| Victorian Court of Appeal confirms approach to liquidated damages | |||
| 25 January 2010 | |||
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A recent Victorian Court of Appeal decision has reviewed the test applying to 'liquidated damages' clauses. Specifically, the court has confirmed the approach to deciding whether a clause providing for payment of a monetary sum upon breach of contract is valid as a liquidated damages clause, or void as a penalty. The decision In Zachariadis v Allforks Australia Pty Ltd, the Victorian Court of Appeal upheld an appeal from the County Court, holding that a liquidated damages clause in a hire agreement was void as a penalty. The clause in dispute provided that if the hire agreement was terminated for, among other things, any breach of the agreement by the hirer, the hirer "shall ... pay to Allforks all Hire Charges that would otherwise have been be payable from the date of termination of ... to the Expiry Date." The Court of Appeal held that the clause was a penalty. In doing so, it confirmed that the relevant test is the "out of all proportion test". Under this test, a clause will be a penalty if the amount payable on default is "extravagant and unconscionable" or "out of all proportion" to the greatest loss that might flow from the breach. The court also confirmed that the "out of all proportion test" is to be applied by reference to the circumstances existing at the time the agreement was made, not at the time of the breach. Accordingly, it is not permissible for the court to compare the actual loss suffered with the amount payable pursuant to the clause. The court held that the relevant clause was a penalty because:
The court observed that some breaches would produce little, or no, loss but if breached and the agreement terminated as a result, would render the hirer liable to pay the whole of the outstanding rent. The court said that "the lack of any relationship between the breach and the amount payable under [the] clause … indicates that the clause was not a genuine pre-estimate of loss". The court distinguished an earlier decision (Yarra Capital Group Pty Ltd v Sklash [2006] VSCA 109) where a clause in a short term loan agreement between money lenders which provided for payment of default interest at a very high rate on default was held not to be a penalty. It was relevant to this finding that it would have been an extremely complex and expensive exercise to establish, with any sort of precision, what damage was likely to flow as a result of a failure to repay the principal on the due date. This was because the parties operated in the short term money market where the cost of borrowing was very high. What should you do? The case provides a timely reminder for parties negotiating contracts to ensure that liquidated damages clauses truly represent a genuine pre-estimate of the innocent party's loss in the event of a breach of contract. Clauses which apply in a variety of circumstances (e.g. for any breach, however trivial) are likely to fall foul of the law relating to penalties. Where possible, it is good practice to agree on a formula for calculating the likely loss. This formula can provide for matters otherwise not known to the defaulting party, e.g. costs that the innocent party would incur as a result of the breach under its own hire purchase agreement with a financier. |
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