A Good Faith Perspective on Liquidated Damages

Abstract

Except to the extent that they have provided for a different result, the parties to a legally binding contract are taken to have agreed to pay such damages as the law requires on any breach of the agreement. The ability to provide for a different result includes an ability to agree in advance what damages are payable in the event of breach. An agreed damages clause is such an agreement. Our principal concern, as the title to the paper indicates, is to examine the role of good faith in relation to the distinction between liquidated damages and penalties, and the process of characterization that the distinction requires. To some extent the paper is prompted by the recent decision of the High Court of Australia in Ringrow Pty Ltd v BP Australia Pty Ltd. Most of the cases on agreed damages clauses which have come before the courts in the past 40 years have involved chattel leases and hire-purchase agreements. Those decisions have tended to push the law of penalties in a particular direction, and led to suggestions that the law requires substantial accuracy between the estimated sum and the amount likely to be awarded in a common law claim. The importance of Ringrow is that it has arrested that development. Thus, the High Court approved and applied a statement of principle by Mason and Wilson JJ in AMEV-UDC Finance Ltd v Austin, to the effect that an agreed sum is only characterized as a penalty if it is out of all proportion to damage likely to be suffered as a result of breach. The High Court in Ringrow saw this approval and application as a necessary reassertion of the approach to liquidated damages enshrined in the classic decision of the House of Lords in Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd, emphasizing the role of freedom of contract. Nevertheless the idea that an agreed damages clause will be characterized as a penalty only if it is out of all proportion, should not be taken at face value. There are, of necessity, limitations on the out of all proportion test. The view which we wish to put forward is that a good faith perspective assists in explaining not only why the High Court was correct in Ringrow to reassert the out of all proportion test, but also the limits on that test.