Liquidated Damages and Penalties
 A contract sometime specifies that a certain amount is payable to one party if the other breaches a term. This is called a liquidated or agreed sum. However, a liquidated sum which is not based on a genuine pre-estimate of the damage suffered as a result of the breach (ie, there is no relationship between the breach and the sum), the clause will be deemed a penalty, which are invalid and unenforceable under contract law.
Distinguishing between liquidated sums and penalties
- The parties' choice of titling the clause a 'liquidated sum' or 'penalty' has no effect.
- A penalty is a stipulated payment of money meant to frighten or deter a party from breaching a term. A liquidated sum is a genuine pre-estimate of the loss which would occur if the term is breached.
- The question of differentiating is a question of construction. Particular circumstances are relevant, judged at the time of the formation rather than the time of the breach.
- To assist the task of construction, the following tests have been helpful:
- (a) If the sum is extravagant or unconscionable in comparison to the greatest loss conceivable from the breach, it is a penalty.
- (b) If the breach is the failure to pay money, and the sum is greater than the sum that out to have been paid, it is a penalty.
- (c) If it is a single lump sum which is payable in the occurrence of one or multiple events, some of which only warranting trifling damages, there is a presumption that it is a penalty.
- (d) Just because the consequences of the breach are very hard or maybe impossible to estimate, it doesn't mean it is a penalty. Rather, there is a presumption that it is a liquidated sum.
- When comparing whether the sum specified is proportionate to the loss suffered, and where the breach led to termination, the relevant loss the loss of the entire benefit of the contract.
- It is emphasised that a clause is not a penalty merely because it exceeds the loss a bit - it needs to be 'out of all proportion' or 'extravagant, exorbitant or unconscionable'.
This article is a topic within the subject Contracts.
Paterson, Robertson & Duke, Contract: Cases and Materials (Lawbook Co, 11th ed, 2009), pp. 703-707 [28.05-28.25]; 710-711 [28.35].
Casebook refers to Paterson, Robertson & Duke, Contract: Cases and Materials (Lawbook Co, 11th ed, 2009).
Textbook refers to Paterson, Robertson & Duke, Principles of Contract Law (Lawbook Co, 3rd ed, 2009).
ACL refers to the Australian Consumer Law.