In September 2012, the High Court threw the law of penalties into a state of uncertainty following its decision in Andrews v Australia and New Zealand Banking Group. Now, more than 12 months later, the trial judge whose decision was overturned in Andrews, has handed down a judgment applying the Andrews principles to many of the same issues. It is hoped that this decision may be the first step to the High Court clarifying the scope of the penalties doctrine.

Andrews decision

In Andrews, the High Court was asked to decide whether a payment (in this case certain bank fees) could be a penalty in circumstances where there was no breach of contract. Importantly, the Court was not asked to decide whether the bank fees in question were, in fact, a penalty.

Ultimately, the Court held that a payment could be a penalty even if there was no breach of contract (see our previous article, What the Andrews decision means for your agency's agreements). In coming to this conclusion, it reversed its previous decisions and underlying reasoning on the issue, several recent Court of Appeal decisions, and the generally accepted position in Australia. This new position was based on the Court's formulation of a threshold test for a penalty, which provided that:

"In general terms, a stipulation prima facie imposes a penalty on a party ("the first party") if, as a matter of substance, it is collateral (or accessory) to a primary stipulation in favour of a second party and this collateral stipulation, upon the failure of the primary stipulation, imposes upon the first party an additional detriment, the penalty, to the benefit of the second party. In that sense, the collateral or accessory stipulation is described as being in the nature of a security for and in terrorem of the satisfaction of the primary stipulation."

In essence, the Court held that there is a distinction between a collateral stipulation to secure the performance of a primary obligation, which is a penalty, and a payment in return for further services or accommodation, which is not a penalty. The decision creates great uncertainty because although it provides a threshold test, it gives very little guidance on the criteria to be applied to determine whether a provision is in fact a penalty.

To confuse matters more, in Andrews the High Court also stated that:

  • the penalties doctrine is a matter of equity rather than contract
  • the penalties doctrine is not engaged if the compensation to the beneficiary of the clause is not capable of assessment, and
  • a penalty is not void or unenforceable, but is able to be enforced to the extent necessary to recover the loss actually suffered.

Each of these propositions is controversial and, due to the lack of guidance in the decision, creates a high degree of uncertainty in their application.

Additionally, the Andrews decision has led many to question the status of a number of commonly used commercial terms including:

  • take or pay clauses
  • break fees
  • termination for convenience payments
  • performance-based incentives, such as loss of incentive payments for not delivering a project early
  • compulsory transfer obligations
  • additional interest rates for late payment indemnities, and
  • time bars.

The scope of the doctrine will need further pronouncements by the High Court before any certainty is obtained.

The Paciocco decision

The recent Federal Court decision in Paciocco v Australia and New Zealand Banking Group Limited, also involved a representative action on whether certain bank fees were penalties. If the matter is appealed up to the High Court, the case may be the vehicle to provide much needed clarity on the scope of the penalties doctrine.

In Paciocco, to determine whether the fees were a penalty, the Court, applying Andrews, analysed the fees in terms of whether they were a:

  • collateral stipulation to secure the performance of a primary obligation, which is capable of being a penalty, or
  • payment in return for further services or accommodation, which is not a capable of being a penalty.

The Court categorised the late fee payment as a collateral stipulation to secure the performance of a primary obligation; therefore, it was capable of being a penalty. The next question for the Court was whether the quantum of the payment was extravagant and unconscionable relative to the loss that may be incurred. To answer this question the Court applied the principles set out in the pre-Andrews authorities.

So where are we now?

The question of how these decisions about the validity of certain bank fees apply to other commercial situations remains unclear. However, based on an analysis of the judgments applying I, it may be that the only change is that parties cannot circumvent the penalties doctrine by drafting the payment so that it arises without a breach of contract. Other than this change, the previously established criteria of what constitutes a penalty seem to continue to be applied.

Given the uncertainty in the area, the lack of superior court guidance and the far-reaching principles stated in the Andrews decision, we recommend that great care be taken when drafting clauses that could fall within the threshold test.

Based on the current state of the law, it seems that the only certainty is that to be a penalty requires the stipulation to be penal in nature. Accordingly, lawyers should ensure that whenever drafting a stipulation that may meet the threshold test, it reflects a genuine pre-estimate of damages.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.