A penalty clause is a term in a contract that imposes a penalty on a party that breaches a contractual obligation. It is important to know that penalty clauses are generally unenforceable under Australian law. However, it can sometimes be difficult to distinguish penalty clauses from other similar clauses that are enforceable.
What is a Penalty Clause?
A contract term that states that one party has to pay an amount upon a breach of contract may be a penalty clause. Penalty clauses are designed to deter breaches of contract, regardless of the actual harm suffered by the non-breaching party. As such, penalty clauses are unenforceable because they are considered to be a form of punishment disproportionate to the actual loss likely to be suffered. However, there are very similar clauses used in contracts, called “liquidated damages” clauses, which are enforceable.
A liquidated damages clause is an agreement that a party in breach will pay the other party an amount which is a reasonable estimate of what the breach will cost the non-breaching party. For a liquidated damages clause to be enforceable, it must be a “genuine pre-estimate”. This means that the amount cannot be random, even if it is agreed between the parties. There must be a genuine effort applied to calculating how much a certain breach would cost the non-breaching party.
Identifying Penalty Clauses
Unfortunately, it can be quite difficult to distinguish between a penalty clause and a liquidated damages clause. For instance, if a contract imposes a fee for late payment of an invoice, this clause could be an unenforceable penalty clause or, it could also reflect a genuine pre-estimate of damages. It is reasonable for a late fee to be set at the cost incurred to re-issue the invoice, as it is not intended to be a penalty.
Termination fees are another example worth considering. If a termination fee is set at an unreasonably high amount, then it is not a genuine pre-estimate of the non-breaching party’s actual losses resulting from the early termination. In that case it will be considered a penalty clause and will be unenforceable. On the other hand, if the termination fee represents a reasonable estimate of the non-breaching party’s actual losses (such as the costs of finding a replacement for the terminated contract), then it may be enforceable as a valid liquidated damages provision.
To determine whether a particular term is a penalty clause, the court will consider the nature of the breach, the loss likely suffered, the amount of the penalty, and the relationship between the parties. It is important to note that whether a particular contractual provision is a penalty clause or not will depend on the specific circumstances of the case. As such, parties should carefully consider the potential risks and consequences of including such provisions in their contracts.
Considerations when Drafting Contracts
When drafting a contract in Western Australia, it is important to ensure that the purpose of a clause is not to punish or to deter a breach by imposing an artificially high fee. In addition, consideration should be given to whether it is necessary to impose a fee for a breach, when other alternatives (such as negotiation) might achieve the desired outcome. However, these concerns should not prevent a drafter from including proportionate and necessary liquidated damages clauses in a contract, as these clauses can be vital to protect businesses against genuine losses.
When drafting a liquidated damages clause, it is wise to document the consideration that was given to calculating the amount of damages that would flow from different types of breaches. Including this documentation in the contract (or associated documentation) means that the contracting parties have all had an opportunity to consider whether the amounts imposed would constitute a reasonable pre-estimate. This will make it more likely that the clause will be enforceable.
Conclusion
Penalty clauses are generally unenforceable as they are considered to be a form of penalty on the breaching party rather than a genuine pre-estimate of loss suffered by the non-breaching party. This, however, should not prevent the inclusion of proportionate liquidated damages clauses in contracts. In such cases, it is important that the clause seeking liquidated damages to deter a breach should not impose an artificially high fee or penalty.
The information in this article is general in nature and does not constitute professional advice. If you or someone you know wants more information or needs legal help or advice, please call 08 9336 6300 or email [email protected].