Australia: When liquidated damages become a penalty?

Since the High Court case of Andrews v ANZ Bank ¹was handed down in 2012, a great deal of legal uncertainty followed in respect of the enforceability of certain common contract provisions. Clauses in contracts that were traditionally not considered to be penalties because they did not arise from breach of contract, were now open to be a penalty and unenforceable or unenforceable to the extent that they were a penalty. The enforceability of liquidated damages clauses was always susceptible to being voided by the penalty doctrine due to the inherent nature of those clauses however the recent Queensland Supreme Court case of Grocon Constructions ² has provided some reprieve to the application of the penalty rule to liquidated damages in contracts.

Liquidated Damages or "LDs"

Traditionally liquidated damages clauses (or "LDs") were defined as a genuine pre-agreed or pre-estimate of damages or a fixed sum of money (or other benefit) for the happening or non-happening of a specified event, typically that event is a breach of contract. By their very nature, LDs were a type of self-help remedy that do not require proof of loss – one need only establish the occurrence or non-occurrence of the specified event, for liquidated damages to be payable.

LDs ordinarily survive termination of the contract as inherently LDs are intended to operate on breach of contract or, in other words, are intended to operate when the secondary obligation to pay damages arises.

Penalties

As the equitable doctrine of penalties evolved, penalties were called upon, at law, in contracts generally (not just property contracts) to provide relief against oppressive or unconscionable provisions or actions of the innocent contract party. Eventually, with common law and equity subsumed, the doctrine became reasonably settled so that it was understood to be activated by a breach of contract ³.

With the penalty doctrine reasonably settled some time ago, LDs have since been on precarious grounds as they were conventionally associated with breach of contract. Despite that, LDs have largely survived and have been largely enforceable provided they were drafted with the penalty doctrine in mind.

What is a Penalty?

Until the Andrews ⁴ case, the modern law of penalties was reasonably well understood. Essentially, a penalty is where, in substance, a requirement to pay money (or other liability) for breaching the contract, is in terrorem or a punishment for the contract breacher not just compensation. The law was set down in the landmark judgment of Lord Dunedin in the Dunlop Pneumatic Tyre ⁵ case which can be summarised in four propositions ⁶:

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 can be regarded" as 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 ⁷.

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

1. 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;
2. the proposition can apply in relation to a discharge of a contract for breach or where a formulae is contemplated;
3. 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;
4. 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" ⁸ 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" including⁹:

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.¹⁰

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 thenon-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 ¹¹:

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 ¹²:

• 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 Paciocco case ¹³ at first instance, 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 under Andrews:

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.

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

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

In the Andrews case, the court held that penalty doctrine is not engaged if the damage is insusceptible of evaluation and assessment in monetary terms and that it is the availability of compensation for the breach of a stipulation which gives rise to the intervention of equity.¹⁴

A clause would be a penalty under Andrews if forfeiture goes beyond a genuine pre-estimate of damages but an act of forfeiture in a contract can be read down as a penalty and is not restricted to a breach of contract and the clause will no longer be void as a penalty but enforced only to the extent necessary to compensate.

The honour fees, dishonour fees and over limit fees were not penalties under Andrews as these fees were payable for additional financial accommodation requested by the customer and on that basis would be removed from the penalty doctrine.

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.

Post Andrews: Paciocco case

The Full Court of Appeal decision in Paciocco & Anor v Australia and New Zealand Banking Group Limited [2015] FCAFC 50 (Paciocco case) continues the debate on the scope of what charges are considered to be penalties, and sets the scene for an appeal to the High Court. The case concerns a challenge to various bank fees charged by ANZ. It was argued that either the fees were penalties or that the fees were unconscionable, unfair or unjust. At first instance, the Court held that only the late credit card payment fees were penalties and none of the disputed fees were unconscionable, unfair or unjust. ANZ appealed to the Full Federal Court and Mr Paciocco cross-appealed. In relation to the penalties issue, the Full Court allowed ANZ's appeal, holding that none of the fees, including the late payment fees, were penalties.

The Full Court applied the High Court's approach in the Andrews case, namely that a clause providing for the payment of a sum upon breach of contract or as security for the fulfilment of a primary obligation will be a penalty clause if the amount to be paid is not a genuine pre-estimate of loss and is 'extravagant' in relation to the loss that could be conceivably suffered by the other party. The Full Court found that any inquiry into loss was to be prospectively assessed (ex-ante) at the time of entering the contract, rather than ex-post.

The decision demonstrates that all circumstances need to be considered when determining if a fee is extravagant, however, the parties do not need to express, negotiate or set out the sum by reference to an estimate of damage. Importantly, increases in ANZ's loss provisions and the cost of regulatory capital were considered as part of the relevant losses that can be considered and the interests being protected as part of the fees charged.

