If the vendor under a sale agreement breaches its undertakings, warranties or other contractual commitments, the purchaser is commonly entitled to recover its damages (subject of course to the range of limitations and exclusions that are usually included in sale agreements). Normally, the purchaser’s damages are assessed at the time of the breach. An alternative approach is for the parties to agree upfront how the recoverable damages will be quantified (either with actual dollar amounts or by using a formula). If the agreed measure of damages is not a ‘genuine pre-estimate’ of the damages but is instead exorbitant, oppressive or out of all proportion with the greatest damage that could conceivably be suffered, then the agreed damages clause is very likely to be a ‘penalty’ and unenforceable.
A recent case involving the sale of a medical practice highlights some of the advantages and disadvantages of using an agreed damages clause in a sale agreement. The case also provides some guidance on how to maximise the prospect of an agreed damages clause being enforceable.
Who needs to know?
Anyone who is involved in negotiating or drafting sale agreements. The case is also relevant to other commercial contracts (such as distribution and licence agreements) which include agreed damages or similar clauses.
Background
In IPN Medical Centres Pty Ltd v Van Houten [2015] QSC 204 (click here for a copy of the case), the Supreme Court of Queensland considered an agreed damages clause in an agreement for the sale of a doctor’s medical practice. The practice was owned and operated by the doctor and his services company.
As part of the sale, the doctor entered into a ‘Doctors Services Agreement’ under which he was essentially required to work with the new owner of the medical practice for 5 years following completion of the sale.
If the services agreement was terminated because of a breach by the doctor, the following agreed damages clause in the sale agreement applied:
The Seller and the Doctor must pay to the Buyer, as agreed and assessed damages under this agreement, a payment equal to the amount specified in Item 8 of the Schedule for each whole month remaining until the term of the expiry of the Doctor Services Agreement at the time of the termination.
As it eventuated, the doctor only stayed on for about 6 months after the sale. After leaving, he made allegations that the new owner had breached various collateral and implied representations and had engaged in misleading conduct. All of these claims were dismissed by the court. The new owner argued that the doctor had breached the services agreement and used this as grounds for terminating the services agreement.
The new owner naturally sought to invoke the agreed damages clause. It claimed $231,500. This was calculated by using the monthly rates specified in the sale agreement schedule of $5,500 per month (for the remaining months within the first 36 months of the term) and $3,000 per month (for the balance of the term). Since the purchase price for the practice was $320,000, this meant that the doctor had to repay a large portion of the purchase price. When default interest was taken into account, the amount he had to repay was in fact significantly higher than the purchase price.
The doctor argued that the agreed damages clause was an unenforceable penalty.
Decision
The court held that the clause was not a penalty. The key points are:
- whether or not an agreed damages clause is a penalty is to be assessed at the time the contract is entered into, rather than at the time of the breach;
- an agreed damages clause will be a penalty if it is extravagant, exorbitant or unconscionable;
- when assessing this, a court will consider the “degree of disproportion” between the agreed damages and a genuine pre-estimate of the damage likely to be suffered; and
- the degree of disproportion will need to “point to oppressiveness”. Usually, this will be satisfied if the agreed damages is greater than the greatest loss that could conceivably be proved as flowing from the breach.
Whilst the court concluded that the agreed damages clause was not a penalty, there appears to have been no evidence before the court as to how the monthly rates in the schedule to the sale agreement were determined or whether the parties had actually turned their minds to making sure these were reflective of a genuine pre-estimate of loss.
Nor did there appear to be any evidence before the court as to what the greatest conceivable loss (assessed at the time of entering into the sale agreement) may have been if the doctor breached the services agreement.
Underlying objectives – the need to step back
The most important point from this case is the way the court took a step back and primarily focussed on whether the agreed damages clause was “commensurate with the interest protected by the bargain”.
In doing so, the court adopted the following statement by the Full Court of the Federal Court in the recent case of Paciocco v Australia and New Zealand Banking Group Limited [2015] FCAFC 50 at 103:
care must be taken not to dwell on the words of expression used by judges in cases as if they were statutes … The object and purpose of the doctrine of penalties is vindicated if one considers whether the agreed sum is commensurate with the interest protected by the bargain … This is not to say that the enquiry is unconnected with recoverable damages; but the question of extravagance and unconscionability by reference to … the greatest loss that could conceivably be proved to have followed from the breach, is to be understood as reflecting the obligee’s interest in the due performance of the obligation.
