With a High Court appeal pending in the bank fees class action case, Paciocco v Australia and New Zealand Banking Group Limited [2015] FCAFC 50 (“Paciocco”), it is timely to undertake a review of where the law currently stands on penalties.

What is a penalty and what is the penalty doctrine?

In general terms, a stipulation prima facie imposes a penalty on party A if, as a matter of substance, it is collateral (or accessory) to a primary stipulation in favour of party B and this collateral stipulation, upon the failure of the primary stipulation, imposes upon party A an additional detriment, the penalty, to the benefit of party B: Andrews v Australia and New Zealand Banking Group Limited [2012] HCA 30 (Andrews).

In general terms, the penalty doctrine will be engaged, and render the penalty unenforceable by party B, where the penalty does not represent a “genuine pre-estimate” of the damage / loss that will actually flow to party B upon the failure of the primary stipulation.

This is a high bar, such that it has been said that for the penalty doctrine to be engaged the amount payable upon failure of the primary stipulation (the penalty generally is, but need not be the payment of money) must be “extravagant and unconscionable”: Andrews. Or put another way, the penalty must be “out of all proportion” to the actual damage / loss likely to be suffered as a result of the breach: Ringrow Pty Ltd v BP Australia Pty Ltd (2005) 224 CLR 656.

Tips to bear in mind to avoid clauses being deemed a penalty

  1. Justify the damages clause on the basis that it is indeed a “genuine pre-estimate of loss”.
  • In order to avoid a clause being struck down as a penalty, it is advisable to explain and record the factors that have been taken into account in reaching the amount payable, with a view to showing that the damages are a genuine pre-estimate of loss. A wide range of factors may be relevant in this regard.
  • For example, in Paciocco v Australia and New Zealand Banking Group Limited [2015] FCAFC 50, the Full Court took into consideration the costs of increased regulatory capital, and the structural costs associated with ANZ running a collections department, to find that late payment fees charged by ANZ on consumer credit cards were not so exorbitant as to be classed a penalty. The Full Court commented that a broad range of costs incurred by the ANZ could be taken into account to assess whether the late payment fee was a penalty.
  • One option to achieve this in practice is to incorporate factors contributing to the pre-estimate of loss as a schedule / annexure to the contract. If this option is not suitable in the circumstances, it is advisable to keep a contemporaneous written record of how the amount / pre-estimate of loss was reached.
  • Furthermore, if the basis of the amount is difficult to quantify - it is helpful to say so. For example, the relevant clause (e.g. a liquidated damages clause) might say that because of the complexity of the subject matter of the contract, it is difficult for the parties to estimate the loss that will be suffered in the event of breach, and that the parties have therefore resolved to agree on a certain amount as representing the best estimate in all the circumstances. This may help to avoid the clause being considered a penalty.
  • It is also advisable to expressly state in the contract that the parties acknowledge and agree damages payable on breach are a genuine pre-estimate of loss. Although courts will not necessarily place great weight on such statements (instead looking to the substance of the provision), they are likely to still be a relevant consideration.
  1. Don’t specify that the same penalty is payable on the occurrence of serious and trivial breaches. Put another way, it is advisable to link the severity of the breach to the amount payable.
  • Where the same amount is payable for triggering events of varying severity, it is difficult to maintain that the damages clause is a ‘genuine pre-estimate of loss’. It is therefore prudent to set a scale of damages payable according to the severity of the breach. For example, in a contract for the supply of goods, where a minimum quantity is required to be ordered, you might have a scale of damages payable dependent on the quantity of goods that remain unordered. You might also have reference to the time (e.g. days or weeks) that has passed to determine the amount payable.
  1. Don’t assume you’re safe from the laws of penalties simply because the damages clause isn’t triggered by a breach of contract
  • In Andrews, the High Court extended the type of clauses which may constitute penalties. The High Court held that a clause may constitute a penalty even when it is not triggered by a breach of contract. This altered the previous position where the law on penalties generally only applied to amounts payable on breach of contract.
  • This means that the law of penalties will capture a wider range of circumstances. In Andrews, the Court commented that certain bank fees (being the ‘honour’ and ‘dishonour’ fees, and overdraw fees) were capable of being characterised as penalties, even where the fees were payable in circumstances where no breach had occurred, and where customers had no obligation to avoid the occurrence of events triggering the fees (e.g. overdrawing an account).
  • This means that clauses with a punitive or penal character, where payment of a fee / damages is triggered upon certain conduct (even if that conduct does not constitute a breach of the agreement), may constitute a penalty, and be unenforceable. Since the decision of Andrews, even greater caution is necessary to avoid such clauses being considered a penalty.
  1. Rather than drafting damages being payable on breach, consider whether it is appropriate to utilise incentives based on positive conduct
  • This is particularly useful in the context of interest rates. It is common in loan agreements for a lender to charge a ‘default interest’ rate on breach of a repayment by the borrower, such that on default, the borrower is required to pay a higher interest rate. These provisions are at risk of constituting a penalty.
  • The general principle of penalties applies similarly here. A provision for the payment of interest at a higher rate after default is not a penalty “provided it can be seen as a genuine pre-estimate of compensation for loss the lender would suffer by being kept out of its money”: David Securities Pty Ltd v Commonwealth Bank of Australia (1990) 23 FCR 1 at 30 and 31.
  • However, if the agreement offers an incentive by reducing the interest rate following prompt payment, this is less likely to attract the rules on penalties (see, for example, Kellas-Sharpe and Ors v PSAL Limited (2012) Aust Contract Reports 90-377).

Concluding thoughts

It is important when drafting terms pursuant to which an amount is payable on breach (or on the undertaking of certain conduct), that special care is taken to avoid those terms being characterised as a penalty. The above tips should be kept in mind when drafting any such clauses.