As a general proposition, parties are free to contract with one another on whatever terms they agree. Breach of a contractual term will entitle a party to recover any loss they suffer as a result of the breach, that is their damages, and in serious breaches may entitle the party to terminate the contract in addition to recovering damages. Ordinarily, a party must prove and quantify their loss in order to be awarded damages by the court. However, in some cases parties may wish to include a clause in the contract which sets out the damages which are payable because of a breach. These are known as liquidated damages clauses.

The use of liquidated damages

Liquidated damages clauses may be useful to parties for a number of reasons. Firstly, by stipulating a figure for damages in the event of breach, parties are made aware from the start of their contractual relationships what liabilities may arise if they do not comply with the contract. Additionally, a liquidated damages clause may provide incentive for parties to complete their contractual obligations faithfully. For example, a delay damages clauses which stipulates a figure payable for each day after the completion date of a construction contract a site is not completed by, would encourage a builder to complete their work in a timely manner. Finally, reliance on a liquidated damages clause will mean the party benefited by the clause will not have to prove their loss as ordinarily required as the liquidated sum is considered to be a genuine pre-estimate of anticipated and reasonably foreseeable loss they are entitled to once a breach occurs.

Liquidated damages must not impose a penalty

Although parties are entitled to impose liquidated damages clauses, theses clauses will be invalid if they impose a penalty. A penalty is a stipulation of damage which purpose is to punish the defaulting party, or where the stipulation of damages is disproportionate to the damage which could reasonably be foreseen. This ensures that any liquidated damages proposed must be reasonable and fair in the circumstances considering the nature and purpose of the contract, and the loss that is likely to be suffered if a breach does occur.

If the liquidated sum is considered to be a penalty then it will be invalid and a party will have to prove their loss rather than merely relying on the clause. The time for assessment of whether a clause is a penalty is at entry into the contract.

Considerations when using liquidated damages clauses

Liquidated damages may only be appropriate in limited circumstances, and as such you should discuss with one of our lawyers to see whether a liquidated damages clause is proper for your contract. Additionally, it should be borne in mind that the existence of a liquidated damages clause will normally limit the amount of recovery of loss to the stipulated figure. As a party cannot recover losses beyond the liquidated sum, it is important to consider this when drafting a liquidated damages clause. As there is a need to ensure the liquidated damages adequately compensates the entitled party but also does not impose a penalty, drafting such figures can be a difficult exercise and requires careful consideration. Some recent NSW authority has suggested that an appropriately drafted liquidated damages clause may provide an option to a plaintiff to pursue a liquidated claim or seek common law damages (retaining a right to seek common law damages as an alternative to the liquidated sum).

When relying on a liquidated damages clause, it is important that the context of breach is taken into account. For example, for delay damages clauses the authorities suggest that where the plaintiff causes delay then they cannot rely on the clause. However, if the builder having a right to claim an extension of time, fails to do so, then the plaintiff may not be precluded from reliance on a delay damages clauses. As the liabilities and rights of the parties often turn to the context and facts of the case including the nature of the contract, its clauses and drafting, and the object of the contract such as building contracts, if you require advice in relation these issues you should speak to one of our lawyers.

If you require advice in relation to your rights and obligations under a contract including contracts with liquidated damages clauses feel free to contact us on 42 222 666 or by email at hansons@hansonslawyers.com.au