The doctrine of penalties

Until the recent High Court decision in Andrews v Australia and New Zealand Banking Group Ltd1 (Andrews), the doctrine of penalties had been generally understood to operate only to make unenforceable certain sums payable upon a breach of contract. In Andrews, the High Court held that there is an equitable rule which will provide relief against penalties where there is no breach of contract, broadening the instances in which clauses specifying a financial consequence of a particular action will not be enforced in accordance with their terms. 

This article provides a summary of the High Court’s findings in Andrews and examines the implications of the decision for take-or-pay clauses of the sort commonly found in energy and resources contracts.

The Andrews v ANZ decision

Background

A representative action was commenced by a group of 38,000 customers in the Federal Court of Australia against Australia and New Zealand Banking Group Ltd (ANZ).The applicants challenged the legal efficacy of various fees charged by ANZ to its customers,  alleging in particular that certain provisions in their contracts with ANZ were void or unenforceable on the basis that they were to be characterised as penalties. 

At first instance, Gordon J held that fees which were not charged by ANZ upon breach of contract by the customer were not capable of characterisation as penalties. The applicants sought leave to appeal to the Full Court of the Federal Court of Australia. The High Court removed certain grounds of appeal from the Full Court for determination including whether the penalty doctrine was limited to cases involving a breach of contract.

Decision

In a unanimous decision, the High Court held that relief against penalties may be available even if the obligation at issue is not triggered by a breach of contract.

The High Court provided guidance for determining whether a clause will be classified as a penalty, highlighting in particular that a distinction exists between:

  • a payment that is to secure performance of a primary obligation; and
  • a payment for further services or accommodation. 

If an obligation to make a payment is classified as security for the performance of a primary obligation, it is prima facie a penalty if it provides for an additional benefit to the promisee or additional detriment to the promisor. If the obligation is to be performed in return for further services or accommodation, it will not be classified as a penalty, and is therefore enforceable.

General implications of the decision

  1. The penalties doctrine will now apply to some clauses which impose obligations on the occurrence (or non-occurrence) of events which do not involve breach of contract. 
  2. Application of the doctrine depends on the provision alleged to be a penalty being found to be collateral to another term of the contract, and designed to secure performance of that term by imposing an additional detriment on the promisor.
  3. Under equitable principles, the obligation to make payment (or cause some other detriment to be suffered by the promisor) is not enforceable to the extent that it provides for a penalty.
  4. The extent of enforceability depends on the actual loss suffered by the counterparty as a result of occurrence (or non-occurrence) of the relevant event relative to the payment or other detriment that the promisee suffered.
  5. If the obligation is to be performed in return for further services or accommodation, it will not be classified as a penalty and is therefore enforceable. It appears that this will be the case even where the payment exceeds market value of the goods or services provided. In addition, the clause will not be a penalty if compensation is impossible to assess, or if the promisor is merely exercising an option under the contract.

Take-or-pay clauses in long term energy and resource contracts

A number of common provisions found in long term energy and resource contracts may need to be considered in light of the High Court’s decision. These provisions will typically require a party to make a payment that is arguably in excess of the maximum loss conceivably sufferable by the counterparty.  One type of provision that has aroused debate among academics, practitioners and contracting parties in this context is take-or-pay clauses in service and supply contracts.

Characteristics of a take-or-pay clause

A take-or-pay clause in the context of a long term supply contract for resources characteristically requires a supplier to make a minimum amount of product available to a buyer on an annual basis. To comply with the clause, the buyer must either take delivery of the product or pay for a minimum amount at a contractually agreed price.2 Similarly, in long term services contracts (such as port user agreements and gas transportation agreements), the transporter or infrastructure owner will commit to transporting a commodity or making capacity available up to a maximum amount in any year. The user in turn agrees to pay for a minimum amount of transportation or usage rights in that year (typically between 60% and 100% of the maximum amount).

There is a well understood rationale for inclusion of take-or-pay clauses in long term supply and offtake contracts. Development of the underlying natural resource (such as a gas field) or piece of servicing infrastructure (such as a port or pipeline) are often very capital intensive, and their owners require some level of certainty as to the level of demand over a period of time before they can commit to the development.

Take-or-pay contracts give some certainty to owners (and in project financed projects, financiers) as to the level of return on investment over the life of the take-or-pay obligation. The amount of any payments made under such clauses are known to both contracting parties at the time of entering into the contract, and are often the result of extensive prior negotiations.3

Why does Andrews matter?

