A recent decision handed down by the Federal Court has potential implications for a wide range of Australian companies and organisations, including water authorities. In the case of Paciocco, the Federal Court held that some contractual terms, which ANZ had relied on in charging fees to its customers, were in fact penalty clauses and therefore unenforceable.1

The Paciocco facts

This was a representative proceeding, brought by Mr Paciocco on behalf of thousands of other ANZ customersThe claim was brought on the basis that a range of ANZ bank fees including dishonour, non-payment, over limit and late fees were penalties and therefore unenforceable. ANZ argued it was contractually entitled to charge the fees because its customers had agreed in writing to such fees.

Courts have traditionally held that liquidated damages clauses must be a genuine pre-estimate of the loss that flowed from a breach of the clause otherwise those clauses would be unenforceable as a 'penalty'. On the other hand, courts have not traditionally looked behind contractually agreed formulas for breaches of contract such as abatements imposed for failures to meet specified service levels.

In essence, the question for consideration in Paciocco was whether the relevant fees were:

  1. A penalty, i.e. security for performance by the customer of other obligations to ANZ.
  2. A fee for an additional service, i.e. a fee charged in accordance with pre-existing arrangements according to whether ANZ chose to provide something more and further to the customer - for example, by ANZ authorising payments upon instructions by the customer upon which ANZ otherwise was not obliged to act, or refusing further accommodation.

 Justice Gordon held that:

  1. The late payment fee charged on the credit cards was a penalty. The purpose of the late payment fee was to secure performance of a primary obligation, i.e. payment on time, rather than being truly a fee for further services or accommodation. Justice Gordon also found that the fees were extravagant and unconscionable.  She found that ANZ was likely to suffer a maximum loss of $0.50 to $5.00 in respect of each fee, whereas the actual fee levied was $20.00, regardless of whether the payment was one day later or longer.
  2. The honour, dishonour, non-payment and over limit fees were not a penalty, as the liability to pay those fees was not contingent on a breach of contract or on failure to perform a collateral stipulation. The liability to pay these fees arose from something more than what was agreed to in the primary stipulation - i.e. fees for the provision of an additional service. The fees were the price customers were required to pay to obtain a further right or benefit, e.g. access to credit beyond their specified credit limit.

Implications for water authorities

The impact of Paciocco and the related High Court decision of Andrews v Australia and New Zealand Banking Group Limited [2012] HCA 30 (which involved the same facts) is that certain performance and non-performance payments under contracts entered into by water authorities will need to be considered more closely during drafting and negotiation. Performance-based contracts will be impacted because:

  1. Outcome or performance based payments and abatement formulas based on deductions for failures to meet key performance indicators can now be regarded as penalties even where they are not connected to a breach of contract.  Before Paciocco and Andrews, they were regarded as contractually agreed formulas and any deduction was not dependent on a breach of the contract terms.
  2. In drafting performance/KPI and abatement clauses, parties will now need to estimate the likely loss and try not to set a performance based fee or payment which exceeds the estimated loss, otherwise they risk drafting a clause which is unenforceable as a penalty.

Water authorities must therefore be able to demonstrate that performance and non-performance payments are not 'penalties'.  This may be on the basis that:

  • the fee is a genuine pre-estimate of the loss and damage that will be suffered by the water authority should the contemplated event occur
  • the fee is consideration for providing an additional service such as agreeing to extend a time period or accepting a lower level of performance.

 A genuine pre-estimate

Clauses which seek to recover a fixed amount from the other party on the occurrence of a specified event must be a genuine pre-estimate of the loss likely to be incurred. The purpose of the clause must be to recover the actual loss suffered by a party, rather than to penalise the other party for non-performance. This requires calculation of the relevant loss which could be based on specific factors such as rent, the cost of labour, the cost of having to retain another service for longer than anticipated or the reduced value of a service being performed at a lower level.

Water authorities should be particularly wary of clauses which purport to charge a flat fee in the case of default of the other party. If the loss is likely to vary depending on circumstances, for example the length of time for which the breach persists or the level of performance, the clause should contain a formula for calculating the loss.

Consideration for an additional service

When drafting a contract, another way to possibly avoid having provisions struck out as penalties is to characterise a transaction as a payment for a right or benefit, rather than as a payment of compensation for breach or failure to adhere to a term. For example, in Paciocco, the overdrawn fees were considered payment for a further accommodation or benefit, being access to extended credit, rather than a penalty for overdrawing the account.

Appeal and other actions

Both parties appealed the Paciocco decision and the appeal was heard by Chief Justice Allsop and Justices Besanko and Middleton of the Full Court of the Federal Court in August 2014. Judgment was reserved.

What have we learnt?

The decision in Paciocco indicates that water authorities should examine any contractual terms which require the other party to make a financial payment on the occurrence of a certain event. Any clauses which impose a penalty on the basis of Paciocco should be re-drafted.

The outcome of the appeal and separate class action proceedings will provide guidance for authorities in correctly drafting enforceable contractual terms in future.