At a time when the opposition bench is calling for the establishment of a Royal Commission into the financial services sector, the High Court is ruling contracts mean what they say, and that bank customers should therefore be held to their bargains.

This Alert provides a practical update on the law of penalties in Australia, and is an essential read for contracting parties either subject to Australian law under pre-existing agreements or looking to adopt Australian law to govern future dealings. At a time when the opposition bench is calling for the establishment of a Royal Commission into the financial services sector, the High Court is ruling contracts mean what they say, and that bank customers should therefore be held to their bargains.

Executive Summary  

  1. Each of the approaches adopted by the majority in Paciocco narrows the scope for application of the penalties doctrine, allowing parties to contract with greater certainty to protect their commercial interests through liquidated damages clauses.
  2. Liquidated damages amounts need not reflect a genuine pre-estimate of damage, but rather can include a broad range of interests such as effects upon reputation, goodwill, ability to win new work, community expectations and shareholder interests, making it harder to successfully challenge such clauses.
  3. In the Construction industry, powerful owners can insist upon higher liquidated damages amounts, in turn increasing project risk which could lead to higher tender prices and higher overall project costs. Risk averse parties and smaller industry participants should take note, and may want to take steps to mitigate their exposure.
  4. Where liquidated damages provisions are challenged, experts will play a significant role in determining potential losses and which interests are reasonably capable of being protected by the liquidated damages amount in question. Parties and their advisers should take time in ensuring that experts are properly briefed and their evidence is tested robustly before appearing in court.

For a complete list of practical implications and drafting tips, we encourage you to read on.

This Alert will take you approximately five minutes to read in full. 

Background 

In September 2010, customers of the Australia and New Zealand Banking Group ('ANZ') issued proceedings in the Federal Court of Australia against ANZ in relation to five kinds of fees ANZ had charged concerning transactions made on their accounts.[1] These were:

  1. late payment fees on consumer credit card accounts;
  2. honour, dishonour and non-payment fees charged to consumer and business deposit accounts; and
  3. overlimit fees on consumer credit card accounts.

At first instance, Gordon J, bound by appellate authority,[2] decided that the honour, dishonour, non-payment and overlimit fees could not be penalties as they were not triggered by a breach of contract. The late payment fees, on the other hand, were capable of being penalties as they were triggered by a breach, namely the failure to pay on time. 

Divergence in the UK and Australia 

The customers then appealed directly to the High Court to overcome the binding precedent and decide: what events must unfold to enliven the penalty doctrine? ('Andrews')[3]

Drawing on the equitable history of the doctrine, the High Court found unanimously in favour of the appellants and decided that a contractual breach is not necessary to enliven the penalty doctrine in equity.

This was heavily criticised by the UK Supreme Court in Cavendish Square v Talal El Makdessi; ParkingEye v Beavis[4], where Lords Neuberger and Sumption said:

"Modern contracts contain a great variety of contingent obligations. ... The potential assimilation of all of these to clauses imposing penal remedies for breach of contract would represent the expansion of the courts' supervisory jurisdiction into a new territory of uncertain boundaries".[5]

Practical Implications for Construction Contracts 

In the Construction context there can be performance-based contracts with variable payment dependent on the standard or speed of performance. The contractor's failure to meet the performance indicator may not necessarily be a breach of contract. It could just mean that the contractor does not qualify for the additional consideration (or the consideration payable to the contractor is reduced) due to its failure to meet the relevant performance indicator. Following Andrews (and now the majority view in Paciocco), a pricing scheme of this kind could fall foul of the rule against penalties if the reduction in payment (to the contractor) is out of all proportion to the interests of the owner in securing early delivery.

This concern extends beyond the Construction context. In the case of a long-term oil and gas purchase agreement the parties can negotiate "take or pay" provisions requiring the customer to either:

  1. take the product from the supplier; or
  2. agree to pay a "penalty" in the event of non-performance.

Similarly, the penalty amount may constitute a violation of the rule against penalties if the sum stipulated is out of all proportion to the supplier's interests in securing performance.

As a result of these developments and in the interests of certainty, might Australian companies consider adopting English law to govern Australian Construction contracts, and commercial contracts more generally?

Back to the Federal Court 

Andrews was ultimately remitted to the trial judge for decision, with a different representative plaintiff, Mr Paciocco.

In the Federal Court, Gordon J again held that only the late payment fees were capable of being characterised penalties. Her Honour found that the fee (initially $35 and later $20) was extravagant and unconscionable in comparison with ANZ's actual loss, which was "no more than $3".[6] The other fees charged were justified by the provision of additional services by ANZ.[7]

Full Federal Court

On appeal by both parties, the Full Federal Court overturned Gordon J's decision in respect of the late payment fees, finding that they were not extravagant or unconscionable and were not, therefore, penalties.

