The law of penalties arises where a contract stipulates that on breach the contract-breaker must pay an agreed sum which exceeds or is out of all proportion to the likely actual loss caused by the breach and, in substance, is used for the purpose of pressuring the other party into performance. In contrast, the essence of liquidated damages is a genuine pre-estimate of the damage likely to be caused by a breach. Where a clause attempting to stipulate a sum for breach is held to be a penalty, the penalty clause cannot be enforced and is disregarded, and the party must rely on an action for unliquidated damages.
The subject of penalty clauses has been the focus of a recent High Court decision Ringrow v BP Australia  HCA 71. The appellant commenced proceedings alleging that a clause of an option deed was ‘void and unenforceable’ as a penalty. In this case, the High Court confirmed that the legal position on penalty clauses in Australia stems from Lord Dunedin’s speech in Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd  AC 79 at 86-87.
Distinguishing Between Liquidated Damages and Penalties
Lord Dunedin put forward a number of tests to assist in determining whether a clause may be regarded as a penalty or a liquidated damages clause. These are:
The use of the words ‘penalty’ and ‘liquidated damages’ are not conclusive in determining the position, and a Court may look at the effect of the clause;The essence of a penalty is the requirement to pay money as a threat to the offending party, whilst the essence of liquidated damages is a genuine covenanted pre-estimate of damages;The question whether a sum stipulated is a penalty or liquidated damages is a question of construction to be decided upon the terms and inherent circumstances of each particular contract, judged of as at the time of the making of the contract, not as at the time of the breach;It will be held to be a penalty if the sum stipulated for is extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved to have followed from the breach.There is a presumption (but no more) that it is a penalty when ‘a single lump sum is made payable by way of compensation, on the occurrence of one or more or all of several events, some of which may occasion serious and others but trifling damage’.
Until recently, the tendency of the courts was to hold stipulated sums extravagant and unconscionable simply on the basis that they exceeded the amount which would have been recoverable at law in a claim for unliquidated damages. However the High Court in Ringrow made it clear that the comparison called for something ‘extravagant and unconscionable’. The appellant’s argument relied on a claim of disproportion between the respondent’s commercial interests and the promise extracted form the appellant to protect it. The court dismissed the appellant’s argument on the basis that there was no authority to support the ‘proportionality doctrine’ which the appellant advocated. An agreed sum can only be ‘characterised as a penalty if it is out of all proportion to damage likely to be suffered as a result of breach’ (AMEV-UDC Finance Ltd v Austin (1986) 162 CLR 170 at 190).
In Andrews v Australia and New Zealand Banking Group Ltd  HCA 30, the Australian High Court decided that bank fees may potentially be penalties, notwithstanding the fact that the trigger for the imposition of most of the fees was not a breach of contract. In short, parties are allowed to stipulate the amount payable for certain breaches of contract (known as ‘liquidated damages’), but if the amount payable is not a genuine pre-estimate of loss and is instead in terrorem of the other contracting party (i.e. designed to scare them into performance rather than compensate for loss) then the clause may be struck down by the law against penalties: see Ringrow Pty Ltd v BP Australia Pty Ltd  HCA 71; (2005) 224 CLR 656, affirming Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd  AC 79.