In this case, the Victorian Supreme Court looked at the rules of abandonment of contracts and when a clause will be a penalty clause.

Key learnings

This case demonstrates that even if a party refuses to terminate an agreement and subjectively did not intend to do so, their outward actions may demonstrate they have abandoned it. By not expressly or impliedly reserving any rights that may have accrued under the agreement prior to the abandonment, they may also be taken to have abandoned them too. The case also confirms that a breach is not necessary for the law on penalties to apply - all that is required is a link between the relevant payment and securing the performance of primary obligations.

Background

This case centred on a manufacturing, processing and packaging services agreement between an abattoir (Cedar Meats) and a lamb producer (Five Star) entered into in 2009. The agreement stipulated that Five Star was to provide certain daily volumes of lamb to Cedar Meats. Under clause 8(a), if Five Star was 25% or more short of the daily volume, it was still required to pay a fee equal to 75% of the price that would have been payable had the daily volume been met. Although Five Star failed to meet the agreed volumes from the commencement of the agreement, Cedar Meats did not invoice Five Star for the shortfall and did not press Five Star to make that payment. In 2011, Five Star announced it was going to a different processor. Cedar Meats then sent them invoices for amounts owing under clause 8(a) for a total close to $15 million.

Abandonment

The judge decided that Five Star did not owe Cedar Meats any money because the parties had demonstrated a mutual intention to abandon the agreement and any rights that may have accrued under it. The judge looked at how the parties had outwardly conducted themselves from the end of October 2010, when production ceased due to the low volumes of lamb. In November 2010, a meeting was held at which Cedar Meats refused to sign a draft termination agreement prepared by Five Star. Despite this, the judge accepted Five Star left the meeting thinking the agreement was no longer on foot. This was based on evidence Cedar Meats had said they did not feel a formal agreement was necessary and they hoped that Five Star would get back on its feet and would produce with them again. Five Star then underwent financial reorganisation and commenced 2011 with fresh equity on the basis it did not owe anything to Cedar Meats.

Production restarted in 2011. However, it was on an ad hoc basis and in quantities and for prices that were different to the original agreement. Invoices rendered by Cedar Meats to Five Star for the different processing services were also provided by different entities. Importantly, the agreement was not mentioned in writing and the period during which the parties acted in variance to the agreement was 1/3rd the length of the original agreement. Further, Cedar Meats did not record as an asset on their balance sheets for the relevant years any debts owed by Five Star to them. The judge found that these facts demonstrated that the parties had abandoned the agreement. Because Cedar Meats had not impliedly or expressly reserved their rights under the agreement, they were also taken to have abandoned any rights to any money owing prior to the abandonment of the agreement.

Penalty Clauses

While not necessary, the judge went on to consider whether clause 8(a) setting out the minimum payment was a penalty clause and would otherwise be unenforceable.

Looking first at whether a payment clause other than for breach could be a penalty clause, the judge took a modern, substantive approach. The critical question was whether the burden imposed by the clause is "extravagant and unconscionable". Through application of the recent High Court decision of Andrews v Australia & New Zealand Banking Group Ltd (2012) 290 ALR 595, the judge then qualified this substantive approach by stating that a payment clause for additional services or accommodation cannot be a penalty clause. For the law as a penalty to apply, there needed to be a link between payment and securing the performance of primary obligations. In this case, the law on penalties applied as the clause was intended to secure the performance by Five Star of its primary obligation to supply a daily volume of lamb.

The clause provided that Five Star would pay Cedar Meats $21.50 per head of lamb as though they had processed 75% of the agreed daily volume of lambs, irrespective of how many lambs Five Star supplied. The judge found this 'greatly exceeded the actual damages likely to be inflicted'. Critical to this finding was that 'most of the costs of performing the contract would be saved' if Cedar Meats did not have to process as many lambs and this saving was 'not reflected in the formula'. On this point, the agreement was distinguishable from a gas supply agreement, under which 'costs associated with supply are sunk costs'. The distinguishing element in this case was the labour intensive nature of the service provided and the significant cost savings incurred when that service was not provided. Although new equipment was required to be installed by Cedar Meats for Five Star's production line (a deboning room), this did not affect the judge's decision. This was because the equipment was borrowed to begin with and also because under the agreement, Five Star was charged per head in respect of equipment fee to off-set this cost. The judge therefore concluded that the clause allowed for an 'extravagant amount that far exceeds the greatest loss suffered' by Cedar Meats. As such, the clause was found to be a penalty.

To see the full judgment in this case, please click here.