Litigation & Disputes

Contracts, Breaches, Damages and Penalties


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Agreed Damages Clauses in Contracts

The High Court decision in Andrews v Australia and New Zealand Banking Group Ltd (Andrews) has significantly increased the level of scrutiny over agreed damages clauses in contracts, particularly those which are non-negotiable. The cases following Andrews have made it clear that the mechanisms used to draft contracts need to be changed to ensure they will survive in the event of judicial scrutiny.

The Penalties Doctrine Historically

The penalties’ doctrine outlines the characteristics which make a clause in a contract a penalty. It looks at a number of elements to determine whether a clause will meet the description of a penalty. The Australian High Court adopted the penalties doctrine found in the United Kingdom decision of Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co Ltd, where agreed damages clauses in contracts in which the sum stipulated is ‘extravagant and unconscionable’ are unenforceable. In order to determine whether a sum is ‘extravagant and unconscionable’ the Courts compare the nominated amount in the clause to the greatest loss the injured party could reasonably sustain. If a clause stipulates a nominated amount which is more than the greatest loss the injured party could reasonably sustain, this is deemed a penalty clause and is unenforceable.

Prior to Andrews the penalties’ doctrine was applied solely to agreed damages clauses which were triggered by a breach of a contract. This meant that agreed damages clauses which were triggered by an action that did not amount to a breach of contract and nominated an amount of damages that was extravagant and unconscionable were still enforceable. However, the decision of Andrews removed the requirement for a breach of contract, thus clauses no longer need to be triggered by a breach of contract to be considered a penalty and be deemed unenforceable.

Penalty Clauses after Andrews

In the decision of Andrews the High Court has said that in the situation that the breach of a contractual obligation triggers an agreed damages clause the Court is to evaluate the agreed damages clause as to whether it aims to induce fear and therefore aims to encourage compliance with the primary obligations in the contract. If a clause falls within these criteria, the Court will then evaluate the agreed damages clause to determine whether or not it is a penalty.

While Andrews has not changed the test for determining which clauses constitute a penalty, it has altered the ways in which contracts are drafted. This is because clauses which previously were not considered a penalty (as they were not triggered by a breach in the contract) are now subject to the penalties’ doctrine. The decision has vastly increased the scope of the penalties’ doctrine.

The Effect of Andrews

Andrews outlines that if an agreed damages clause is deemed a penalty clause, it is to be struck out to the extent it is a penalty. Therefore the money payable under that clause is to be reduced to an amount which reflects the genuine loss suffered. This means that even if a clause is deemed a penalty the provision does not preclude the party from recovering damages whatsoever, it simply reduces the amount of damages to a sum which reflects the actual or maximum potential loss to be incurred.

Alternatively, the court will accept evidence of pre-contractual negotiations in its evaluation of whether a clause involves a genuine pre-estimate of loss. Therefore, it is wise to document the negotiations surrounding the drafting of any damages clauses contained in a contract in order to show that the parties made genuine attempts to evaluate the potential loss.

Further, so long as a damages provision is a genuine pre-estimate of loss it is enforceable and is unlikely to be deemed a penalty provision. The best way to ensure this is to draft the contract in such a way that includes a market-based valuation, such as setting out a detailed procedure to calculate the damages owed.

Conclusion

While the case of Andrews has raised issues in drafting agreed damages clauses in contracts, it must be noted the facts involved largely disparate parties and a non-negotiable contract. Therefore, while this case widens the Court’s ability to apply the penalty doctrine, it may not provide an appropriate precedent for cases of dissimilar facts. In conclusion, Andrews and the subsequent decisions have iterated the need to take care when drafting agreed damages clauses of any type in order to avoid them being deemed unenforceable by the Courts.

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