The Supreme Court of Queensland last week clarified the law relating to penalties as it applies to liquidated damages clauses in construction contracts and, in so doing, provided welcome reassurance for many contracting parties operating within the construction industry across Australia.
The decision of Justice Peter Lyons in Grocon Constructors (Qld) Pty Ltd v Juniper Developer No. 2 Pty Ltd  QSC 102 related to the troubled Soul development in Surfers Paradise, over which receivers were appointed in late 2012 amid mounting financial difficulties.
Following completion of the $850 million building in 2011, the head contractor, Grocon Constructors (Qld) Pty Ltd (Grocon), sued the developer, Juniper Developer No. 2 Pty Ltd (Juniper), for more than $10 million it claimed remained owing. In response, Juniper counterclaimed for liquidated damages of more than $30 million.
The court was asked to consider (as a preliminary determination) whether the liquidated damages clause in the amended Australian Standard AS4300-1995 design and construct contract was a penalty and therefore void. If that were the case, not only would Juniper have been left with having to prove its actual loss arising out of delays to the project, a large proportion of construction contracts in Queensland (based on standard form contracts) would have been directly affected by the ruling.
Law relating to penalty clauses
Contractual clauses requiring the payment of money on breach of the contract are unenforceable if they are a penalty. Clauses are penalties where the amount payable on breach is not a genuine pre-estimate of the loss suffered as a result of the breach. Where a clause is found to be a penalty, the party is generally left with having to prove the damage caused by the breach, which can be difficult and costly.
Two key indicators of a penalty are where the amount payable is “extravagant and unconscionable” in comparison to the anticipated loss and where the clause requires payment of a single lump sum on the occurrence of a variety of events, some which may be significant and others trivial.
This so-called ‘penalty doctrine’ has been a hot topic in Australia in recent years due to the High Court decision in Andrews v Australia & New Zealand Banking Group Ltd (2012) 247 CLR 205 and Federal Court decision in Paciocco v Australia and New Zealand Banking Group Limited  FCA 35 which both arose from an ongoing class action against major commercial banks in Australia relating to the imposition of bank fees on customers.
The decision in Andrews changed the understanding of the penalty doctrine in Australia by widening its scope significantly so that it applied not just to clauses requiring payment on breach of the contract, but also to clauses requiring payment upon the occurrence of a condition that was not a breach (for example, bank fees). This significantly widened the scope of the penalty doctrine to clauses that would have been otherwise out of its reach.
Submissions by Grocon
In essence, Grocon argued that the liquidated damages clause was a penalty as it:
imposed substantial payment obligations on Grocon for trivial breaches of the contract that would not cause Juniper comparable loss; and
required payment of a single lump sum on the occurrence of a variety of events, some significant and some trivial.
This is because, under the contract Grocon was required to comply with detailed and sometimes minor requirements before practical completion could be achieved including, for example, the provision of correctly labelled keys for each unit. Grocon submitted that the clause was a penalty as the amount recoverable under it by Juniper was disproportionate to the loss that may be suffered if, for example, Grocon failed to provide a correctly labelled key.
Submissions by Juniper
Juniper argued that, for the penalty doctrine to apply, the amount payable under the liquidated damages clause must be extravagant or unconscionable when compared to the greatest possible loss that could flow from a breach of the clause, rather than the smallest loss as argued by Grocon.
In the present case, the loss caused by Grocon’s failure to achieve practical completion was Juniper’s inability to take possession of the property and in turn provide vacant possession to purchasers in order to settle the sales contracts, with the ultimate result that Juniper would suffer a loss of revenue.
It was also argued that the liquidated damages clause did not operate in respect of a variety of events, but only where Grocon failed to achieve practical completion by the specified date.
Ultimately, the judge held that the liquidated damages clause was not a penalty. This is because the clause operated where there had been a failure to achieve practical completion by the specified time which was a breach of a single obligation, notwithstanding that it may be consequential on a number of other minor breaches, and the loss suffered by Juniper by this breach was not disproportionate to the amount of the liquidated damages. This confirms most industry participants’ view of the enforceability of liquidated damages clauses in construction contracts.
The Grocon case could be distinguished from Andrews and Paciocco as the obligation for payment in those cases could be breached many times and in many ways, with each breach having different consequences.
This decision has left in place the pre-Andrews position that, unless a liquidated damages clause in a construction contract can be shown not to be a genuine pre-estimate of the party’s loss, it should not be considered a penalty. However, it would nonetheless be prudent to consider the practical implications of this decision, as outlined below.
Importance of record keeping
Another interesting aspect of this case was the decision of the judge in relation to the consideration that a court is able to give to extrinsic evidence (evidence outside the contract such as the surrounding circumstances) when determining whether a liquidated damages clause is a penalty. Ordinary principles of contractual construction generally only allow a court to consider this evidence in certain circumstances, such as to resolve an ambiguity in the meaning of a clause. However, the judge held that courts were also able to consider extrinsic evidence to determine whether a clause was a penalty, even where that evidence would be otherwise inadmissible.
For example, in the present case the extrinsic evidence considered by the judge resulted in him determining that both parties were sophisticated, legally represented, and suitably informed, and that they had negotiated at arm’s length in relation to the amount of liquidated damages to be included. This supported his finding that the liquidated damages clause was not a penalty. This finding reaffirms the importance of detailed record keeping throughout a construction project.
Had Grocon been successful in its arguments, it is likely that many construction contracts across Austraila would have undergone swift redrafting as it is common for parties to include detailed preconditions to practical completion such as site clean-up and provision of keys. As it stands, and absent an appeal or further judicial consideration, substantial redrafting of these provisions does not appear necessary.
However, liquidated damages clauses should always be drafted so as to maximise the likelihood that the clause will ultimately be held to be a genuine pre-estimate of the party’s loss by, for example:
carefully considering and calculating the actual losses that will be suffered as a result of a delay at the time of the formation of the contract;
providing evidence of those calculations to the other contracting party during negotiations; and
expressly acknowledging within the contract that the liquidated damages are a genuine pre-estimate.
Further, parties should retain evidence of how the amount was calculated and the negotiations to ensure that, if necessary, that evidence may be presented to the court.