Penalty clauses and liquidated damages clauses

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Penalty clauses and liquidated damages clauses appear in a wide variety of different commercial contracts and are useful commercial device to ensure performance of the contract. Loosely speaking, these are clauses whereby the parties seek to pre-agree a remedy or contractual consequence that will flow in the event of a breach.

In general, a clause which can be categorised as a penalty is regarded as being unenforceable. Conversely, a clause which represents a genuine liquidated damages clause is enforceable.

How to tell the difference between the two has been the subject of a recent change in direction.

Our Court of Appeal has also recently considered the redirection in approach ents in Wilaci Pty Ltd v Torchlight Fund no 1 LP (In receivership) [2017] NZCA 152, albeit in a case in which the law of New South Wales was applied. Although the case was governed by that state’s law, I am of the view the same principles are likely to apply to contracts governed by New Zealand law.  The decision is therefore likely to influence how the New Zealand courts now approach penalty clauses.

Traditionally, the test was whether or not the contractual provision provided a genuine pre-estimate of the parties losses on the happening of a certain event or breach. If it did, then it was regarded as a liquidated damages clause and was enforceable. If it bore no relation to the parties genuine pre-estimate of the losses then it was regarded as a penalty clause and was unenforceable.

As a result of this “redirection”, the enquiry has however swung away from a focus on the genuine pre-estimate of the parties’ loss. The central issue is now whether a stipulated remedy for breach is out of all proportion to the legitimate performance interests of the innocent party, or is otherwise exorbitant or unconscionable, having regard to those interests.

The following factors are relevant to this assessment:

a) Whether the parties were commercially astute, had similar bargaining power and were independently advised; and

b) Whether the predominant purpose of the impugned clause is to punish (as opposed to simply deter) non-performance.

It is thought that this redirection could make it easier for the drafters of such contracts to avoid the penalties doctrine.

This article is not a substitute for legal advice about your own individual situation. Every case can be different so please seek legal advice or contact me direct for advice that applies to you.