When are LDs a penalty?

In brief

The Supreme Court of Queensland recently considered whether liquidated damages in a standard form construction contract were a penalty. In a decision that traversed long-held doctrines on penalties and recent developments in Andrews and Paciocco, the court ruled that the obligation to pay liquidated damages in this case was not penal. Partners Nick Rudge and David Donnelly and Lawyer James Waters report.

Summary

In Grocon Constructors (Qld) Pty Ltd v Juniper Developer No. 2 Pty Ltd & Anor [2015] QSC 102, Justice Peter Lyons held that a liquidated damages clause is not a penalty where the obligation to pay liquidated damages depends solely on the failure to achieve Practical Completion by the Date for Practical Completion.

His Honour observed that there may be many causes of a failure to achieve Practical Completion by the Date for Practical Completion, some of which may be relatively minor, while others may be serious. However, the obligation to pay liquidated damages only arose due to a delay in achieving Practical Completion rather than the reasons underlying such a failure.

In addition, his Honour held that extrinsic evidence is admissible to determine whether the rate of liquidated damages was a genuine pre-estimate of the greatest conceivable loss that a party may suffer from the other party's breach.

Background

Grocon was engaged by Juniper to design and construct a mixed-use development in Surfers Paradise under a modified AS4300-1995 contract. As is typical, the parties' contract provided that:

• Grocon was obliged to complete the work under contract so as to achieve Practical Completion by the Date for Practical Completion;
• the initial Date for Practical Completion could by extended by extensions of time;
• the Date of Practical Completion was defined as being the date on which the Independent Certifier certified that Practical Completion was achieved; and
• if Grocon failed to achieve Practical Completion by the Date for Practical Completion it would become liable for liquidated damages at various rates depending on the length of delay in achieving Practical Completion.

The definition of Practical Completion for each separable portion included the usual requirements, such as that the works were complete, fit for occupation and use, and free from all but minor defects or omissions. In addition, the definition required achievement of a number of specific and detailed requirements, including:

• two sets of keys for the works, with plastic key tags having approved label inserts;
• that all fittings, including kitchen appliances, must be installed and fully operational; and
• that the works were completed to allow Juniper to meet its obligations under sale contracts for residential units in the development.

The dispute

Both parties agreed that Grocon bore the onus of establishing that the impugned clause was a penalty.

Grocon submitted that:

• it had completed the works, apart from some minor defects or omissions that would result in it being liable under the liquidated damages clause;
• if one of the keys was fitted with a non-approved label insert, or a single kitchen appliance was non-operational, Grocon would be liable for substantial financial costs under the liquidated damages clause;
• there was a presumption that the liquidated damages clause was a penalty. In Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd [1914] UKHL, Lord Dunedin set out a number of well-accepted principles and presumptions that assist in determining whether a liquidated damages clause is enforceable or is unenforceable because it is a penalty;
• on the basis of Dunlop, a minor omission in the achievement of Practical Completion, such as a missing key tag, could not be expected to cause Juniper substantial damage, while other defects or delays could cause serious damage to Juniper. The payment of a daily rate of liquidated damages, regardless of the seriousness of the failure to achieve Practical Completion, meant that the liquidated damages clause ought to be presumed to be a penalty;¹
• the liquidated damages clause was a penalty under the framework in Andrews v Australia and New Zealand Banking Group Limited [2012] HCA 30. It submitted that achieving Practical Completion by the Date for Practical Completion formed a primary stipulation and that the liquidated damages clause contained a collateral (or accessory) stipulation that imposed on Grocon an additional or different liability, or detriment, to the benefit of Juniper in the event of the failure to satisfy the primary obligation; and
• accordingly, the liquidated damages clause was a penalty because it was in the nature of security for, and in terrorem of, the satisfaction of the achievement of Practical Completion by the Date for Practical Completion.

Juniper argued that the penalties doctrine was engaged where the amount of liquidated damages were extravagant or unconscionable in comparison with the greatest conceivable loss flowing from the breach of the obligation. Addressing its loss, Juniper submitted that a failure to achieve Practical Completion by the Date for Practical Completion meant that it could not give vacant possession to potential purchasers and that in this period it may suffer very serious loss from a collapse in the market.

The decision

Penalties: general principles

Justice Lyons set out Lord Dunedin's principles on the analysis of penalties and liquidated damages in Dunlop, stating that the critical essence of liquidated damages is that they are a genuine covenanted pre-estimate of damage. The difficulty in accurately pre-estimating damage is not determinative of whether an obligation is a penalty. Rather, it is a reason that supports a finding that the parties' pre-estimate was a true bargain. Similarly, in light of principles of freedom of contract, courts are generally reluctant to redraft an agreed rate of damages between parties unless the alleged penalty is 'extravagant and unconscionable in amount' or 'out of all proportion' compared to a party's greatest conceivable loss.²

In relation to Andrews, his Honour reiterated that the doctrine of penalties was no longer limited to instances of breach, hence the High Court's reference to primary and collateral stipulations so as to permit broader application of the revised doctrine.³

Characterisation of the liquidated damages clause

Characterisation of the obligation to pay liquidated damages was at the crux of Justice Lyons' analysis. His Honour held that:

• the words used by the parties to describe the obligation in question are not determinative of whether it is a penalty;⁴
• the process of characterising the obligation to pay liquidated damages is grounded in substance (over form), due to its equitable origins;⁵
• the critical task in characterising the impugned clause was to identify the breach on which a sum of money becomes payable; and
• in the present case, liquidated damages were only payable when there was delay in reaching Practical Completion. There were no other causes for which liquidated damages were payable. While it was true that there were many causes that could result in a failure to achieve Practical Completion as a matter of fact, only the failure to achieve Practical Completion by the Date for Practical Completion resulted in an obligation to pay liquidated damages. His Honour observed that this view was supported by the balance of authority.⁶

Justice Lyons rejected Grocon's argument that the liquidated damages clause imposed an 'additional detriment', as referred to in Andrews, and that this supported the characterisation as a penalty. His Honour held that the reference in Andrews to an 'additional detriment' in relation to an alleged penalty was intended to distinguish between the general damages available for failure of the primary stipulation. In the present case, the fact that the liquidated damages clause was different from general damages for Grocon's delay in achieving Practical Completion was not sufficient to make it a penalty.⁷

His Honour distinguished the application of Paciocco to the process of characterisation, as the various breaches in that case resulted in vastly different consequences. In the present case, the operation of the liquidated damages clause arose solely because of Grocon's delay in achieving Practical Completion. As a result, the liquidated damages clause was found to not be a penalty.

An exception to the parol evidence rule: a genuine pre-estimate of loss

The case also provides guidance on the evidence courts will use to determine whether an agreed damages is a genuine pre-estimate of loss. The parol evidence rule limits the process of contractual construction to the parties' written agreement. However, as the doctrine of penalties is concerned with whether the parties should be held to the damages they have agreed, rather than what they agreed, this forms an exception to the parol evidence rule.⁸ Courts typically consider extrinsic evidence of the circumstances and the full context that gave rise to the clause.⁹ In the present case, the court considered evidence of the parties':

• lengthy negotiations;
• sophistication;
• agreement of a tiered liquidated damages structure; and
• exchange of financial information that estimated Juniper's loss in the event of delay.

These factors led the court to hold that the clause was a genuine pre-estimate of loss and not a penalty.