The rule against penalties is an issue that comes up in the ICT contracting space reasonably frequently. Essentially the rule means that a court may refuse to enforce a provision requiring one party to pay another party money in event of a contractual breach if that amount is a penalty.  The test of whether a payment is a penalty has traditionally been whether or not it is a 'genuine pre-estimate of loss'.

Most often, the rule comes up in discussions about liquidated damages provisions where a party agrees to pay a certain amount for failure to meet a key contractual milestone. However, it is also relevant to other payments made in ICT contracts such as service credit regimes and early termination payment provisions.

Part of the uncertainty about the application of the rule has arisen due to Australian case law in the last few years regarding the enforceability of bank fees. Traditionally an amount could only be an unenforceable penalty if it was triggered by a breach of a contractual obligation.  However, in the key case of Andrews v ANZ [2012] HCA 30; 247 CLR 205 the High Court held that it is not necessary for a fee to be payable for a breach of contract for the rule against penalties to be engaged. This potentially widened the scope of the rule to affect a number of common contractual mechanisms which require payments (or remove a right to receive a payment) but aren't triggered by a breach of contract such as 'take or pay' contracts or contracts where rights to terminate a contract carry with them a loss of accrued rights (eg loss of a trailing commission) or require payment of an early termination fee.

The uncertainty also arose because there was some debate about what was a genuine pre-estimate of loss and whether this was indeed the only test.

The recent United Kingdom Supreme Court decision, Cavendish Square Holdings BV v Makdessi [2015] UKSC 67,addresses the uncertainty and suggests that the threshold under English law for finding that a clause creates an unenforceable penalty is a high one. 

While the Supreme Court did not abolish the penalty doctrine it did restate it. In doing so it:

  • Considered and rejected the Australian approach in the Andrews decision and held that under English law the doctrine still requires that the alleged penalty is triggered by a breach of a contractual obligation
  • Held that the distinctions drawn between a penalty and a genuine pre-estimate of loss are unsatisfactory and artificial. The true test was whether the clause "imposes a detriment on the contract-breaker out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation."

The Supreme Court noted that the penalty doctrine may undermine the certainty which parties are entitled to expect of the law and that if the relevant contract is negotiated by properly advised parties with comparable bargaining power, there is a strong initial presumption that the parties are the best judges of "what is legitimate in a provision dealing with the consequences of a breach".  While we do not yet know whether New Zealand law will follow either the Australian or the English approach to the doctrine, the UK Supreme Court decision is, in our view, a welcome development which puts the focus back on freedom of contract.