A recent decision of the High Court of Australia in Andrews v Australia and New Zealand Banking Group Limited (Andrews) (available here) has expanded the scope of the common law penalty doctrine to include payments stipulated for events other than breach of contract. The decision is likely to present potential challenges to the enforcement of a variety of fees/payments. It has implications for contractual drafting, including in relation to break fees in a corporate finance context.

In this FYI, we:

  • summarise the traditional formulation of the penalty doctrine and how Andrews might have altered it;
  • summarise the Andrews decision;
  • discuss the practical implications of the Andrews decision; and
  • offer a starting point for "Andrews-proofing" a break fee arrangement.

Summary of the penalty doctrine

It is a basic principle of contract law that parties are free to contract for the payment of a sum of money between them. This basic freedom has historically been subject to a significant proviso - where a payment is triggered by a breach of contract, the payment must be a genuine pre estimate of loss suffered by the recipient. If the payment is not a genuine pre-estimate of loss, it will be unenforceable as a "voidable penalty". This is commonly known as the penalty doctrine.

In the past, any payment which was not triggered by a breach of contract (such as a break fee) would not amount to a voidable penalty under the penalty doctrine, regardless of its quantum. However, Andrews has cast doubt upon this position. Andrews suggests that the penalty doctrine can apply to situations in which the event requiring the payment of a fee is not a breach of contract. In light of Andrews, drafting contracts with specified contingent payment obligations will require more careful consideration to ensure those obligations remain enforceable.

Andrews v ANZ

In Andrews, the claimants (a group of around 38,000 ANZ customers) argued that certain fees charged by ANZ (including late payment and "over limit" fees) were void as penalties, and sought repayment of those fees. At first instance, the Federal Court followed the traditional formulation of the penalty doctrine, concluding that since the fees were not charged as a result of the customer's breach of contract they could not be subject to the penalty doctrine and had been legitimately charged.

The High Court of Australia disagreed, concluding that the penalty doctrine could apply to charges stipulated in circumstances other than for breach of contract. The court endorsed a previous lower court finding that, in addition to cases relating to a breach of contract, "relief may be granted in cases of penalties for non-performance of a condition, although there is no express contractual promise to perform the condition."

The High Court in Andrews observed that the application of the penalty doctrine does not turn on the occurrence (or otherwise) of a breach of contract. Instead, it turns on whether the payment of the fee, construed on the specific wording of the contract, was designed to impose a penalty for a breach of contract (in which case the penalty doctrine applies) or simply to impose a payment in consideration for the accommodation of the payor taking a different course from that contemplated by the contract (in which case it doesn't). In other words, the High Court, in determining whether to characterise a stipulated payment as a penalty, emphasised the essence of the payment or fee (according to the pre-estimate of loss rule), rather than the circumstances under which the payment or fee is charged - a classic 'substance over form' analysis.

Importantly, while the High Court found that the penalty doctrine could in theory apply to bank fees, it did not determine whether the fees charged by ANZ were penalties - this question remains to be decided by the Federal Court.

Andrews in practice

Andrews is an Australian decision. However, it is a decision at the highest appellate level and is likely to be persuasive in NZ courts. It is therefore no longer safe to assume that a term of a contract which obliges a party to make a payment on the occurrence of a certain event will escape the penalty doctrine simply because the circumstance which triggers the payment is not a breach of contract.

In a commercial context, parties will wish to consider carefully the use of liquidated damages clauses and prescribed payments clauses when formulating agreements, and should ensure as best they can that such payments amount to a genuine pre-estimate of the loss which is likely to arise as a result of the triggering event. Such clauses should not be penal in substance.

Perhaps of most concern in the corporate finance context is the potential for the penalties law in New Zealand to be expanded based on Andrews permitting break fee arrangements to be challenged. Break fee arrangements have, to date, been considered immune from treatment as penalties. This historic immunity has been on the basis that break fees are due and payable not on the failure of the target to fulfill a contractual promise (ie breaching the contract) but rather upon the target being entitled to cease and ceasing to treat with the relevant bidder.

Andrews-proofing a break fee arrangement: a starting point

It is difficult to speculate on how break fees will be treated by the courts as a result of Andrews. However, the following considerations should be borne in mind when attempting to "Andrews-proof" agreements which stipulate non breach-related fees or charges, for example break fee arrangements:

  • any entity seeking to enforce on a break fee should, to the extent possible, seek to specify the relevant costs (in terms of both subject and quantum) in the break fee arrangement. Such a specification will support an argument that the fee is a genuine pre-estimate of loss. This approach contrasts with that currently adopted by many bidders, where the fee is simply linked to a percentage of equity value.
  • the High Court in Andrews attempted to set out an alternative test for whether or not a payment obligation amounts to a penalty - whether the payment is strictly a punitive amount or whether it is consideration for the target company being allowed to take an alternative course or provision of a further service. Such arrangements could, in the future, seek to highlight the latter aspect of the break fee. For example, a contract might state that the fee is to be paid as consideration for the target being allowed to pursue an alternative transaction.

Further reason to be pessimistic about break fees

In addition to the uncertainties created by Andrews, 2012 saw the High Court of England and Wales hand down the decision in Paros plc v Worldlink Group plc, which casts further doubt upon the legitimacy of break fee arrangements.

In that case, a break fee was agreed by Worldlink in return for Paros' investigation of a potential takeover. Although the takeover did not take place, the court concluded that the fee amounted to financial assistance as a payment which "smooths the path" toward an acquisition. This certainly casts doubt on the view that a break fee will not amount to unlawful financial assistance merely because it will not be paid in the context of an actual acquisition of shares.