Reading time: 5 minutes

Contracts will outline an agreement between two or more parties that allows all parties to benefit. Indeed, a contract will contain what is required of each party in specific circumstances. Contracts are essential as they are a legal document you can use in a court of law to enforce the provisions of that agreement. However, there may be cases where either party does breach the terms of the contract. If one party breaches the contract, the other party may be entitled to compensation. During the contract formation, the parties usually predetermine the damages. Indeed, these damages are called liquidated damages. Depending on what provision of the contract one of the parties has breached, there may be differing amounts. This article will discuss what liquidated damages are and how they are different from penalty clauses.

What Are Liquidated Damages?

Before forming a contract, the parties will determine the necessary compensation paid if either party were to be in breach of contract. Liquidated damages is any compensation established by parties during contract formation. Liquidated damages are popular in contracts as they ensure that each party upholds their obligations. Liquidated damages can be a set figure that rises with inflation, depending on the contract

What Are Penalty Clauses?

Ordinarily, a penalty clause is a liquidated damages clause that is classed as a penalty. However, other clauses can be classed as a penalty too. A clause that has been classed as a penalty is not enforceable. Generally, if the damages sought are disproportionately more significant than the party’s loss, a clause may be considered a penalty. 

Main Differences Between Liquidated Damages and Penalty Clauses

Differing Amounts

Ordinarily, parties will predetermine an amount before a contract takes effect. The clause will likely be classed as a penalty if this amount is unconscionable or extravagant. Therefore, if you include a liquidated damages clause in your contract, you must ensure it is in proportion to the loss incurred because of that breach of contract. If it is not, your clause will not be enforceable.

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 to ensure neither party is being taken advantage of. The court will also look at the agreement’s wording to determine if the clause is a penalty.

View Post

When Will They Be Enforceable?

A liquidated damages claim will always be enforceable if the party has broken the obligation that the clause covers. However, if the clause turns out to be a penalty, it may not be enforceable under New Zealand law. 

The law now rarely considers a clause to be a penalty. This is because the courts must look at the broader business interests when considering the loss that has been sustained. The courts are now more interested in protecting the legitimate interest of the party in a contract. The court considers this more important than whether the predetermined amount is an accurate estimate of the loss. This means that the number of pre-agreed damages can be higher than the direct loss sustained. However, the courts can still rule a clause is a penalty if the damages clauses are exorbitantly greater than the loss incurred. The court will also consider whether one party is in a higher bargaining position.

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. Most contracts will include a liquidated damages clause. A liquidated damages clause is a pre-determined figure that will be 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

However, the courts are now less likely to class a class as a penalty if both parties predetermined the sum. The courts will look at what interest the contract is trying to protect and if the sum of money will cover that interest. If you need any legal assistance with damages, contact LegalVision’s experienced contract lawyers on 0800 005 570 or fill out the form on this page.

Frequently Asked Questions

Can other clauses be determined penalty clauses?

Yes, other clauses can be considered a penalty if they are disproportionately more than the loss incurred.

Can damages still be claimed if a liquidated damages clause is considered a penalty?

Yes you can still claim damages but the amount you get might be a lot less than what was predetermined in your contract.

About LegalVision: LegalVision is a commercial law firm that provides businesses with affordable and ongoing legal assistance through our industry-first membership.

By becoming a member, you'll have an experienced legal team ready to answer your questions, draft and review your contracts, and resolve your disputes. All the legal assistance your business needs, for a low monthly fee.

Learn more about our membership

Need Legal Help? Get a Free Fixed-Fee Quote

If you would like to receive a free fixed-fee quote or get in touch with our team, fill out the form below.

Our Awards

  • 2019 Top 25 Startups - LinkedIn
  • 2020 Excellence in Technology & Innovation Finalist – Australasian Law Awards
  • 2020 Employer of Choice Winner – Australasian Lawyer
  • 2021 Fastest Growing Law Firm - Financial Times APAC 500
  • 2021 Law Firm of the Year - Australasian Law Awards
  • 2020 Law Firm of the Year Finalist - Australasian Law Awards