Anybody who enters into contracts as part of a construction contract will be familiar with the idea of “liquidated damages”. These clauses outline the amount of money which is payable by a party who breaches the contract. The amount payable under a liquidated damages clause is meant to be a genuine pre-estimate of the damage which will be suffered by the innocent party as a result of the breach. The amount does not have to be entirely correct, but it needs to be genuine.
Almost all commercial building contracts include a liquidated damages clause. The courts have adopted a policy that it is not permissible to penalise a party by specifying an entirely unreasonable amount of liquidated damages.
A liquidated damages clause is used in a contract because of a long standing rule of law that the Courts will not enforce a penalty provision in a contract. Historically, New Zealand law on the doctrine of penalties has been based on United Kingdom law.
The UK Courts have confirmed that a clause in a contract which imposes an additional obligation on the guilty party will not be a penalty unless the additional obligation is out of all proportion to the interest which the clause seeks to protect. The obligation to be protected may simply be an obligation to pay money. However, it may well be a much wider obligation such as an obligation to supply products, or some other obligation to behave in a particular way. The “penalty” provision may impose more onerous obligations on the party breaching the contract, or it may provide for some other right for the innocent party as a result of the breach.
For example, the contract between A and B might provide for A to supply goods to B, but has an obligation to sell a specified volume of those goods in a market. The contract might provide that in the event that B fails to sell the specified volume of goods, A can increase the price of the goods, or appoint an additional distributor. A might also be able to require payment of some amount of compensation for the breach.
As the law stands in New Zealand, the right of the innocent party to appoint another distributor will not be at risk of being a penalty. The right of the innocent party to be paid compensation may be held to be a penalty, and therefore unenforceable, if it imposes a detriment on the contract breaker which is out of all proportion to any legitimate interests of the innocent party to the contract in the performance of the primary obligations under the contract.
If, as in many cases, the interests of the innocent party will not extend beyond compensation for breach of contract, the use of a liquidated damages clause will still be appropriate.