Liquidated damages clauses and unenforceable penalties

In many commercial contracts, parties seek to agree liquidated damages amounts or formulas to determine such
amounts resulting from any breach, which are meant to be a genuine pre-estimate of the loss that would be suffered by
the non-defaulting party as a result of the breach.

In Australia, the law of contract upholds the freedom of the parties, with no relevant disability, to agree upon the terms of their future relationships. However, if the impugned liquidated damages clause is found to be a penalty, the general rule is that term will be unenforceable.

It is not merely the words used in the contract to determine whether or not the amount claimed is a penalty and
consequently unenforceable. The Courts look to the facts. In a recent Victorian Court of Appeal decision [2017] VSCA
161 (23 June 2017), an applicant initially sought to borrow 50% of the value of a property to be mortgaged, with an
estimated value of $1,775,000. The lender required an establishment fee calculated at 1.5% of the loan, and that would be the fee payable if the loan proceeded; i.e. $26,625.

The valuation of the property to be mortgaged came in at slightly over $1,000,000 and the lender indicated it would be willing to only lend $500,000. However the lender insisted that the initial establishment fee (1.5% of $1,775,000) remained payable, even though an establishment fee at the rate of 1.5% on the $500,000 loan would only be $7,500. The higher establishment fee was claimed by the lender as appropriate because of the additional administrative work undertaken in respect of the proposed loan.

The borrower did not proceed on the loan transaction. The lender sought to recover the establishment fee. It was
successful at first instance, but failed in the Court of Appeal. The court noted that a contractual term will not be a penalty if it protects the legitimate commercial interests of the non-defaulting party under the contract.

The ultimate question for the court to determine was whether the stipulation is “a genuine pre-estimate of the innocent party’s probable or possible interest in the due performance of the principal obligation or a penalty merely inserted to secure the enjoyment of a collateral object.”

The decision reflects the situation that the precise wording of the liquidated damages clause is not determinative of the enforceability of the clause. The court looks deeply into the transaction and whether or not the amount sought to be claimed under the liquidated damages clause lacks any proportionality to the loss likely to be suffered as a result of the breach. In this case the Court inferred that the lender retained the higher establishment fee to punish the borrower for the inconvenience caused in the lead up to the loan.

Any sums claimed “out of all proportion” to the likely loss, will be unenforceable.