Australia: When will a fee be a penalty (for breach of contract)?

Last Updated: 25 November 2014
Article by Roger Mattar

The doctrine of contractual penalties has arguably gone full circle since its equitable origins in the 17 th century. Largely regarded as settled law relying essentially on Lord Denedin's judgment in Dunlop Pneumatic Tyre 1 until the recent High Court case of Andrews v ANZ Bank 2 . With the extensive history of the doctrine of penalties and its slow evolution, any case that expands or significantly modifies the doctrine is likely to be considered controversial. The Andrews case 3 (as applied in the Paciocco 4 case recently) has certainly been called controversial 5 if not just for extending the penalty doctrine to any clause in any type of contract and drawing on both equity and common law to establish a "new" test as to whether or not a clause will be a penalty.

Brief overview of Penalty origins

The doctrine of contractual penalties initially arose from equity to provide relief against penal bonds in property contracts, back in the 17th-centrury. Penal bonds operated at common law similarly to security bonds do today for example in leases, but in essence equity granted relief in respect of payments activated by a variety events occurring – not limited to breach of contract. In the early days, equity would grant relief against a penal bond where it was possible to compensate the obligee for the loss suffered as a result of the default (by contract damages). The question at that time as to whether or not a particular contractual provision constituted a penalty did not turn upon the conduct of the parties, but on the question of whether or not the sum required to be paid constitutes, in itself and in substance, a penalty 6 .

As the doctrine evolved, penalties were called upon in contracts generally (not just property contracts). Eventually the doctrine became reasonably settled so that it was understood to be activated by a breach of contract.

Now, after the Andrews case, the penalty doctrine has been expanded and a new test propounded where a breach of contract is no longer a necessary ingredient for its activation.

What is a Penalty?

Until the Andrews 7 case, the modern law of penalties was well understood. Essentially, the law was set down in the landmark judgment of Lord Dunedin in the Dunlop Pneumatic Tyre 8 case which can be summarised in four propositions 9 :

  1. distinguishing between a "genuine pre-estimate of loss" and a "penalty" when claiming liquidated damages for breach of contract;
  2. a genuine pre-estimate of loss is enforceable in a claim for liquidated damages where as a penalty clause is void or unenforceable (and the claimant is left to rely on a damages claim);
  3. whether a clause is a penalty or not is a question of legal construction as at the contract date (not the date of breach) and the parties' intentions are not relevant; and
  4. an agreed damages provision is prima facie effective, however, the onus is on the promisor to establish that the clause is a penalty.

Where a clause in a contract to pay an agreed sum is activated when a breach of a primary obligation under a contract occurs, it will be a penalty if that agreed sum (also referred to as a secondary obligation) exceeds, what a court would consider to be a genuine pre-estimate of the damages likely to be caused by a breach as at the contract date or would be more than the greatest loss that could conceivably be proved 10 .

It should be noted, however, there are qualifiers to the general propositions outlined above, such as:

the proposition is not limited to claims of payment of sums of money or money claims – it can apply to other property or provision of benefits for example, you must sell me your property if you default under this clause; the proposition can apply in relation to a discharge of a contract for breach or where a formulae is contemplated; not every consequence that is to follow a breach of contract will be open to the penalty doctrine. For example, the right to terminate for breach is not subject to the penalty doctrine as penalty deals with executory promises and not promises that result in forfeiture on breach; a clause that provides for an "indulgence" or "concession" is not necessarily a penalty unless it is, in substance and effect, "exorbitant, extravagant and unconscionable"11 considering the contract as at the date it was made and as the contract as a whole.

The test in determining whether a clause is to be categorised as a penalty or as a genuine pre-estimate of damages is "one of degree and would depend on a number of circumstances" including 12 :

  1. The degree of disproportion between the agreed sum and the loss likely to be suffered by the claimant – how "oppressive" is the clause on the contract breaker? and
  2. The nature of the relationship between the parties becomes relevant – a factor relevant to the unconscionability of the claimant in seeking to enforce the clause.

The agreed sum would be a penalty if it is determined by the courts to be "extravagant", "exorbitant" or "unconscionable" in amount in comparison with the greatest loss that could conceivably be proved rather than merely an amount greater than the damages which could be awarded for the breach of contract. 13

Another way of expressing this proposition is: where the agreed sum is intended to operate "in terrorem" or as a threat to keep the potential contract breaker to his or her bargain, it is not liquidated damages but a penalty, or if the non-observance of a clause results in an additional or different liability on breach (example, a higher rate of interest) then it is not liquidated damages but a penalty.

What is not a Penalty?

The following have been found not to be penalties 14 :

  1. a lender accepting a lesser amount in satisfaction of debts on certain conditions. If those conditions are not met, the full debt continues to be payable.
  2. In a loan or mortgage agreement, providing for payment of default interest or additional interest is found not to be a penalty. Nor is a compound interest normally considered a penalty.
  3. The requirement to pay a sum on repossession of hired goods following a breach of contract is not a penalty.
  4. A clause providing for forfeiture of a share or of a reasonable deposit (for example, 10% of the purchase price) is not a penalty – note, however, if a larger deposit is payable on default it may be considered a penalty.

Andrews v Australia and New Zealand Banking Group Ltd (2012) 247 CLR 205 and beyond?

The High Court in the Andrews case has arguably extended the law on penalties in at least two significant ways 15 :

  • The rule against penalties is a rule of equity as well as a rule of law; and
  • Consequently, the penalty doctrine might be triggered by events other than a breach of contract.

