Liquidated damages

Liquidated damages (also referred to as liquidated and ascertained damages) are damages whose amount the parties designate during the formation of a contract^[1] for the injured party to collect as compensation upon a specific breach (e.g., late performance).^[1]

When damages are not predetermined/assessed in advance, then the amount recoverable is said to be 'at large' (to be agreed or determined by a court or tribunal in the event of breach).

Common law

At common law, a liquidated damages clause will not be enforced if its purpose is to punish the wrongdoer/party in breach rather than to compensate the injured party^[2] (in which case it is referred to as a penal or penalty clause).^[3] One reason for this is that the enforcement of the term would, in effect, require an equitable order of specific performance. However, courts sitting in equity will seek to achieve a fair result and will not enforce a term that will lead to the unjust enrichment of the enforcing party.^[4]

In order for a liquidated damages clause to be upheld, two conditions must be met.

• First, the amount of the damages identified must roughly approximate the damages likely to fall upon the party seeking the benefit of the term.^[3]
• Second, the damages must be sufficiently uncertain at the time the contract is made that such a clause will likely save both parties the future difficulty of estimating damages.

Damages that are sufficiently uncertain may be referred to as unliquidated damages, and may be so categorized because they are not mathematically calculable or are subject to a contingency which makes the amount of damages uncertain.

Example

For example, suppose Neal Townsend agrees to lease a store-front to Richard Odness, from which Richard intends to sell jewelry. If Neal breaches the contract by refusing to lease the store-front at the appointed time, it will be difficult to determine what profits Richard will have lost because the success of newly created small businesses is highly uncertain. This, therefore, would be an appropriate circumstance for Richard to insist upon a liquidated damages clause in case Neal fails to perform.

In the case of construction contracts, courts have occasionally refused to enforce liquidated damages provisions, choosing to follow the doctrine of concurrent delay when both parties have contributed to the overall delay of the project.

Contracts in the NEC3 family use the term 'low service damages' (optional clause X.17) and generally include a Low Service Damages Schedule.^[5]

The law applied to bank and credit card charges

UK bank and credit card customers were being charged as much as £39 for a single transaction that took them over their credit limit. Consumers argued these charges were well beyond the cost of sending a computerised letter.

In 2007 the Office of Fair Trading investigated the charges being imposed on customers of credit card companies. In its report, the OFT claimed these charges were unlawful under UK law as they amounted to a penalty. It said it would be prepared to investigate any charge over £12, though this was not intended to indicate that £12 is a fair and acceptable charge. The OFT said it would be up to a court to determine such an amount based on the established legal precedent that the only recoverable cost would be actual costs incurred.

The credit card companies did not produce evidence of their actual costs to the OFT, instead insisting their charges are in line with clear policy and information provided to customers.

In 2009 the Supreme Court ruled (see Office of Fair Trading v Abbey National plc) that terms in bank account contracts were not capable of being penal, bar those applicable to NatWest Bank customers between 2001 and 2003.^[6] The court ruled that the charges were a charge for a service, and not a penalty for damages for breaching a contract term.

Uniform Commercial Code

In the United States, Section 2-718(1) of the Uniform Commercial Code provides that, in contracts for the sale of goods:^[7]

Damages for breach by either party may be liquidated in the agreement but only at an amount which is reasonable in the light of the anticipated or actual harm caused by the breach, the difficulties of proof of loss, and the inconvenience or nonfeasibility of otherwise obtaining an adequate remedy. A term fixing unreasonably large liquidated damages is void as a penalty.

This largely mirrors the common law rule, which applies to other types of contracts under the law of most US states.

Other legal systems

Civil law

Civil law systems generally impose less severe restrictions on liquidated damages. For example, Article 1226 of the French Civil Code provides for clause pénale, a variant of liquidated damages which combines compensatory and coercive elements. Judges may adjust excessive contract penalties, but such clauses are not generally void as a matter of French law.^[8]

Article 420-1 of the Civil Code of Japan provides an even firmer basis to uphold contractual penalties:^[9]

1. The parties may agree on the amount of the liquidated damages with respect to the failure to perform the obligation. In such case, the court may not increase or decrease the amount thereof.
2. The liquidated damages shall not preclude the demand for performance or the exercise of the cancellation right.
3. Any penalty is presumed to constitute liquidated damages.

In the U.S. state of Louisiana, which follows a civil law system, liquidated damages are referred to as "stipulated damages".^[10] Prior to 1 January 1985, Louisiana law used the term “penal clause” under former article 2117 of the Civil Code.^[11] Stipulated damages create a secondary obligation for the purpose of enforcing the principal obligation. The aggrieved party may demand either the stipulated damages or performance of the principal obligation, but may not demand both except for delay.^[12] Stipulated damages may not be modified by the court (and will therefore be enforced) "unless they are so manifestly unreasonable as to be contrary to public policy".^[13]

Islamic law

Islamic law prohibits gharar (uncertainty) in contracts, and liquidated damages provisions are a favored mechanism to overcome uncertainty regarding contractual damages.^[14]

References

see also Esanda Finance Corp v Plessing (1989) 166 CLR 131^[1] and Andrews v ANZ Banking Group Ltd [2012] HCA 30 (6 September 2012) ^[2]

See also

• Unspecified claim
• Penal bond

1. ↑ http://www.austlii.edu.au/au/cases/cth/HCA/1989/7.html
2. ↑ http://www.austlii.edu.au/cgi-bin/sinodisp/au/cases/cth/HCA/2012/30.html