In Short
- Liquidated damages clauses specify a pre-agreed amount for breach of contract.
- These clauses must be a genuine estimate of potential loss, not a penalty.
- Courts may invalidate penalty clauses that are deemed excessive or punitive.
Tips for Businesses
When drafting contracts, ensure liquidated damages clauses represent a fair estimate of potential losses rather than a penalty. This can help avoid legal disputes and ensure enforceability. Regularly review your contracts to align with current legal standards and protect your business interests.
Contracts outline the agreement between two or more parties. A contract should specify what is required of each party in certain circumstances and detail the benefits each party receives in return for taking on such obligations. This is particularly beneficial when a party breaches the terms of the arrangement, where the other party may be entitled to compensation. During contract formation, the parties may choose to predetermine the damages for breach rather than leave these consequences to the courts. These damages are known as ‘liquidated damages’. This article will discuss what liquidated damages are and how they differ from penalty clauses.
What Are Liquidated Damages?
Before forming a contract, the parties may determine the compensation to be paid if either party breaches a contract provision. Liquidated damages are widespread in contracts as they help to ensure that each party upholds their obligations. Liquidated damages can be a:
- set figure;
- percentage amount; or
- value that rises with inflation.
What Are Penalty Clauses?
Penalty clauses do precisely what they say; they penalise a party for breaching an element of their contractual agreement. By intention, penalty clauses and liquidated damages clauses are very similar, as they both act to pre-determine a remedy in the event of a breach. However, a clause that has been classed as a penalty is not enforceable.
Commercial disputes are costly, stressful and can damage your business reputation. LegalVision’s free Guide to Resolving NZ Business Disputes can help.
Main Differences Between Liquidated Damages and Penalty Clauses
Differing Amounts
In the case of damages, parties will predetermine a remedy before a contract takes effect. Generally, if the compensation sought is disproportionately more significant than the non-breaching party’s loss, this clause may be considered a penalty clause instead. Therefore, if you include a liquidated damages clause in your contract, you must ensure the compensable amount is not unconscionable or extravagant, as this will render the clause unenforceable.
Nature of the Party
Another issue that may make your liquidated damages clause a penalty is the nature of the two parties. The courts will consider the relationship between the two parties to determine if a liquidated damages clause is a penalty. For example, if the party enforcing the clause is in a relatively higher bargaining position than the other party, the courts will be more likely to rule the clause a penalty. To determine this, the courts will examine contract fairness, the commercial context of the contract, and whether both parties obtained independent legal advice to ensure neither party is being taken advantage of.
When Will They Be Enforceable?
A liquidated damages claim will generally be enforceable if the party has broken the obligation the clause covers. However, if the clause penalises a party for breach rather than just compensating the non-breaching party, it may not be enforceable under New Zealand law.
Key Takeaways
Contracts are the best way to ensure all parties uphold their obligations in an agreement. It also helps outline what rights that each party has. Some contracts will include a liquidated damages clause. A liquidated damages clause is a pre-determined figure paid to one party following a contract breach. However, there are circumstances when this clause may be considered a penalty clause. These include if the:
- amount of damages is disproportionate to the loss incurred; or
- bargaining position of one party is much higher than the other.
If you need any legal assistance with damages, our experienced contract lawyers can assist as part of our LegalVision membership. For a low monthly fee, you will have unlimited access to lawyers who can answer your questions and draft and review your documents. Call us today at 0800 005 570 or visit our membership page.
Frequently Asked Questions
Yes, other clauses can be considered a penalty if they are disproportionately more than the loss incurred.
Yes you can still claim damages but the amount you get might be a lot less than what was predetermined in your contract.
We appreciate your feedback – your submission has been successfully received.