In Paciocco the Federal Court also expressly recognised that just because something is not a ‘genuine pre-estimate’ of loss does not necessarily mean that it is a penalty (see Paciocco at 100 for a discussion about this dichotomy). The Federal Court also noted at 101 that:
It is not necessary, for the sum to be regarded as a genuine pre-estimate of loss, for the parties to have set the figure by reference to likely loss. (underlining added for emphasis)
Whilst the judge in this case nevertheless applied the tests of extravagance and disproportion (see above), the judge approached matters by giving more weight to the underlying question espoused in Paciocco of whether the agreed damages clause was legitimate having regard to the “interests” of the new owner.
Commensurate to protecting an interest
In this case, the interest to be protected was the new owner’s interest in the benefit of the long term service agreement with the doctor. The interests possibly also included the goodwill of the practice (some of which may have been goodwill personal to the doctor).
The sale agreement allocated $145,000 of the purchase price to goodwill and $145,000 to intellectual property rights. The court held that these amounts were “reflective” of the value of the new owner’s interest in the ongoing benefit of the service agreement.
The sale agreement contained an acknowledgment by the doctor that he would comply with the service agreement. The sale agreement also contained an acknowledgement that the doctor’s commitment to enter into and comply with the service agreement were “fundamental reasons” why the new owner entered into the sale agreement.
The doctor also acknowledged in the service agreement that, in entering into the service agreement, the new owner had relied on his representations that his expected practice billings would be approximately $525,000 per annum and that the terms of the service agreement were dependent on him achieving at least that level of billings each year. The court considered that the new owner’s interest in the ongoing benefit of the service agreement was also reflected by these acknowledgements.
Insights
The question of whether the agreed damages clause was a penalty was largely approached by the court by directly comparing the agreed damages clause against the “value” of the interest (i.e. the value of the benefit to the new owner from the doctor’s promised compliance with the service agreement). In contrast, a more usual approach would be to directly compare the agreed damages clause against the greatest damage that could (at the time the contract was entered into) conceivably be suffered if the relevant interest was violated (i.e. if the doctor breached his obligations under the service agreement).
This is an interesting application of the penalties doctrine. It may be that an agreed damages clause is unobjectionable when compared to the value of the relevant “interest”, yet the same agreed damages may be exorbitant or completely disproportionate (and therefore unenforceable) when compared against the conceivable damage to that interest that may flow from a breach. This distinction probably doesn’t matter much when (as in this case) the circumstances to which the agreed damages clause applies are the complete loss of the entire interest (e.g. breach resulting in termination of the relevant contract and therefore loss of all or the remaining benefit of the contract).
Practical Points to Take Away
- Apart from applying the familiar penalty tests about extravagance and disproportion, remember to step back and first consider whether the agreed damages clause is commensurate with the interest sought to be protected. Doing so will help to point your radar in the right direction when it comes to then applying the familiar tests.
- To maximise the enforceability of an agreed damages clause, include acknowledgements in the sale agreement. The doctor’s acknowledgements in the sale agreement and the services agreement were particularly important in this case.
- The approach in this case is consistent with the recent decision of the Full Court of the Federal Court in Paciocco. This is a welcome development. It gives greater certainty to the enforceability of commercially justifiable arrangements involving claw-backs, restraints, exclusivity and take or pay obligations where the innocent party clearly has a legitimate interest to protect but it is often difficult in practice to justify the agreed damages by reference to evidence of a ‘genuine pre-estimate’ of loss.
- Rather than having an agreed damages clause which essentially claws back part of the purchase price, try to have at least some of the purchase price paid in a series of deferred payments contingent on the vendor continuing to perform its post completion obligations (e.g. compliance with a service agreement).
- Even if your agreed damages clause is held to be a penalty, it can still be enforced to the extent that it is not penal (i.e. the clause is not completely void or unenforceable). This means that you can basically still recover your actual loss or damage arising from the relevant breach.
- If your agreed damages clause is valid, then that clause acts as a limit on the damages you can recover. For example, in this case, the new owner claimed that its actual damage was significantly higher than the amount payable under the agreed damages clause, but because the agreed damages clause applied, the new owner was not entitled to elect to claim the higher damages.