When is a Liquidated Damages Clause a Penalty?

Introduction

Leighton Contractors entered into a contract with the State of Tasmania for the design, construction and maintenance of a bypass highway to the township of Hagley.  The contract, for an amount of $30 million, included a liquidated damages clause entitling the State to retain $8,000 for each day that completion was delayed beyond the agreed date.  Leighton was delayed in completion and liquidated damages were retained amounting to $1.8 million.

Leighton disputed the State’s entitlement to the money on a number of grounds.  Ultimately the matter proceeded to the Supreme Court, where a 7 month trial ensued about this and other issues.  Leighton succeeded at trial, and the State was ordered to pay to Leighton the $1.8 million plus $0.5m in interest. The judge held that the clause was a penalty rather than a genuine pre-estimate of the damages that would flow from late completion, and for that reason had no effect.

The State appealed to the Full Court.

Liquidated Damages

The term “liquidated damages” in this context refers to the usual practice of agreeing in the terms of the contract an amount that is to be paid for each day that a project is late in reaching practical completion.  In order for the amount agreed to be contractually binding, the amount specified in the contract must be a genuine pre-estimate of the damage likely to be caused by the breach of contract.  Otherwise, a court might find that the amount is a “penalty” and not damages for the breach of contract.  If the court finds that the clause is a “penalty”, it will set the clause aside and the liquidated damages payable will be zero.

The circumstances in the Leighton case

In the Leighton case, the parties were both well resourced and the judge had held that they negotiated on an equal footing.  The State had proposed the sum of $8,000 as the daily liquidated damages amount following careful discussion with its lawyers.  The amount had been calculated by reference to a list of potential expenses.  Given that there must be a genuine pre-estimate, it was particularly useful to the State that it was able to produce a document that set out in considerable detail how it had calculated the daily costs.

The document included a schedule with details such as the daily rate for the principal, the principal’s representative, 2 hours of legal advice each day, 2 hours of contract advice each day, a site representative, a clerk of works, site vehicles, testing, site expenses, accommodation, and travelling.  Adjacent to the list of these items was a column “Liquidated Damages Estimate” with a $ amount beside each item.  The grand total of the column amounted to $7,985 per day.

The judge’s view of the estimate

At the initial Supreme Court hearing, the judge had held that these estimated amounts were “extravagant”, “exorbitant”, “totally disproportionate”, “not a genuine pre-estimate” and “unconscionable”.  He noted that the annual rates of pay for some of the personnel would have amounted to over $300,000 based on the daily rates allowed.  He queried the basis for the need for 2 hours legal advice each day.

It appears that the judge regarded the estimate of liquidated damages as contrived to support the $8,000 per day liquidated damages figure.

The judge also noted that the State would not suffer loss from the late completion, as the Commonwealth government was reimbursing the State for the cost of the works.

The application of the legal principles

The Full Court summarised the principles and concluded by saying that:

1.    Whether a contract imposes a penalty must be determined by reference to the true operation of the clause.  If the pre-estimate of the parties is either extravagant and unconscionable in amount in comparisonwith the greatest loss that could conceivably be proved to have followed from the breach or, judged as at the time of making the contract, is unreasonable in the burden which it imposes in the circumstances which have arisen, it is a penalty regardless of the intention of the parties in making it.

2.  There is much to be said for the view that the courts should return to the Clydebank and Dunlop concept, thereby allowing parties to a contract greater latitude in determining what their rights and liabilities will be, so that an agreed sum is only characterised as a penalty if it is out of all proportion to damage likely to be suffered as a result of breach.

The Full Court noted that the High Court had recently approved of these two principles in Ringrow v BP Australia.

The Full Court held that, in deciding that the clause was a penalty, the judge had misapplied the legal principles.

  • It said that the $8,000 figure was not arbitrarily chosen and the integrity of the figure had not been disturbed at the trial.  The focus on the individual elements of the estimate had been a diversion.
  • It noted that government departments face a difficult task in quantifying the losses that flow from delays, but this factor should not deprive them of claiming damages.
  • Another calculation had arrived at a similar figure by including a $4,000 interest component.
  • The cost of the maintenance of the existing road had not been considered. The State would have been obliged to spend money maintaining the road until the new road was completed.
  • The fact that the Commonwealth would reimburse the State for any losses suffered was not relevant to an assessment of the likely damages to be suffered by the State.

For these reasons, the Full Court overturned the decision of the Supreme Court and found that the liquidated damages clause was valid, thereby entitling the State to retain the $1.8 million from the amount due to Leighton.

Conclusion

When inserting a liquidated damages figure into a contract, it is prudent to prepare a simple summary supporting the estimated figure.  The estimate must be based on the losses that will flow from the breach of contract, and cannot be extravagant and unconscionable in comparison to the greatest loss that could conceivably be proved to flow from the breach.

The courts are increasingly reluctant to intervene in the business dealings of large organisations, regarding them as able to take advice and protect their own interests.

 

Contributor: Tom Grace

Tom is a former engineer who ran his own construction company for 20 years before becoming a construction lawyer.  He has wide experience in the engineering and construction fields and specialises in the resolution of commercial disputes.

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