Many Australian contracts include clauses that impose financial consequences if a party breaches the agreement. But not all such clauses are enforceable. If a clause is considered a penalty, it won’t hold up in court – even if both parties agreed to it!
This guide, prepared by our seasoned contract law team, explains the difference between penalties and liquidated damages, how Australian courts approach them, and how you can use these clauses to safeguard your contracts in 2025.
Key Takeaways
Penalties are unenforceable if they go beyond what’s reasonably necessary to protect the other party’s interests.
Liquidated damages are enforceable if they represent a genuine pre-estimate of the loss likely to result from a breach.
- Proportionality and documentation are critical, especially for high-value contracts.
Clauses must be tailored to the specific breach and commercial context to avoid being struck down.
What is a Penalty Clause in Australian Contract Law?
A penalty clause is a contract term that imposes a financial or other detriment on a party for breaching the contract, where that detriment is not a genuine estimate of potential loss. Its primary purpose is to deter breach or punish the party in default.
Under Australian law, penalty clauses are void and unenforceable. If struck down, the non-breaching party must prove actual loss under general contract principles to recover damages.
Penalties vs Liquidated Damages: The Crucial Difference
The fundamental difference lies in their intent and effect:
- Liquidated Damages are enforceable because they reflect a genuine, good-faith attempt to estimate real loss at the time the contract is formed.
- Penalties are typically a pre-agreed sum or detriment designed to punish the breaching party or deter breach, which is disproportionate to the legitimate interest in performance, making them unenforceable.
Tip: Courts will look at the substance of the clause, not labels. Calling a clause “liquidated damages” won’t save it if it’s punitive in nature (i.e. it acts as a penalty).
Liquidated damages can also be considered unenforceable in special circumstances, learn more in our article.
How This Affects Your Business
For business owners, these clauses are more than legal technicalities – they can directly impact cash flow, legal risk, and dispute resolution.
For businesses, getting penalties right is important because:
A well-drafted liquidated damages clause means you can recover losses quickly, without costly legal battles.
If a clause is struck down as a penalty, you may end up with no compensation (even after a clear breach).
If you’re the breaching party, a penalty clause could expose you to unfair and excessive financial consequences.
Common Real-World Examples
Examples of enforceable liquidated damages in practice include:
Construction Projects: Delay damages must reflect actual harm (like additional rent or project hold-ups) not just round numbers.
Service Agreements: Flat fees for missed deadlines or service levels should relate to the expected financial impact.
Supply Contracts: A large fee for a late delivery must be supported by evidence of real loss (e.g. customer penalties or lost sales).
Legal Principles in Practice
Australian courts apply a proportionality test. A clause will be struck down if:
The amount is extravagant, unconscionable, or out of proportion to the risk.
It applies one sum to multiple types of breaches (some of which may be minor).
Key Case Law
The enforceability of such clauses is determined by Australian common law, guided by key judicial decisions:
Andrews v ANZ (2012) and Paciocco v ANZ (2016): Clarified that a clause must protect a legitimate commercial interest, not punish a breach.
Carbone v Fowler Homes (2024): Reinforced the importance of clarity and context.
How to Draft an Enforceable Liquidated Damages Clause
Follow these best practices to reduce the risk of your clause being struck down:
Estimate Real Losses: Do this at the time the contract is signed, not later.
Tailor to Specific Breaches: Avoid applying the same amount to all types of breach.
Document Your Reasoning: Keep records of how you calculated the figure.
Use Clear Language: Avoid vague or punitive terms.
Consider Commercial Context: Courts will take the nature of your business into account.
Enforcement Challenges
If a clause is challenged:
The court may void it as a penalty.
You must then prove your actual losses, which is often much harder and less certain.
To avoid this, build your clause on measurable, documented losses, not assumptions or threats.
Project owners or parties seeking to enforce such clauses should maintain thorough records demonstrating how the pre-agreed amount was calculated and the actual losses incurred as a result of the breach to support the argument that the clause was a genuine pre-estimate of loss.
Frequently Asked Questions
What is the difference between liquidated damages and penalties?
Liquidated damages reflect a real estimate of loss and are enforceable. Penalties punish or deter and are not enforceable.
How do Australian courts determine if a liquidated damages clause is enforceable?
By applying the proportionality test: Is the clause fair, reasonable, and tied to actual commercial interests?
Are liquidated damages clauses common in Australia?
Yes, particularly in construction, service contracts, and leases. But they must be properly drafted.
Contact our experienced Australian contract lawyers today. We’ll help you draft clear, enforceable agreements that protect your interests and meet legal standards.
What happens if a liquidated damages clause is deemed a penalty?
You won’t be able to claim the agreed amount. You’ll need to prove actual loss, which can be difficult.
Poorly drafted clauses can leave your business exposed and limit your recovery in the event of a breach.
How can I ensure my liquidated damages clause is enforceable?
To help protect your business, we recommend that you:
Calculate damages based on likely, measurable losses at the time of contract formation.
Avoid “one-size-fits-all” damages (and tailor amounts to the specific risks and consequences).
Use clear language and avoid punitive language.
Keep records of how the figures were calculated as this will help defend the clause if it’s ever challenged.
