What is a penalty?
History of doctrine against penalties
Current position
Exceptions
Comment


A recent case before the High Court, involving 38,000 customers of the Australia and New Zealand Banking Group Limited (ANZ) who disputed the bank fees charged to them, will have a profound impact on any contracting party, in any industry, that has penalty or liquidated damages clauses in their contracts.

What is a penalty?

An amount payable under a contract will be a penalty where:

  • it is imposed to secure the performance of another obligatory or non-obligatory contractual provision; and
  • the amount of the fee is out of proportion to the damage or loss suffered.

Where a contract contains a penalty, a court will order that only the actual damage suffered be paid.

A penalty should not be confused with a liquidated damages provision - this acts much like a penalty in that it may be charged when an obligatory or non-obligatory contractual provision is not observed, but unlike a penalty, it is a genuine pre-estimate of the loss or damage suffered and accordingly will not be invalid for being out of proportion to the loss or damage suffered.

A party generally cannot sue to recover a sum designed to punish another party; it therefore makes sense that the parties cannot agree to punish one party or another in advance.

History of doctrine against penalties

Understanding the doctrine of penalties, as the High Court has stated, "requires more than a brief glance backward". In Roman law, like today's law, liquidated damages were well known. In fact, the Institutes of Justinian, commissioned by Emperor Justinian I (483-565 AD), recommended them. Using the formal Roman law contractual form of question and answer, the institutes set out the following recommended contractual question/stipulation: "If any default is made, either as contrary to what is agreed upon, or by way of non-performance, do you promise to pay a sum of 10 aurei?"

Despite its clarity, the above stipulation was not conclusive. If more damage was incurred than was estimated in the clause, then more would be due; if less was incurred, the amount would be reduced accordingly. In essence, similarly to today's law, the clause needed to embody a genuine pre-estimate of damages and an amount could not be recovered that was out of proportion to the loss or damage actually suffered. Hunter, in his work on Roman law, recounts the story of Cornelius, who had a contract with Maevius for 60 aurei. If Maevius did not keep to the terms, a 100 aurei sum could be charged under the contract. This was invalid as a penalty at the time, just as it would be today, as the penalty was out of proportion. Here, Cornelius could not recover more than was due (60 aurei); if he tried, the claim could be defeated on the Roman law ground of bad faith.

Recently, Interstar Wholesale Finance Pty Ltd v Integral Home Loans Pty Ltd(1) (incorrectly) established that relief from penalties was available only for fees payable on breach of contract.

By way of example, a person has a smartphone on a finance plan with XYZ Ltd in which the contract states that:

"you must pay $200 on 1 September 2012, and $50 the 1st of every month thereafter until a total of $1000 is paid. If you do not pay $50 on the 1st of any month before the $1000 is paid, then XYZ Ltd will bill you a further $500, bringing the total repayment to $1000 plus $500 per late payment".

If Interstar were correct (which it is not), then if the person breached the contract by refusing to pay any of the A$50 instalments at all, XYZ would not be allowed to charge the penalty as it would be in breach; however, if the person kept the contract and was merely a few days late in payment, then he or she would have to pay the penalty.

Lord Denning in Campbell v Bridge made the apt observation that this means that the law of "equity commits itself to this absurd paradox: it will grant relief to a man who breaks his contract but will penalise the man who keeps it". Accordingly, the current position is that the penalty cannot be charged in either scenario.

Current position

At present, penalties are always illegal, whether charged on breach or otherwise.

In Andrews v ANZ, ANZ charged customers honour, dishonour, non-payment and over-limit fees. Justice Gordon, the trial judge, followed Interstar (as she was required to do by the doctrine of precedent) and ruled that the penalties doctrine had no application without breach.

The High Court unanimously ruled that customers had no responsibility or obligation to avoid the events on which these fees were charged (ie, non-compliance with these events was not a breach of contract). The court then stated that just because there was no breach, that did not mean that the doctrine against penalties could not apply. Accordingly, if these fees were out of proportion to the actual damage suffered, those fees would be invalid as penalties (the High Court did not decide whether the fees were actually penalties; that question was sent back to the Federal Court).

In essence, the High Court ruled that Interstar was incorrect to confine the doctrine against penalties to instances where a contract was breached.

Exceptions

Where damages cannot be accurately quantified, a clause awarding a sum on some event cannot be characterised as a penalty; nor can a fee for an additional service, regardless of how expensive that service is. However, parties should be careful that they do not try to recharacterise a penalty as something else, as the court will look at the substance of the sum charged, not the form it is cloaked in; a disguised penalty is still a penalty.

For example, a cinema acquires a licence to show a movie for A$100 on its first screening, with additional screenings costing A$400. The cinema will not be paying a penalty for the additional screenings; the additional payment is not to secure the obligation of paying the A$100, but for an entirely separate service.

Comment

This ruling will have important and wide-ranging implications on contracts across almost all industries - including late delivery fees in shipbuilding contracts, library loans and infrastructure projects, excess baggage fees, change of appointment or examination fees, bank fees and finance balloon rate fees - depending on the individual circumstances.

Companies with liquidated damages clauses or penalty clauses in their contracts or persons being charged penalties under contracts should seek legal advice. Some examples of penalties include the following:

  • A bank's customer is obligated by contract to not overdraw her account. If she overdraws her account by A$0.01, then the contract might allow the bank to charge her a A$35 penalty. If the bank needs to pay interest rates only on that cent - for example, of 3.5% plus a buffer for possible default of 3% - and for the services of a computer to automatically charge the payment, then A$35 would likely be out of proportion to the real cost of providing that cent and would accordingly be considered a penalty.
  • A university student is obligated to sit an examination at 9:15am on October 1 2012 and her contract with the university states that if she cannot make the examination on time, the university will charge her a A$180 penalty. This will likely be out of proportion to the cost of taking her off the examination roll (and the cost of putting her on another, later roll) and will be classed as a penalty.
  • A consumer buys a smartphone on a repayment plan and is one day late in one of the payments. If he is then charged a A$100 fee, this will likely be out of proportion to the damage suffered by the financier and will accordingly be a penalty.

For further information on this topic please contact Quintin Rares at Piper Alderman by telephone (+61 2 9253 9999), fax (+61 2 9253 9900) or email (qrares@piperalderman.com.au).

Endnotes

(1) (2008) 257 ALR 292.

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