Contractual provisions requiring agreed payments designed to discourage particular behaviours are now more likely to be legally enforceable.

The recent Australian High Court decision in Paciocco v Australia and New Zealand Banking Group Ltd [2016] HCA 28 has provided much needed guidance on how the rule against contractual penalties should be applied to modern commercial contracts.

The High Court has adopted similar thinking to that expressed by the UK Supreme Court late last year in Cavendish Square Holding BV v Makdessi [2015] 3 WLR 1373. This thinking allows contractual provisions to legitimately protect a broader range of interests than mere recovery of compensation for loss caused by the event triggering the payment.

The rule, its rationale and its consequences

The rule against penalties renders unenforceable any provision in a contract that seeks to punish a party for non-observance of a contractual stipulation. The rationale for this rule is grounded in public policy ‒ the law of contract has no role in punishing wrongdoing. Rather, the purpose of contract law is to satisfy the expectations of the party entitled to performance.

The problem with the rule is that it creates an exception to the primacy that the law otherwise accords to the ability of parties, with no relevant disability, to agree upon the terms of their future relationship. It creates an exception to the principle of freedom of contract. It is for this reason, that courts have long accepted they should not set aside the contractual bargains that parties of full capacity have agreed without good reason. To do otherwise would undermine the commercial certainty the contracts should provide.

Unfortunately, the rule had developed in a manner which created considerable uncertainty regarding the enforceability of many provisions in modern contracts, including performance-based payment regimes involving abatements for poor performance, break-fees chargeable for early repayment of a loan, time-bar provisions, and "take-or-pay" regimes, to name but a few. The High Court's 2012 decision on this rule in Andrews v Australian and New Zealand Banking Group Ltd (2012) 247 CLR 205 led to much speculation amongst legal commentators that many common contractual provisions were potentially unenforceable.

A broader view of the interests that contractual provisions can protect

In Paciocco, the Australian High Court adopted a similar approach to that taken by the UK Supreme Court to the "tests" articulated by Lord Dunedin in Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd [1915] AC 79, by finding that these tests have come to be applied more rigidly and literally than was originally intended.

In particular, much was said about the "test" that a stipulated amount "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." Put another way, it is often said that this test requires the agreed amount to be a "genuine pre-estimate" of the loss that the other party will suffer as a result of non-performance.

The High Court found that this test had come to be applied too rigidly. The reasoning of the majority was not unanimous, but two of the three judgments in the majority found that the relevant question is whether the agreed sum is out of all proportion to the interests of the party seeking its payment. The other judgment found that the test was whether the only purpose of the term was to punish and undertook a tailored inquiry into the commercial circumstances that involved reviewing the costs associated with particular interests protected by the clause.

So what are these interests that can be protected? Examples from past cases include:

  • the interest of a tyre manufacturer in deterring its distributors from price-cutting and thereby harming to the tyre manufacturer’s business in other locations;
  • the interests of a purchaser of a business in the observance of restrictive covenants preventing the former owner from competing against the business;
  • the interests of a credit card provider in avoiding provisioning costs, regulatory capital costs and operational costs associated with late repayment of credit extended;
  • the interests of the Spanish Government in ensuring the timely delivery of torpedo boats for its Navy to suppress an insurrection in Cuba; and
  • the interest of a car park manager in deterring car owners from staying more than two hours in a shopping centre car park, and in generating an income stream to pay for its services. The sum charged (£85, reducible to £50 if paid within 14 days) was not out of all proportion to these interests.

Where the interests that the innocent party has in contractual performance are intangible and difficult to quantify, as they were in each of the above cases, it makes no sense to limit the sum which the defaulting party can agree to pay to the loss that the innocent party can be expected to suffer as a result of the breach. Indeed, difficulty in proving and quantifying loss makes it more reasonable for the parties to agree beforehand what the figure for damages should be in order to avoid the problem.

The rule is not limited to cases arising out of breach of contract

The Australian High Court's 2012 decision in Andrews found that in order for there to be a penalty there is no need for there to be a contractual breach. A clause can be a penalty if in substance it is collateral to another clause and is "security for" or "in terrorem of" performance of that other clause. Accordingly, the law in Australia doesn't allow the drafters of contracts to avoid the rule against penalties by drafting provisions, such as performance regimes, so that the payment obligation is triggered by an event that isn't a breach of the contract. This principle still applies, however the impact of the Paciocco decision is that a wide range of losses can be called upon to justify potentially impugned provisions.

But a broad range of losses can be taken into account to justify provisions that might otherwise be penalties

Under Australian and English law there is a limit on the losses that can be recovered in an action for breach of contract. To be recoverable, the loss must be sufficiently connected to the breach. To be sufficiently connected, the loss either be of a kind which arises naturally (ie. according to the usual course of things) from the breach of contract, or it must have been (or ought to have been) within the contemplation of the parties when they made the contract as the probable result of a breach of it. If the loss doesn't satisfy either of these tests it will be considered too "remote" from the breach to be recoverable by way of damages.

Prior to Paciocco, it was considered by some that a liquidated damages clause could only cover losses which were recoverable for a breach of contract. However, it is now clear that loss attributable to a party's interests may encompass items of loss that could be suffered, even if they would be considered too remote to be recoverable by way of damages for breach of contract.

Accordingly, even if the only interest of a party in the enforcement of a provision is to be compensated if it is breached, a court can now take into account losses which would be too remote to be recoverable for a breach of contract when deciding whether the agreed sum is out of all proportion with the greatest conceivable loss of the innocent party.

For example in a contract for delivery of government project ‒ the Government has interest in protecting against losses caused by:

  • additional costs incurred by the Government or the intended users or beneficiaries of the project;
  • loss of or delay in realising benefits for the community;
  • lost productivity in the economy generally; and
  • damage to reputation of Government.

A win for contractual certainty

The High Court's decision is Paciocco is a welcome development. The speculation which followed Andrews regarding the enforceability of common contractual provisions was bad for contractual certainty. Performance based payment regimes, take-or-pay provisions, time-bars, break-fees and the like are regularly chosen by parties as effective contractual tools for regulating commercial relationships and encouraging adherence to contractual bargains. Courts should not interfere with these arrangements, without good reason.

By requiring Australian courts to consider the broader interests of a party in having the contract performed before declaring a provision to be unenforceable, and allowing parties to pre-agree liquidated damages which cover conceivable losses which are greater than what could be recovered by way of damages for breach of contract, the High Court has paved the way for parties to enter into contracts with greater confidence that their bargains will be upheld.