Law of penalties in contract
Court of Appeal judgment
In Wilaci Pty Ltd v Torchlight Fund No 1 LP (in rec), the New Zealand Court of Appeal had to determine whether late payment fees of A$28 million on a 60-day loan of A$37 million were an unenforceable penalty according to the law of New South Wales, Australia, which was the law of the contract.(1) Although the judgment addresses the law of New South Wales, it offers some insight into the New Zealand court's view of recent international developments on penalties.
The debtor, Torchlight, was a private equity fund that invested in distressed assets. It purchased a debt owed by an Australian property group to the Bank of Scotland International for A$185 million. Torchlight had paid all but A$37 million of the purchase price but, with less than two weeks to settlement, it had no more cash and required short-term bridging finance.
Torchlight sought a loan from Wilaci through a financial intermediary. Torchlight was aware that Wilaci was not ordinarily in the business of making commercial loans. After some negotiation, the parties agreed that:
- Wilaci would lend Torchlight A$37 million, repayable after 60 days;
- the interest payable was calculated at Credit Suisse cost of funds plus 1.5%, but was fixed at A$320,000 elsewhere in the agreement;
- a A$5 million facility fee was payable after 120 days;
- a late payment fee of A$500,000 per week applied if the money was not repaid after 60 days, which would be reduced in proportion to any reduction in the principal sum;
- non-payment within 60 days constituted an event of default; and
- the contract was subject to the law of New South Wales.
Torchlight defaulted on the loan after the 60-day period. It repaid the principal over the next 18 months. Wilaci then issued demand for A$33,828,934, comprising the A$5 million facility fee, A$320,000 in interest and A$28,308,934 in late payment fees. It issued proceedings to recover the sum. The proceedings were brought in New Zealand as Torchlight was based in that jurisdiction.
At trial, Torchlight argued that the late payment fees were an unenforceable penalty. The High Court found in Torchlight's favour.
Since 1911, Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co Ltd has been the leading authority on the test for whether a term of contract is an enforceable penalty. In that case, Lord Dunedin set out tests for whether a sum payable on breach was a penalty. The most influential of those tests was that a sum will be held to be a penalty if it is extravagant and unconscionable in amount compared with the greatest loss that could have flowed from the breach of contract. On the other hand, if the sum is a genuine pre-estimate of loss, it will not be a penalty.
After the High Court issued its judgment in Torchlight, but before the Court of Appeal hearing, judgments were delivered by the UK Supreme Court and the High Court of Australia which significantly changed the approach to penalties in those jurisdictions.
In Cavendish Square Holding BV v Makdessi,(2) the UK Supreme Court held that the apparent dichotomy between a penalty and legitimate liquidated damages, as set out in Dunedin's test, was false. There may be other, non-compensatory interests that justify the imposition of an additional financial burden on a party in breach. The fact that the substituted obligation is designed to deter a breach does not automatically mean that it is penal. The focus was thus on whether the substituted obligation is unconscionable, extravagant or in terrorem (ie, by way of threat). If the parties had equal bargaining power and were independently advised, there was a strong presumption that they were the best judges of whether a term of the contract was a legitimate consequence of a breach.
In Paciocco v Australia and New Zealand Banking Group Ltd,(3) the High Court of Australia also rejected the Dunlop test. It held that the correct test was whether:
- the substituted obligation was out of all proportion to any legitimate interest of the innocent party; or
- the substituted obligation was unconscionable or exorbitant.
Justice Gageler's judgment emphasised that the test is whether the exclusive purpose of the clause was to punish, in order to deter a breach. Despite this, the judgment expressly rejected the Cavendish expression "in terrorem".
Was the late payment fee a facility fee?
The New Zealand Court of Appeal rejected Wilaci's argument that the late payment fee was a facility fee that enabled Torchlight to extend the loan term beyond the 60-day period. It held that the late payment fee was a secondary obligation arising in response to a default under the loan agreement. There was no provision in the contract for an extension of the 60-day period and non-payment was an event of default entitling Wilaci to enforce the contract immediately. The fact that Wilaci did not immediately make demand was immaterial.
Was the late payment fee unenforceable?
The Court of Appeal canvassed the development of the doctrine of penalties. It agreed with the judgments in Cavendish and Paciocco that the comparison between the substituted obligation and the legitimate liquidated damages recoverable was incorrect.
The Court of Appeal held that, aside from the issue of whether the penalties doctrine applied more broadly than contract law, the tests expressed in Cavendish and Paciocco were similar. Although Gageler expressly disagreed with aspects of the Cavendish judgment, his approach was not too removed from the majority decision, as it ultimately focused on whether the secondary obligation was in proportion to the interest in performance of the contract. The Court of Appeal concluded that Paciocco represented the law of New South Wales.
The Court of Appeal held that the late payment fee was enforceable and that the best measure of parties' legitimate interests in performance is the value agreed between parties of equal bargaining power in their contract. In this case, both parties were commercially astute, independently advised and stood to make substantial returns from the loan agreement. The high cost of credit reflected the exceptionally high risk to Wilaci. The Court of Appeal noted that there was evidence that no bank would have provided the loan. It was particularly relevant that the late payment fee also represented a lower daily cost of credit than the cost of credit during the 60-day term.
Although the Court of Appeal's conclusions were ultimately based on the law of New South Wales, the judgment suggests that the court will be heavily influenced by the Cavendish and Paciocco decisions in developing New Zealand's approach to penalties. The court's emphasis on the position of the parties suggests that it will be less likely to find an unenforceable penalty when commercial parties are involved. The court was prepared to accept that a higher cost would be justifiable in order to encourage due repayment and account for the increased risk of default.
For further information on this topic please contact Felicity Monteiro or Rachael Baillie at Wilson Harle by telephone (+64 9 915 5700) or email ([email protected] or [email protected]). The Wilson Harle website can be accessed at www.wilsonharle.com.
(1) Wilaci Pty Ltd v Torchlight Fund No 1 LP (in rec)  NZCA 152.
(2) Cavendish Square Holding BV v Makdessi  UKSC 67  AC 1172.
(3) Paciocco v Australia and New Zealand Banking Group Ltd  HCA 28 (2016) 333 ALR 569.