalties and are void and unenforceable.
The enforceability of liquidated damages clauses comes down to its drafting and taking into account the surrounding circumstances of your business and the transaction contemplated under the subject contract. If you require any assistance in preparing your commercial contracts or advice on whether a particular liquidated damages clause is enforceable against you, contact LegalVision’s dispute resolution lawyers on 1300 544 755 or fill out the form on this page.
Frequently Asked Questions
This is a term in a business contract requiring the other contracting party to pay a certain amount of money in the event that they breach an obligation under the contract. Or alternatively, if an event occurs that would cause the business to suffer some loss or damage.
Penalties are provisions requiring the payment of money by the breaching party by way of a legal threat or intimidation. Penalty provisions are void and unenforceable.
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