A recent case before the High Court, involving 38,000 ANZ customers who disputed the bank fees charged to them, will profoundly impact any contracting party, in any industry, that has penalties 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 that fee is out of all 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.

This should not be confused with a liquidated damages provision which 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 will accordingly not be invalid for being out of all proportion to the loss or damage suffered.

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

History of the doctrine against penalties

Understanding the doctrine of penalties, as the High Court 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. And where less was incurred, the amount would be reduced accordingly. In essence, the clause, similarly to today’s law, needed to embody a genuine pre-estimate of damages and an amount could not be recovered that was all out of proportion to the loss or damage actually suffered. Hunter, in his great 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 aueri sum could be charged under the contract. This was invalid as a penalty then, just as it would be today, as the penalty was all out of proportion. Here, Cornelius could not recover more than was really due (60 aurei), and 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 (2008) 257 ALR 292 (incorrectly) established that relief from penalties was only available for fees payable on breach of contract. What does this mean? Say you have a smartphone on a finance plan with XYZ Ltd, and the contract says ‘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 you breached the contract by refusing to pay any of the $50 instalments at all, XYZ would not be allowed to charge the penalty as you would be in breach, but if you kept the contract and were merely a few days late in payment, then you would have to pay the penalty. Lord Denning in Campbell v Bridge made the apt observation that this means 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: penalties are always illegal, whether charged on breach or otherwise.

In the case of Andrews v ANZ, ANZ charged customers honour, dishonour, non-payment and over limit fees. Justice Gordon, the trial judge, followed Interstar (as her Honour 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 upon which these fees were charged (making non-compliance with these events not breaches of contract). The High Court then stated that just because there was no breach, did not mean that the doctrine against penalties could not apply. Accordingly, if these fees were out of all proportion to the actual damage suffered, those fees would be invalid as penalties. (Note: the High Court did not decide if the fees were actually penalties; their Honours sent that question 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.

Two important exceptions to the doctrine against penalties

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. Parties should be careful, however, 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 that acquires a licence to show a movie for $100 on its first screening, with additional screenings costing $400, will not be paying a penalty for the additional screenings; the additional payment is not to secure the obligation of paying the $100, rather it is for an entirely separate service.

Conclusion

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

If you have liquidated damages clauses or penalty clauses in your contracts or if you are being charged penalties under contracts, you should seek legal advice.

Examples of penalties:

  • A bank’s customer might be obligated by contract to not overdraw her account. If she overdraws her account by 1 cent, then the contract might allow the bank to charge her a $35 penalty. If the bank only needs to pay interest rates on that cent, of say 3.5% plus a buffer for possible default of say 3%, and for the services of a computer to automatically charge the payment, then $35 would likely be all out of proportion to the real cost of providing that cent and will accordingly be an penalty.
  • A university student may be obligated to sit an exam at 9:15am on 1 October 2012, and her contract with the university might say that if she cannot make the exam on time, the university will charge her a $180 penalty. This will likely be out of all proportion to the cost of taking her off the exam roll (and the cost of putting her on another, later roll) and it 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 $100 fee, this will likely be all out of proportion to the damage suffered by the financier and will accordingly be a penalty.

Quintin Rares