The Full Federal Court accepted ANZ's evidence as to its losses, which included provisioning for bad or doubtful debts, maintaining additional regulatory capital and increased collection costs ('the indirect costs').[8] In commercial contracts, this is synonymous with asking for the commercial justification for a liquidated damages clause, a useful development where many commercial arrangements have a broader interest than just money. These interests can include community expectations, reputation and goodwill.

Having regard to the totality of the circumstances, which included ANZ's legitimate interests and the nature of the relationship between the parties under which the customers could use and even terminate their accounts at will, the fees charged by ANZ were not extravagant or unconscionable.

The legitimate interest approach was accepted by a majority of the High Court in Paciocco, and is now "essentially undisputed territory" in both Australia and the UK.[9]

Round Two in the High Court: Paciocco 

By grant of special leave, the customers appealed to the High Court to decide, among other issues, whether the late payment fees were unenforceable as penalties. By a 4:1 majority (French CJ and Kiefel, Gageler and Keane JJ; Nettle J dissenting), the Court dismissed the appeal.

Kiefel J, with whom French CJ agreed,[10] noted that an agreed sum can be used to protect an interest that differs from and is greater than an interest that would be recoverable as unliquidated damages in an action for breach of contract at common law.[11]

While the fees charged were disproportionate to ANZ's actual loss and ANZ itself conceded that the late payment fees were not genuine pre-estimates of damage, neither of those factors alone rendered the late payment fees penalties. Each of their Honours articulated a more nuanced test, similar to the one put forward by Kiefel J,[12] being "whether a provision for the payment of a sum of money on default is out of all proportion to the interests of the party which it is the purpose of the provision to protect."[13] It was accepted that these interests could be of a business or financial nature.

Gageler J framed the inquiry in terms of whether the agreed sum could be characterised "as having no purpose other than to punish".[14] His Honour felt that this approach would compel a more tailored assessment of commercial circumstances than would asking whether the stipulation serves a legitimate interest, though ultimately reaching the same view as Kiefel and Keane JJ.

On these bases, the majority found that ANZ had a commercial interest in receiving timely payment and that the Full Court, therefore, correctly characterised the indirect costs as affecting ANZ's legitimate interests. Contrary to the view taken by Gordon J at first instance, ANZ's interests extended beyond the mere reimbursement of the expenses occasioned by the customers' default.

Keane J, unlike Kiefel and Gageler JJ, focused on ANZ's profit-making incentive for the justification of the fees. His Honour considered ANZ's shareholders' profit expectations, noting that, if the appellants' challenge were to succeed, the cost of financial accommodation to all customers (including non-breaching customers) would increase "to maintain ANZ's revenue streams at a level unaffected by the proscription of the late payment fee."[15]

Keane J further observed that a rational economic choice of a voluntary and self-interested nature "is the opposite of the rational response which one might expect to be generated by a penal provision",[16]which ordinarily would deter non-compliance.

Practical Implications

The decision in Paciocco confirms that the courts are reluctant to impinge on the parties' freedom of contract, even more so where the agreement involves large corporate parties with legal representation.

With the adoption of the legitimate interest approach, the distinction between a liquidated damages clause and a penalty clause is now significantly clearer in Australia. While in many cases, a comparison of the pre-agreed sum with the amount that can be recoverable in an action for damages will often suffice to decide whether an amount is penal, where the interests of the innocent party extend beyond an amount that would be recoverable as unliquidated damages to interests that are "intangible and unquantifiable",[17] a party seeking to protect those interests will not be limited to compensation for breach by virtue of the rules in Hadley v Baxendale[18].

We have set out below some helpful tips when drafting and reviewing liquidated damages clauses:

  1. There is no longer a mechanical fixation on the innocent party's possible loss. The real question is not whether the pre-agreed sum is a "genuine pre-estimate of loss", but rather whether it is penal, having regard to the totality of the circumstances.
  2. Liquidated damages amounts can take into account the owner's projected losses, which are related to the breach but which at common law cannot be recovered as unliquidated damages (because, for example, they are too remote or the owner failed to mitigate).
  3. The legitimate interests of the innocent party in the performance of the primary obligation can include a broad range of matters, such as the commercial context in which the pre-agreed sum is intended to operate.
  4. Where there are complex interests, the courts will be particularly reluctant to stand in the way of the parties' negotiated bargain and valuation of those interests. Even where there is little (if any) room to negotiate, it will be difficult to prove in such cases that the liquidated damages amount is penal.
  5. It follows that, in future cases, it will be considerably more difficult to successfully challenge liquidated damages clauses, placing a greater emphasis on the parties' freedom of contract.
  6. Ultimately, the courts will take a broad approach to the evidence admissible in assessing whether a pre-agreed sum is enforceable, having regard to all of the circumstances available to the parties, including whether the parties have negotiated and considered the kind of damage that has arisen, the nature of the defaulting party's breach and the innocent party's interests in securing performance of the primary obligation.

In the commercial arena, these are positive developments. Contracting parties are usually in a better position to bargain for, approximate and price their entitlements and obligations than the courts.