Understanding Penalty Clauses: Why Your breach and damages clause may not be protecting you
O*NO! You’ve had a client/supplier/contractor or other third party sign a contract, however you’ve just now realised you’ve included a penalty clause. You’ve done this in a bid to protect yourself and have some recourse for when things go wrong. In a contract, the parties will generally agree to what will happen if one party breaches it. These provisions will either be a damages clause, which is enforceable, or a penalty clause which is not enforceable, and now you’re operating under a false safety blanket. What should you do?
This blog takes a deep dive into the world of contracts and penalty clauses, and how you can future-proof your arrangements and safeguard your interests.
What is a penalty clause?
A penalty clause is a provision in a contract that imposes a penalty on a party who fails to fulfill their contractual obligations or breaches the contract. This penalty is often in the form of harsh monetary payments and is designed to discourage non-performance or breaches by making it costly for the defaulting party. At first glance, this seems fair. However, things get murky when the proposed penalty amount is far greater than the actual loss or damages that could be suffered from the breach or non-performance.
According to the courts, a payment that is ‘extravagant’ and ‘unconscionable’ when compared to the greatest loss or damage that could be suffered is a penalty.
How can you include a damages clause without it being a penalty?
A penalty clause is designed to punish a party by imposing a disproportionally high fees, making it unenforceable. Alternatively, you can include a liquidated damages clause, which, when drafted appropriately will be enforceable. Liquidated damages clauses represent a pre-agreed estimation of the actual loss that would occur due to a breach. They are typically enforceable if they are a reasonable forecast of the probable damages. For this clause to be enforceable, it must be a "genuine pre-estimate" of the damages. This means you need to have made a sincere effort to calculate the potential cost of each breach.
Case Study Examples
Real Estate Scenario: Let’s say an agent is involved in an off-the-plan property sale, and now faces a challenge when the vendor failed to pay the agreed commission by the settlement date specified in the listing agreement. As per the terms, the commission was due upon settlement, and any delay incurred interest charges. Despite repeated reminders, the vendor's late payment triggers the agent’s right to charge interest on the outstanding amount. If this sum is excessive and meant to punish rather than compensate for actual losses, it could be considered a penalty and potentially unenforceable in court. However, if the sum reasonably reflects the expected loss due to the delay, it could be enforceable as liquidated damages.
Commercial Lease Scenario: In a commercial lease agreement, there might be a clause that imposes a penalty on the tenant for late rent payments. For instance, a clause stating that a tenant must pay an additional $500 for each day the rent is late. If $500 per day is excessively high and not tied to any actual loss incurred by the landlord, it may be viewed as a penalty. On the other hand, if the additional amount is reasonable and reflects the potential loss of income or inconvenience to the landlord, it might be enforceable.
Construction Contract Scenario: In a contract for building a new property, a penalty clause might require the contractor to pay $1,000 for each day the project is delayed beyond the agreed completion date. The enforceability of this clause would depend on whether $1,000 per day is a reasonable estimate of the loss the property owner would suffer due to the delay (e.g., lost rental income or additional financing costs).
Real World Case – ANZ Bank: In this case, the ANZ bank was charging a $20 late fee payment. The court had to determine whether this was a penalty clause, as the actual loss suffered per late payment was no more than $3. Despite the fee exceeding the actual loss, the court ruled that it was not a penalty, considering ANZ's broader financial interests such as operational costs, loss provisioning, and regulatory capital costs. Thus, the late payment fee was upheld.
What can you do to avoid the risks of penalty clauses?
It can be difficult to find the line between an enforceable damages clause and unenforceable penalty clause. The common clauses that may fall under the penalty risk include late payment fees, fees for cancellations or rescheduling if you’re a service provider, performance delays, early termination fees, which we often see in franchise or lease agreements, and non-completion penalties.
To avoid penalty clauses in your contracts:
Clear Language: Use clear and precise language to define obligations and consequences. Ambiguities can lead to disputes over the interpretation of the clause.
Focus on Liquidated Damages: Instead of penalties, use liquidated damages clauses that are a genuine pre-estimate of the loss that might occur due to a breach. Ensure these amounts are reasonable and justifiable.
Document the Calculation: Keep records of how you arrived at the liquidated damages figure. This documentation can help demonstrate that the amount is a reasonable estimate of potential losses.
Alternatives to Fees: You should consider whether imposing a fee is necessary for a breach, or if other avenues such as dispute resolution like a negotiation can be undertaken to resolve it.
Legislative Requirements: Ensure you’re in compliance with the relevant legislations and regulations, as some have processes for applying damages. For example, the Franchise Code requires reasonable time to be given to a party to remedy a breach.
Consult Legal Advice: Work with a lawyer to draft and review your contracts. They can help ensure that your clauses comply with legal standards and are likely to be enforceable.
Negotiate Fair Terms: During contract negotiations, ensure that both parties agree on the terms and understand the consequences of a breach. Fair and mutually agreed-upon terms are less likely to be seen as penalties.
Regular Reviews: Periodically review and update your contracts to ensure they remain compliant with current laws and reflect any changes in your business operations.
Key Takeaways:
The primary aim of a penalty clause is to ensure that all parties adhere to their contractual obligations. By imposing a financial penalty for non-compliance or breach, it creates a strong incentive to fulfill the terms of the contract.
A penalty clause is not enforceable as it is a disproportionately high financial punishment imposed.
Instead, use a liquidated damages clause to protect yourself in case of a breach. These clauses are typically enforceable if they are a reasonable forecast of the probable damages.
To avoid the risks of unenforceable penalty clauses, when drafting your contracts use clear language, include liquidated damages clauses, document the calculation process of the pre-estimate damages, find alternatives to monetary remedies, ensure legislative compliance, regular audits of your contracts, negotiate with the other party, and when in doubt, have a lawyer take on the stress and draft and review your contracts.
Your Next Steps
Whether it’s a sales contract, contractor arrangement, services agreement, or other third-party contract it's crucial to future-proof your agency with a rock-solid, legally enforceable contract. Let our real estate agency law experts guide you through the process. Book your discovery call today and to see how we can help protect your business.
Boring legal stuff: This article is general information only and cannot be regarded as legal, financial or accounting advice as it does not take into account your personal circumstances. For tailored advice, please contact us. PS - congratulations if you have read this far, you must love legal disclaimers or are a sucker for punishment.