By expanding the penalty doctrine in this way, the High Court has arguably constricted the long held principle of freedom of contract.

Justice Gordon in the recent Paciocco case 16 had the first real opportunity to apply the "new" penalty doctrine. She provided the following succinct outline of the steps to assist in determining whether or not a clause or "stipulation" in a contract is a penalty in form and substance:

  1. Identify the terms and inherent circumstances of the contract, judged at the time of the making of the contract;
  2. Identify the event or transaction which gives rise to the imposition of the stipulation;
  3. Identify if the stipulation is payable on breach of a term of the contract (a necessary element at law but not in equity). This necessarily involves consideration of the substance of the term, including whether the term is security for, and in terrorem of, the satisfaction of the term;
  4. Identify if the stipulation, as a matter of substance, is collateral (or accessory) to a primary stipulation in favour of one contracting party and the collateral stipulation, upon failure of the primary stipulation, imposes upon the other contracting party an additional detriment in the nature of a security for, and in terrorem of, the satisfaction of the primary stipulation.

If the answer to either question 3 or 4 is yes, then further questions arise (at law and in equity) including:

  1. Is the sum stipulated a genuine pre-estimate of damage?
  2. Is the sum stipulated extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved?
  3. Is the stipulation payable on the occurrence of one or more or all of several events of varying seriousness?

In considering several bank fees or exception fees that ANZ charged to its customer, only one was held to be a penalty both at law and in equity (namely credit card late payment fees). The late payment fee was held to be payable as a consequence of a breach of contract (penalty at law) and as a collateral stipulation to the primary stipulation to pay the outstanding amount owing by a certain time (penalty in equity). Her honour decided that the quantum of the fee was extravagant and unconscionable as the loss to the Bank would be no more than $3 while the Bank fee was $35. Accordingly, the fee in excess of $3 was a penalty and to that extent not enforceable.

The honour, dishonour and over limit fees were not penalties but held to be fees payable for additional financial accommodation requested by the customer.

On that basis, it may be possible to draft a "fee", that may otherwise be judged a "penalty" under the Andrews test, so that the fee was payable in consideration for further services or financial accommodation rather than a threat to ensure compliance with a contractual term or be associated with a breach of contract.

Non bank fees case

Another opportunity to consider or apply the new penalty doctrine post Andrews case occurred in October this year. In the recent Queensland Supreme Court case of GWC Property Group 17 Justice Dalton had an opportunity to apply the Andrews case but to a different factual circumstance to bank fees.

In that case, lease incentives clawback (usually documented in separate incentive deeds) were in question. The landlord had provided the tenant law firm (that since became insolvent) with a fitout contribution and rent abatement as an incentive to enter into the lease. As the tenant became insolvent, the landlord sought to enforce the incentive deed against the guarantors. The incentive deed contained provisions that required the tenant (and the guarantors) to repay or "claw back" a proportion of the incentive paid to the tenant (determined by way of a commonly used formula) if the tenant was in default and the lease was terminated as a consequence.

The court decided that the incentive claw back negotiated at the commencement of lease terms was penalty and not enforceable. Justice Dalton in that case was of the view that the incentive clawback in the incentive deed would have been a penalty before or after the Andrews era as the claw back payments were a secondary obligation to the primary obligation and were linked exclusively to any breach of contract. The claw back payments were significantly greater than contract damages that could be awarded to the landlord for the breach of the lease, especially where termination was for non-repudiation of the contract.

Final thoughts?

While the High Court in the Andrews case may have been controversial in its judgment by expanding the doctrine of penalties to any contract provision and, to some commentators, without applying any "modern authority" to support its judgment 18 , the court has however provided new guidelines or test for when a penalty is a penalty. While yet to be further tested, it still may be possible to draft a clause that might otherwise be a penalty, by associating the "fee" with a service or further consideration to avoid equity and common law rules voiding the clause as a penalty.


1 Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co Ltd [1915] AC 79
2 Andrews v Australia and New Zealand Banking Group Ltd [2012] HCA 30
3 Refer note 2
4 Paciocco v Australia and New Zealand Banking Group Ltd [2014] FCA 35
5 Carter JW, Courtney W, Peden E, Stewart A and Tolhurst GJ, "Contractual Penalties: Resurrecting the Equitable Jurisdiction" (2013) 30 JCL 99
6 Halsbury's Laws of Australia [185-995]
7 Refer note 2
8 Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co Ltd [1915] AC 79 applied in Australia in Ringrow Pty Ltd v BP Australia Pty Ltd (2005) 224 CLR 656
9 Refer note 4
10 Refer Ringrow Pty Ltd v BP Australia Pty Ltd (2005) 224 CLR 656
11 AMEV v UDC Finance Ltd v Austin (1986) 162 CLR 170 at 190
12 Halsbury's Law of Australia [185-990]
13 Refer note 1
14 Halsbury's Laws of Australia [185-992]
15 Tyree A, "Fees and Penalties" (2014) 25 JBFLP 43
16 Refer note 4
17 GWC Property Group Pty Ltd v Higginson & Ors [2014] QSC 264 per Dalton J
18 Refer note 5 at 101

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.

Kemp Strang has received acknowledgements for the quality of our work in the most recent editions of Chambers & Partners, Best Lawyers and IFLR1000.

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Roger Mattar
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