Penalise at your peril
Drafting agreed damages clauses post-Andrews
The following article was first published in Proctor - October 2015.
Damien Clarke and Andrew Bukowski provide a practical guide to drafting agreed damages clauses in a world forever changed by Andrews v Australia and New Zealand Banking Group Ltd.
For decades penalty clauses dressed up in sheep’s clothing have allowed the often-dominant party in contract negotiations to include agreed damages clauses which were extravagant, unconscionable and all out of proportion with the greatest amount of loss they were likely to suffer.
Andrews v Australia and New Zealand Banking Group Ltd1 (Andrews) dramatically increased the scrutiny of agreed damages clauses and other clauses providing for payments upon specific events.
Recently, other cases have clarified how Andrews applies to agreed damages clauses. These cases reinforce the need to re-examine drafting techniques to ensure an agreed damages clause can withstand judicial scrutiny. Rather than rehash Andrews in depth, this article focuses on how to approach agreed damages clauses in this post-Andrews world.
Pre-Andrews penalties doctrine
Australian courts have rejected the concept of penalising a party for a contractual wrong. Rather, any damages awarded by the court or by agreement should be compensatory in nature. The principle is summarised best in Robinson v Harman2:
“…where a party sustains a loss by reason of a breach of contract he is so far as money can do it to be placed in the same situation with respect to damages as if the contract had been performed.”
This policy position has shaped the English and subsequently Australian treatment of agreed damages clauses. The High Court accepted the Dunlop principle,3 which provides that a clause is unenforceable as a penalty4 if the sum stipulated is “extravagant and unconscionable” compared to the greatest loss that the injured party could suffer (penalties doctrine).
Until Andrews, the penalties doctrine in Australia was only applied to agreed damages clauses triggered by a breach of contract that provided for the payment of money (or money’s worth) when the clause was activated by a breach of contract.5 So a clause which operated without a party breaching the contract was enforceable even if the agreed damages were extravagant and unconscionable. For example, if a failure to pay a scheduled payment under a contract triggered an excessive interest rate but at the same time did not give rise to a breach, the clause would have previously not been considered a penalty.
Post-Andrews penalties doctrine
Andrews removed the requirement for a breach of contract. The High Court held that the penalties doctrine applies when:6
- There has been a failure of a primary stipulation in favour of party A.
- The clause which activates the agreed damages clause is, as a matter of substance, collateral or accessory to the primary stipulation.
- The clause which activates the agreed damages clause imposes an additional detriment (a penalty) on party B to the benefit of party A which is in the nature of a security for and in terrorem of (meaning in fear of) the satisfaction of the primary stipulation.
- The prejudice or damage to the interest of party A caused by the failure of the primary stipulation is not insusceptible to evaluation and assessment in monetary terms.
Simply put, if a primary obligation under a contract is breached and triggers an agreed damages clause (the secondary obligation), the court will look at whether this secondary obligation was included to encourage compliance with a primary obligation of the contract. This secondary obligation is effectively a gun to the head of the faulting party. If the criteria are met, a clause is then evaluated to determine whether it is a penalty.
This decision has changed how contracts both big and small are drafted. Clauses which may have previously been triggered by an event rather than a breach are now subject to the penalties doctrine. But the test for what makes a clause a penalties clause has not changed.
What makes a clause a penalty clause?
Since Andrews, a great deal of attention has been given to the increased scope of the penalties doctrine while the characteristics that make a clause a penalty have been largely ignored. These characteristics are unchanged by Andrews.
Substance over form: An agreed damages clause is enforceable if it is a genuine pre-estimate of loss. This has always been, and remains, a question of substance over form. As such, merely including an acknowledgement that an estimate is a genuine one in your contract does not prevent the penalties doctrine7 applying.
Amount must not be extravagant and unconscionable: The amount of money (or moneys’ worth) payable under an agreed damages clause is likely to be penal if it is more than the greatest amount of loss likely to be suffered by the other party.8 Importantly, this is not a scientific calculation. The amounts do not have to be exact. But if the difference is extravagant and unconscionable, the clause will be a penalty.
Breach of payment obligations: A rebuttable presumption applies to clauses triggered by a party’s failure to make a payment under the contract. If the clause requires a party to pay more than the amount they initially failed to pay, then that clause is presumed to be a penalty.
Single sum for all breaches: A clause is more likely to be a penalty if the same amount is payable for all types of breaches or events under a contract regardless of whether they are trivial or serious.
Commercially justifiable: A clause is less likely to be a penalty if it is commercially justifiable, as this supports the principal that it is a genuine pre-estimate of loss. A court will consider the commercial circumstances surrounding the contract including:
- the negotiations
- the level of sophistication of the parties, and
- certain ancillary information available to the parties at the time the contract was entered into.
Most recently, Justice Peter Lyons in the Supreme Court of Queensland in Grocon Constructions (Qld) Pty Ltd v Juniper Developer No.2 Pty Ltd9 (Grocon Constructions) allowed the use of documents and information outside the contract to determine whether an agreed damages clause was a genuine pre-estimate of loss. This is an exception to the general rule which prohibits the use of extrinsic evidence in interpreting a contract. Justice Lyons noted that:
“The doctrine of penalties, however, is not primarily concerned with the identification of that to which the parties agreed; rather it is concerned with the question whether they should be held to their agreement, including in some cases an agreed characterisation of a liquidated damages clause.”10
This consideration of factors outside the four corners of a contract relates to the point noted above – that it is substance over form when considering penalties clauses. Accordingly, the court will not strictly limit its considerations when enforcing the penalties doctrine.
