The High Court’s Andrews decision[1]fuelled widespread concern that contractual devices everywhere were under threat. Service credits, take-or-pay provisions, liquidated damages clauses, time bars – how could we be sure they are enforceable?

The Paciocco appeal[2] is a welcome reminder that the law of penalties should not wreak havoc in our contractual landscape.

Customers can take comfort that service level regimes should generally be free from challenge in all but the most extreme circumstances.

PENALTIES IN THE PACIOCCO ERA

The first case that applied Andrews to find that a bank fee was a penalty was the Federal Court decision of Paciocco.[3]

In that case, Justice Gordon found that a $35 late payment fee for failure to pay a credit debt was a penalty as it significantly exceeded the estimated $3 loss it caused the bank. But her Honour found that other alleged penalties such as honour, dishonour and overlimit fees were not penal because they were fees for additional services.

On appeal, the Full Court of the Federal Court found that the $35 late payment fee was not a penalty because it was not “unconscionable” or “extravagant” when compared against the greatest conceivable loss the bank may incur. The amount of the fee could factor in all benefits of the bargain and encompass a wide range of losses. In this case, it included the costs of running a collection centre and maintaining regulatory capital. Further, the amount of the fee could be justified retrospectively: ie there need not be a full consideration of the amount at the time the fee is charged.

In short, the Paciocco appeal reminded us the test for proving a penalty is very high. A party setting an agreed damages amount can capture the “greatest conceivable loss” suffered by that party and a penalty will only be found when the amount is “extravagant”, “unconscionable” or “has a degree of disproportion sufficient to point to oppressiveness”. 

ARE SERVICE CREDITS PENALTIES?

Particularly in the areas of outsourcing and technology procurement, service providers may be remunerated based on the provider meeting certain performance targets – “service levels”. Payment for the service may be discounted based on the failure to meet the prescribed (or optimum) performance.

On the face of these provisions, it appears they could meet the “penalty test” in Andrews. This is because they are detriments imposed on the provider to secure the provider’s performance.

However, in many cases, these regimes should be valid according to their terms for several reasons.

Unconscionabilityit’s only a penalty if it’s “unconscionable” or “extravagant”.

Service credits are generally unlikely to reach that high threshold. Importantly, as service credits are generally proportional to the failure to meet a standard, this weighs against a finding that the detriment is out of proportion to the greatest loss that could be suffered and therefore penal.

Difficulty of estimating loss – the penalty doctrine does not apply to damages insusceptible of evaluation in monetary terms.

In some service level contracts, it may be very difficult to estimate the loss that would be caused by sub-optimal performance before entering into the contract. An example is where the damage sought to be avoided is reputational or otherwise difficult to quantify. 

In these cases, there is case law that supports the view that where loss is insusceptible to evaluation, the relevant provision will not be penal.

Additional benefit – the penalty doctrine does not apply to fees for additional benefits or services.

A cleverly-constructed contract can frame the performance regime as offering bonus payments as fees for additional benefits. In particular, an incentive regime that calculates payment with reference to a minimum standard of service, and rewards service beyond that standard is likely to be valid.

WATCH THIS SPACE

The law of penalties is continuing to develop. Both the High Court of Australia and the United Kingdom Supreme Court have matters relating to the law of penalties before them at the moment.

The High Court has recently granted Paciocco special leave to appeal from the Full Court’s decision in Paciocco. Interestingly, Justice Gordon who heard that case in the first instance is now a Justice of the High Court, though she will not sit on the appeal.

In England, the Supreme Court heard arguments in July in two matters in which it was submitted that the court should overrule the doctrine of penalties, at least in arm’s-length commercial transactions.[4] Judgment is currently reserved.

In the meantime, customers should maintain confidence in the enforceability of service credit regimes that do not excessively punish a poor performer.