The rule against penalties

Conventional wisdom, until now, has been that the rule against penalties could only be engaged in situations of breach of contract. As such, the mindful contract drafter arguably only had to ensure that the relevant consequence (that is, the potential ‘penalty’) was triggered by an event that was not a breach of contract, in order to avoid the application of the rule.

This approach is no longer certain following today’s High Court decision in Andrews v Australia and New Zealand Banking Group Ltd (2012) HCA 30.

The key statement is: “The primary judge erred in concluding, in effect, that in the absence of contractual breach or an obligation or responsibility on the customer to avoid the occurrence of an event upon which the relevant fees were charged, no question arose as to whether the fees were capable of characterisation as penalties.” ((78) of Andrews vs ANZ)

The case

A class action was brought against ANZ claiming that certain fees charged by the bank to its customers constituted penalties (for example, dishonour, late payment and over-limit fees) and that as a result ANZ should be required to refund these amounts to its customers.

ANZ argued that as these fees were not charged upon breach of contract by the customer (that is, the customer was under no contractual obligation to avoid overdrawing an account), the rule against penalties was not engaged.

The Federal Court at first instance accepted this proposition, following the NSW Court of Appeal decision in Interstar Wholesale Finance Pty Ltd v Integral Home Loans Pty Ltd (2008) NSWCA 310. In Interstar, the NSW Court of Appeal held that a breach of contract was necessary to engage the rule against penalties.  It overturned the first instance decision of Brereton J ((2007) NSWSC 406).  Brereton J had said:

"(The High Court judgement in AMEV-EDC) does not decide that relief against a penalty is available only when it is conditioned upon a breach of contract; to the contrary, it suggests that relief may be granted in cases of penalties for non-performance of a condition, although there is no express contractual promise to perform the condition – apparently on the basis that despite the absence of such an express promise, a penalty conditioned on failure of a condition is for these purposes in substance equivalent to a promise that the condition will be satisfied." (extracted at (67) of Andrews v ANZ)

High Court decision

In essence, the High Court accepted the statement by Brereton J. The reasoning applied by the High Court traces the history of the rule back to the 17th and 18th century, before the existence of ‘contract law’ as we now know it.  A thumbnail sketch of the reasoning is:

  • before modern contracts, obligations were settled in ‘bonds upon condition’;-
  • a bond under condition was an instrument under seal under which one person is required to perform a certain act – and if they failed to do so, they were required to pay a certain sum as set out in the bond;
  • the failure of the condition did not constitute a breach of contract.  Rather, it was merely an event that triggers the payment of the bond;
  • chancery courts would grant relief in cases of bonds under condition, where the bond itself was in excess of the damage or loss suffered on the failure of the condition.  This was later extended to cover contracts not under seal;
  • common law courts responded to the intervention of equity by providing that if a defendant paid to the plaintiff an amount equivalent to the actual loss suffered, the common law courts would grant a permanent stay preventing any recourse to chancery courts; and
  • this development of the common law courts did not supplant or extinguish the jurisdiction of equity.  Therefore, as equity has granted relief against penalties in the event of failure of conditions which did not constitute a breach of contract, there is no need to find a breach of contract before the rule may be engaged.

The High Court also emphasised that there is a difference between a provision that breaches the rule against penalties and one that simply reflects an additional obligation agreed by the parties.

For instance, MGM v Greenham (1966) 2 NSWR 717 was cited in illustration. In that case, an exhibitor was only permitted to screen a film in public once.  If it screened the film more than once, then it became liable to pay an amount 4 times the original fee for each additional screening.  There, the court held that screening the film more than once was akin to exercising an option, albeit that the option attracted a larger than normal fee (and as such was not a penalty).

Lessons

Notably, while the High Court decided that the rule against penalties could apply to these bank fees, it did not determine that the bank fees were actually penalties. This remains to be decided by the Federal Court. Regardless, it should no longer be assumed that a pecuniary payment required to be made on the occurrence of a certain event will necessarily escape the rule against penalties simply because the relevant triggering event is not a breach of contract.

In a supply contract context, particular attention should be given to the characterisation of termination and other fees required to be paid by the customer and, specifically, the circumstances in which those fees may become payable.

The case may also have the potential to affect the scope of recovery under indemnities that a party seeks in its contracts, considering that an indemnity, at its most basic, represents an independent contractual promise to do something – often, to pay an amount – on the occurrence of a certain event (which event is not necessarily a breach of contract).