Generally speaking, if a clause is deemed to be a penalty, that clause will be void. Accordingly, when negotiating and drafting damages, liquidated damages and fee clauses in particular, it is important to be mindful of and apply the relevant tests developed by the courts to ensure that the contractual term will not be characterised as an unenforceable penalty.

There have been several recent cases which provide useful commentary and clarification on the current test for determining whether a fee is a penalty. This case note examines one of those cases, Melbourne Linh Son Buddhist Society Inc v Gippsreal Ltd [2017] VSCA 161 (Linh Son), in which the Victorian Court of Appeal considered the issue of penalties in the context of an establishment fee charged for a loan.

Background facts

The applicant, Melbourne Linh Son Buddhist Society Inc (Borrower), is an incorporated association which brings together members of Melbourne’s Vietnamese Buddhist community.

The respondent, Gippsreal Ltd (Lender), is the responsible entity of a registered managed investment scheme established under the Corporations Act which offers first mortgage real estate investment loans to borrowers, predominantly on behalf of small investors in the South Gippsland region in Victoria.

The parties entered into a contractual agreement under which the Lender made a loan offer to the Borrower of $1,775,000 on terms which included, relevantly, the payment of a loan establishment fee of 1.5% of the loan amount, equating to an amount of $26,625 (Loan Establishment Fee).

Subsequently, by agreement between the parties, the loan amount was reduced to $500,000. However, the Loan Establishment Fee was not reduced, which amounted to a fee of over 5% of the reduced loan amount.

The Borrower failed to settle the loan transaction within the timeframe of three days specified by the Lender, which resulted in the Lender purporting to terminate the contract for breach and claiming liquidated damages, including the entirety of the Loan Establishment Fee.

At first instance, the Supreme Court of Victoria held that the Lender was within their rights to terminate and awarded the Lender $49,466.77, which was inclusive of the Loan Establishment Fee.

Issues and findings on appeal

The primary issue for consideration by the Court of Appeal was whether the Lender was within its rights to terminate the agreement. The Victorian Court of Appeal unanimously allowed the Borrower’s appeal on this issue.

However, as a secondary issue, the Court also considered by way of obiter dicta whether the Loan Establishment Fee would classify as a penalty.

The Court’s findings on the Loan Establishment Fee

The Court ultimately held that the Loan Establishment Fee of $26,624 was a penalty, stating that:

In our opinion, the establishment fee of $26,625 is a penalty because it bears no relation to any possible damage to or interest of the [Lender] arising from the putative breach of the Deed of Offer by the [Borrower] and it is not commensurate with any legitimate commercial interest of the [Lender] which is sought to be protected by that deed in the event of its breach…

In a 2-1 majority, the Court found that the fee was not proportionate to the possible damage that would have been suffered and was not sufficiently linked to the ‘legitimate commercial interests’ of the Lender. The majority acknowledged that there were additional administrative costs suffered by the Lender as a result of the change in the loan amount, however believed that these costs were negligible and that the fee could be characterised as a means of ‘punishing’ the Borrower for the inconvenience.

President Maxwell (in dissent on this point, but not on the outcome of the appeal), held there was insufficient evidence to support a finding that the establishment fee was a penalty.

Key takeaways – when is a fee a penalty?

Applying the majority approach of the Court of Appeal, parties wishing to make sure that an agreed fee will be enforceable should consider the fee in light of its purpose and should ensure that, in particular, the fee in question is:

  • necessary to guard their legitimate commercial interests
  • directly proportionate and reasonable to the loss that will actually be suffered
  • not a fee imposed in order to ‘punish’ a party for the default.

Statements in a contract that the amounts specified as liquidated damages ‘are agreed to be a fair and reasonable pre-estimate of [the relevant losses]’ or ‘are not disproportionate to the greatest loss that is likely to be suffered by the [lender] in the event of default by the [borrower] and are accordingly not a penalty’ (as specified in the contract in Linh Son) will not be determinative that damages are not a penalty.

It is recommended that entities review their existing agreements, especially standard form contracts, to ensure the enforceability of their terms. Simultaneously, a review could be undertaken to ensure that that none of the terms are unenforceable on the basis that they may be ‘unfair’ under the Australian Consumer Law (see here for a previous publication on this topic).