When in time must the clause be a genuine pre-estimate of loss?
Whether a clause is a genuine pre-estimate of loss and commercially justifiable is assessed as at the time the parties entered into the agreement.11
What happens if it is a penalty?
If a clause is found to be a penalty, the clause is struck out to the extent it is a penalty. Essentially, the money (or moneys’ worth) payable under the clause is reduced to the genuine loss suffered.12
Importantly, a party is not precluded from seeking damages if a penalties clause is struck out altogether.13
What does this mean for contract drafting?
In this post-Andrews world we need to reconsider the drafting mechanisms previously used to avoid the scope of the penalties doctrine. But agreed damages clauses are not going to disappear. They give the desired certainty to a contract. So we need to consider alternative drafting mechanisms.
Payment for a further service
The penalties doctrine ensures a party is not punished under a contract. The doctrine does not stop a party contracting to pay more for a further service. In the recent case Paciocco and Another v Australia and New Zealand Banking Group Ltd14 (Paciocco), the Federal Court held that the fees charged by ANZ for extending an over limit were not a penalty. Rather those fees were payment by the customer for a further service.15
In Paciocco, the over-limit fee was one of a number of fees challenged and the only fee found not to be a penalty. The court found that the over-limit fee was charged because the customer elected to exceed their limit, which was a service ANZ offered.
This type of drafting lends itself to hire agreements and other ongoing contracts. Drafting clauses to give a party a further benefit in exchange for another payment reduces the likelihood that the clause will be a penalty.
Market valuation mechanism
Sometimes offering a further benefit is not practical and a more traditional agreed damages clause is required. If so, parties should consider what steps they can take to ensure that the agreed damages are a genuine pre-estimate of loss. One alternative is including a market-based mechanism.
An agreed damages clause which is triggered by a party’s failure to deliver goods in a certain condition on time may be a penalty if it simply requires that party to pay a set amount. Instead, consider redrafting the clause to require the defaulting party to:
- pay for the defective or late goods to be returned
- return any monies paid, and
- pay the difference between the contract price and the price of the goods as listed on a certain market.
This is a genuine attempt to estimate the lost profits resulting from the breach.
This is effectively setting out a precise formula and process for what the court would otherwise do. As such it achieves certainty while avoiding costly litigation.
Document the process
As discussed in Grocon Constructions (and above), the court will consider the commercial standing of the parties to an agreement. Specifically, if parties can show that a clause was agreed to after lengthy negotiations with access to the appropriate advice, the clause is more likely to be a genuine pre-estimate of loss.
This should be kept front of mind when drafting an agreement in which the reliance on an agreed damages clause is a core issue for a client. Consider recording, in an admissible manner, the negotiations around the clause. Being able to demonstrate the parties made genuine attempts to estimate the potential loss will assist when a court is evaluating the substance of the clause.
Andrews raised a number of issues when approaching the drafting of commercial contracts, particularly because the case concerned parties of unequal bargaining power (bank v customer) and a non-negotiable contract. Subsequent cases have clarified how to apply Andrews when parties are of more equal commercial standing.
What Andrews did not change was what makes a clause a penalty. When drafting any clause requiring payment upon breach or other event, you still need to ask, is the amount calculated by this clause out of proportion to the greatest amount of loss that the party not in breach could suffer because of the events which triggered the clause? If yes, a redraft of the clause needs to be made to avoid it being later struck out as a penalty by the courts.
Agreed damages clauses are inevitably open to the argument that they constitute a penalty; this risk should always be addressed through considered drafting and most fundamentally ensuring your clause is a genuine pre-estimate of loss.
1  HCA 30.
2  EngR 135 at 855.
3 Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd  AC 79.
4 Ibid at 87.
5 Ringrow Pty Ltd v BP Australia Pty Ltd (2005) 224 CLR 656 at 10.
6  HCA 30 at 12.
7 Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co Ltd  AC 79 at 86.
8 Ibid at 87.
9  QSC 102.
10 Ibid at 113.
11 Esanda Finance Corp v Plessing (1989) 166 CLR 131 at 142.
12 Andrews v Australia and New Zealand Banking Group Ltd  HCA 30 at 10.
13 AMEV-UDC Finance Ltd v Austin (1986) 162 CLR at 170.
14  FCA 35.
15  FCA 35 at 202.
About McCullough Robertson
McCullough Robertson is a leading Australian independent law firm with industry experts combining legal expertise with deep industry knowledge and foresight. The firm provides innovative, relevant and commercial legal solutions to major corporate, government and high net worth individuals across Australia and internationally. Established in 1926, the firm’s major focus areas are the resources (mining and energy), food and agribusiness, technology, telecommunications, health, life sciences, real estate and financial services sector.
This article covers legal and technical issues in a general way. It is not designed to express opinions on specific cases. The article is intended for information purposes only and should not be regarded as legal advice. Further advice should be obtained before taking action on any issue dealt with in this publication.