1. Take home message

The recent High Court decision in Andrews v Australia and New Zealand Banking Group Limited1 has expanded the scope of the penalties doctrine.

Contract drafters will need to be cognizant of this updated interpretation to avoid drafting clauses that may be challenged as a penalty, where the clause requires one party to a contract to pay a counterparty to the contract an amount of money, or otherwise suffer a detriment, where the first party has failed to meet an obligation on it in the contract.

  1. Decision in the Andrews case

Prior to the Andrews case the generally accepted position in Australia was that penalties doctrine was only activated when there had been a breach of contract.

In the Andrews case the High Court unanimously held that, even in circumstances where there is no breach of contract, a payment which is:

  1. security for the performance of an obligation under a contract; and
  2. payable on the failure to perform that obligation,

could be unenforceable as a penalty to the extent it exceeds what could be regarded as a genuine pre-estimate of the loss that the claimant was likely to suffer because of that failure.2

  1. Implication for existing contracts and the drafting of new contracts

The High Court’s decision has significant implications for both contracts already entered into and the drafting of new contracts.

Some provisions that are commonly seen in commercial contracts which may face challenge as a penalty, depending on how they are drafted, include:

  1. non-compete covenants: where a payment is required to be made if a party breaches a non- compete covenant;
  2. late payment clauses: where a fee or interest is charged for the late payment of an account;
  3. take-or-pay clauses: where a payment is required to be made if the minimum volume of a product is not purchased under the contract;
  4. break fee clauses: where a payment is required to be made because the party has withdrawn from a transaction other than for cause, for example, because it has decided to pursue another more attractive alternative;
  5. compulsory share sale clauses: where an outgoing shareholder that has decided to join a competitor is required to sell its shares in the company to continuing shareholders at less than market value;
  6. KPI clauses: where a payment is required to be made because a subcontractor has failed to meet a contractual KPI; and
  7. practical completion clauses: where a payment is required to be made because the contractor did not complete the construction on time.

Further and importantly, the Andrews case suggests that the penalties doctrine does not only apply to payments, and may extend to other detriments. For example, the confiscation of property at undervalue – such as pursuant to a compulsory share sale provision – is a detriment that may be considered a penalty.