It is rare in the Australian energy and resources sector for long term supply and services contracts to feature a separate obligation on the buyer/user to actually make a minimum order for a commodity, or to use a minimum amount of the relevant service, every year.  A payment under the take-or-pay clause therefore does not arise due to a breach of a primary obligation under the contract.  As previously understood, this would take such a clause outside the ambit of the doctrine of penalties. 

The Andrews decision, which has broadened the application of the doctrine to clauses which are triggered by events which do not involve any breach of contract, may bring these types of take-or-pay clauses within the scope of the doctrine.  Each take-or-pay clause now needs to be considered in light of the doctrine as now understood.

Implications

We expect that courts will be reluctant to strike down take-or-pay clauses. Doing so could be seen to interfere with the principle of freedom of contract.  Consideration would undoubtedly be given to the fact that take-or-pay clauses as they appear in energy and resource contracts are typically the result of arm’s length negotiations between sophisticated commercial parties of comparable bargaining power. 

Support for this proposition can be found in a landmark UK case on take-or-pay clauses, M & J Polymers.4In that case, the take-or-pay clause was accompanied by an obligation to order a minimum quantity of product. The Court therefore proceeded on the basis that the law of penalties would apply, as payment was to be made upon breach of that obligation. The Court ultimately found that the take-or-pay clause was ‘commercially justifiable’ and ‘did not have the predominant purpose of deterring a breach of contract nor amount to a provision ‘in terrorem’ (literally, ‘in fear’, meaning a clause which compels a party to act through fear or intimidation of loss).

These principles have recently been confirmed in the UK case of E-Nik6, where similar contractual circumstances arose in the context of an IT consultancy agreement. The court held that as a matter of principle, the rule against penalties may apply to take-or-pay clauses, though the clause in question, which required the purchaser to pay for minimum quantities of a consultancy service per year, was held to be enforceable. The clause was:

“commercially justifiable, did not amount to oppression, [was] negotiated and freely entered into between parties of comparable bargaining power and did not amount to a provision in terrorem.”7

There are other reasons why a take-or-pay clause may not amount to a penalty in a contract where there is no obligation to take a minimum supply amount:

  1. They are not collateral to another term in the contract – it is a question of construction whether the obligation to make payment under a particular take-or-pay clause is collateral to a requirement that the buyer take a minimum supply quantity. It is also a question of construction whether performance of the payment element is designed to secure for the supplier that the buyer take a minimum quantity. There is no general rule and each contract must be judged on its merits. If there is no such relationship, the take-or-pay clause stands outside the ambit of Andrews. For example, the construction of the contract may be that the buyer has unconditionally promised to pay a certain sum, in consideration of the conferral of a right to receive a certain supply.
  2. Performance options - take-or-pay clauses may, depending upon how they are constructed, be properly characterised as merely providing for options in performance by the promisor, that is, the user/buyer has the option of either ‘taking’ the goods or services (and paying for the supply), or just paying for the goods or services. The provider of the goods or services is, to some extent, unconcerned with which performance option is adopted.
  3. Make-up rights - At least in Australia, take-or-pay clauses are often accompanied by what are referred to in the industry as ‘make-up’, ‘banking’ or inventory rights. These rights essentially amount to a prepayment for product or service that the buyer does not currently require in circumstances where they can then take delivery of that product, or use that service, in a subsequent year (within prescribed limits). A payment of this type is unlikely to be characterised as a penalty, but rather a ‘pre-payment for a future product’ or, using the terminology employed in Andrews, a payment for further services or accommodation. Put another way, they provide the supplier with confidence as to a total revenue stream under the contract to underpin the development, and provide the buyer with some flexibility as to when the product or service will be supplied, during the life of the contract.
  4. Reservation or capacity rights - in certain service contracts an obligation to pay a minimum amount for that service in any year (even when not used) may be properly construed as a fee for the service of ‘reserving’ the capacity for use by the buyer. This is particularly the case where the relevant infrastructure is capacity constrained and not easily replicated, such as many of the coal export terminals in Queensland and certain gas pipelines on the east coast of Australia. Payments in return for a service are not penalties.

Notwithstanding the above, caution should be taken when drafting take-or-pay clauses until specific guidance on their enforceability has been provided by the Australian courts.  Such guidance is expected when the Federal Court gives its decision on whether the fees and charges in Andrews were in fact penal in nature.