The issue of Liquidated Damages and Penalty Clauses has been
commonly litigated and the courts are often confronted with the
question of whether the Liquidated Damages Clause is a penalty.
Surprisingly, the 1915 decision in the case of Dunlop Pneumatic
Tyre Co Ltd -v- New Garage and Motor Co Ltd still remains the
starting point for any answer to this question. The pre-eminent
principle that emerged from this case is the notion of 'genuine
pre-estimate' and the Dunlop case has stood the test of time
and remains the leading authority on this issue.
What is a genuine pre-estimate?
If forced to litigate on the issue of whether or not parties
have agreed on a reasonably accurate preestimate of loss or damage,
the key determining factor will be whether the estimate agreed upon
is regarded as liquidated damages or a penalty. It is at this point
where the parties are free to agree upon the genuine pre-estimate,
and the courts will only get involved where the amount involved
goes so far beyond a genuine pre-estimate of loss that it is
considered out of all proportion, extravagant or exorbitant.
More recently, the concepts of terms like 'quite
extravagant', 'quite exorbitant', 'totally
disproportionate', 'not a genuine pre-estimate' and
'unconscionable' were considered in a 2005 Tasmanian
Supreme Court case involving the State of Tasmania and Leighton
Contractors Pty Ltd. The issues that emerged from this case were
"The terms encapsulate the following propositions:
A comparison between the sum provided for in the event of a
breach and the greatest loss which could conceivably be proven in
the light of the total amount of the contract as a whole;
A comparison between the sum provided and the nature of the
breach. If any breach activates the operation of a damages term
irrespective of its import, then it might more readily be regarded
as a penalty;
Equivalence of bargaining power at the time of agreement or
whether one party was subject to unreasonable pressure in
The potential outcomes to which the clause was directed;
The means, if any, used in the compilation of the sum provided;
The import of the contract provision for damages to be
considered at the time of the making of the contract, not as at the
time of the breach."
It is important to remember the fact that no loss has actually
been suffered is irrelevant when deciding whether a liquidated
damages clause amounts to a genuine pre-estimate of any loss that
might be suffered.
What is a penalty clause?
It is often the case where parties intend on agreeing upon a
liquidated damages clause, and in fact the pre-estimate becomes
extravagant and unconscionable effectively rendering it a
When considering whether your clause might actually be a
penalty, revert back to the terms, 'quite extravagant',
'unconscionable', 'exorbitant' and do your own
Usefulness for the contractor
An effective, well thought out and properly considered
liquidated damages clause can provide a cap on the liability of a
As a minimum, the liquidated damages clause can make a tendering
process more certain from the pricing perspective, insofar as the
contractor knows the liability that will result from delay and can
allocate risk accordingly.
It seems obvious, but I do need to say this regularly to clients
and that is, 'don't pluck a figure from the air'. The
concept of 'genuine pre-estimate' needs to override all
considerations when dealing with liquidated damages clauses. The
loss to be suffered needs to be genuine.
If you are a contractor, ask for evidence of the genuine
pre-estimate prior to agreeing to the operation of the clause, and
if you are a principal be prepared to provide documentary evidence
or whatever extrinsic material available to prove that the genuine
pre-estimate is genuine.
Liquidated damages clauses can be the contractor's friend if
the concept for 'genuine pre-estimate' is explored
thoroughly at the outset. Make sure you agree to the figure on the
basis that comprehensive discussion on the point has occurred with
the principal to avoid disputes down the track.
We discuss whether certain clauses commonly found in ordinary commercial contracts could be considered to be penalties.
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