Unconscionably harsh termination clauses are void as a penalty

Unconscionably harsh termination clauses are void as a penalty

In Zachariadis v Allforks Australia Pty Ltd [2009] VSCA 258 the Victorian Court of Appeal upheld an appeal from a decision of the County Court and held that a liquidated damages clause in breach of contract was not a genuine pre-estimate of damages and was subsequently void as a penalty. 

Facts

In 2006 Zachariadis, as director of Priority Road Express Pty Ltd (PRE), entered into four agreements with Allforks Australia Pty Ltd (Allforks) for the hire of forklifts that contained guarantees.  The termination clauses of the agreements stipulated that PRE would be required to pay all charges which would have been payable from the date of termination to the expiry date of the agreements if the agreements were terminated within the hire period. 

After a period of four months, PRE went into receivership and consequently breached the hire agreements by failing to pay charges owing.  The agreements were terminated and Allforks sought liquidated damages for outstanding charges as well as charges that would have been payable from the date of termination to the expiry date, as per the termination clause.   

At first instance, judgment was found in favour of Allforks.  It was held that clauses requiring payment for the unexpired term of the relevant hire agreement did not impose a penalty.  

Decision

The Court of Appeal subsequently found in favour of the appellant, Zachariadis.  In considering whether the termination clause was a penalty or provision for payment, it was held that a sum fixed by a contract is a penalty only if it is ‘extravagant and unconscionable’ in comparison with the greatest loss that could conceivably be proved to have followed from the breach.

The applicable test was the “out of all proportions” test applied in Amev-UDC Finance Ltd v Austin (1986) 162 CLR 170, where it was held that if there was a significant disproportion between the sum agreed to be paid and a genuine pre-estimate of damages, then the sum should be held to be a penalty.  

The Court of Appeal outlined the relevant termination clause void as a penalty because:

• it did not provide a means of calculating the net loss Allforks would suffer if the hire agreement was terminated early;
• there would have been no difficulties in establishing the quantum of any genuine pre-estimate loss suffered as a result of the breach if the parties had drafted a clause providing a formula for a pre-estimation of loss likely to be suffered; and
• the requirement to pay all future charges under the agreement applied in the event of ‘any breach’ which gave right to termination.  The lack of any relationship between the breach and the amount payable under the clause indicates that the clause was not a genuine pre-estimate of loss.

Implications

The decision provides a reminder to parties negotiating a contract that difficulties can arise in establishing the quantum of any loss suffered if there is no means of calculating the loss in the event of a breach.  Parties should be aware that a liquidated damages clause may be construed as a penalty if it is not drafted with a genuine pre-estimate of the loss likely to be suffered in the event of a termination or breach, no matter how trivial the termination or breach.  If a Court determines the clause to be a penalty, then it will be void.