In our last two articles, we have talked about liability for a breach of contract and under an indemnity. You will recall that in contract law when we talk about liability, we mean liability to pay general damages (ie compensation). However, instead of liability for general damages, the parties may agree in the contract to apply so-called liquidated damages for a breach of a particular obligation.

Liquidated damages are pre-agreed (i.e. agreed in the contract) amounts payable for a breach of a specific contractual obligation. For example, it is common for the parties to a contract for supply of goods to agree upon liquidated damages applicable if the supplier is late in delivering the goods. Likewise, it is not unusual for the parties to a contract for services to agree on liquidated damages for not meeting certain service levels or KPIs.

A few key points about liquidated damages:

1. It is important to remember that the purpose of liquidated damages is to compensate, not to penalise or force performance. Therefore, the law provides that liquidated damages have to be a genuine pre-estimate of loss at the time of the contract. If they are disproportionate to any potential loss, they may be deemed to be “penalties” and be un-enforceable. On the other hand, if the liquidated damages are agreed upon for a breach of an obligation, they are payable in the event of the breach even if there is in fact no loss suffered by the other party (as long as the liquidated damages were a genuine pre-estimate of loss at the time of the contract). Estimating potential losses for the purpose of liquidated damages is not an exact science, but it is a good idea to make a genuine attempt at it and to keep any records explaining the rationale for and calculations of the liquidated damages.

2. The idea of liquidated damages is that they are in in lieu of general damages in respect of a breach of the relevant obligation. However, contracts often do not make this clear, or even worse, say the opposite (ie that liquidated damages are in addition to general damages). This should not be acceptable to the party who is potentially liable for liquidated damages (usually the supplier or service provider). It is best to state clearly in the contract that the liquidated damages are in full satisfaction of any liability for damages in respect of non-compliance with the relevant obligation.

3. The party who is potentially liable for liquidated damages (usually the supplier or service provider) will usually want to limit its exposure to them. It is common to limit liability to liquidated damages to 5% or 10% of the contract price.

The High Court of Australia may soon have an opportunity to consider the law on liquidated damages/penalties as it will hear an appeal in a class action by ANZ’s customers in respect of late credit card fees (ANZ Bank prevailed earlier in the year in the Federal Court which held that the fees were not illegal penalties). We will keep you informed of any significant developments in this case.

For more information or for assistance in preparing, reviewing and negotiating any contracts, please contact Stanislav Roth at Source Legal, email stanislav.roth@sourcelegal.com.au.

A copy of the article can be downloaded here.