Special leave to appeal to the High Court was granted in Paciocco in September 2015. The appeal provides a further opportunity for the High Court to consider the principles relating to penalty clauses (and their application) since Andrews. It may be that the High Court will move away from its earlier controversial decision in Andrews and move towards the Court of Appeal's approach. If so, this may make it more difficult for consumer groups to challenge standard form contracts used by banks and utility providers.

Non-bank fees cases:

Grocon Constructors (Qld) Pty Ltd v Juniper Developer No. 2 Pty Ltd

In July 2015, the Queensland Supreme Court had an opportunity to apply the Andrews case to a liquidated damages clause in a construction contract. The decision gave many traditional lawyers some comfort as the result confirmed the enforceability of LDs, considering the Andrews test.

The basic facts of the Grocon Constructors case are that the developer (Juniper) contracted with the builder (Grocon) to build a large development in Queensland in 4 severable parts using AS4300-1995 standard form of contract. Grocon sued Juniper for unpaid moneys for work and other delay costs and Juniper counterclaimed for over $33 million in liquidated damages under the contract.

The LD clause was triggered by Grocon failing to achieve practical completion by the specified date under each part of the project. Practical completion for each part included, what most would consider, relatively minor or trivial defects such as:

• Providing the developer with 2 sets of keys for the project fitted with plastic tags with approved label inserts and final locks supplied
• Replacing and defective light globes
• The whole development to be professional cleaned and all rubbish and unwanted equipment removed

The liquidated damages clause in the contract provided for an initial rate of liquidated damages that increased (actually doubled) over time and there was a different rate for each part of the project. The clause specified whether the amounts were cumulative or not and the extent of them cumulating.

Grocon argued that the liquidated damages clause was a penalty because:

1. It imposed substantial payment obligations on Grocon for trivial breaches of contract that would not cause Juniper comparable loss; and
2. It required payment of a single lump sum on the occurrence of a variety of events, some significant and some trivial.

Basically, Grocon was claiming that the clause was a penalty as the amount recoverable under the clause was disproportionate to the loss that may be suffered if Grocon failed to provide the items required for practical completion.

Juniper's submission was that the penalty doctrine did not apply unless the liquidated damages clause was extravagant or unconscionable when compared to the greatest possible loss that could flow from the breach, rather than the smallest loss, as argued by Grocon. In this case, Juniper was unable to provide possession of the property and settle the sales contract until practical completion. Further, Juniper argued that the liquidated damages did not operate in respect of a variety of events, but only where Grocon failed to achieve practical completion by a specified date.

The Court essentially accepted Junipers arguments and the liquidated damages clause was not a penalty. The Andrews case was distinguished on one part because, unlike the Andrews case, this case is not one where the breach can occur many times and in many ways with each breach having different consequences. Also, the court decided that it is insufficient for the accessory or secondary liability be of a different nature to the primary stipulation, but that the different liability must satisfy the penalty test set out in Dunlop and in particular that additional or secondary liability must be in the nature of a punishment for the breacher. Considering the onus of proof for the penalty doctrine lies with the party seeking to establish the penalty doctrine applies, it cannot be assumed triggered simply because a different or accessory liability had arisen under the contract.

The Court in Grocon Constructors case emphasised that the penalty doctrine was an exception to the freedom of contract and as such, for the penalty doctrine to be triggered it must be judged "extravagant and unconscionable in amount" or out of all proportion, rather than just lacking in proportion. A consideration of what attracts the liquidated damages clause is important in determining the application of the penalty doctrine, as set out in Dunlop. Whether a number of events attract the LD clause or just one event (which itself may comprise of many elements) is also important in whether the LD clause is a penalty.

GWC Property Group Pty Ltd v Higginson & Ors

Another opportunity to consider or apply the new penalty doctrine post Andrews case occurred late in 2014. In the recent Queensland Supreme Court case of GWC Property Group (15) Justice Dalton had an opportunity to apply the Andrews case but to a different factual circumstance to bank fees.

In that case, lease incentives clawbacks (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 a 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.

Other recent cases

Other recent cases do not necessarily follow a common and uniform trend. For instances in Zomojo Pty Ltd v Hurd (No.2) (16) the issue before the court was basically whether a certain clause in an employee share ownership plan whereby the company had discretion to set the price of shares acquired from a "bad leaver", was a penalty. Gordon J concluded the clause was inserted because intellectual property knowledge of Hurd was such that if used to his advantage, could substantially affect the value of the company. The court held as the extent of the damage couldnot be known, the clause was a penalty. This would appear to be contrary to both Dunlop and Andrews where it was held if compensation is insusceptible to assessment in monetary terms, the penalty doctrine was not triggered.

In IPN Medical Centres v Van Houten (17) the issue before the court was whether a clause in a sale contract requiring a doctor to pay for the remainder of the service contract if he breached that contract, was penal. Jackson J in deciding it was not a penalty, held that a clause will be a genuine pre-estimate of loss if it is not "unconscionable, extravagant or oppressive". The scope of pre-determined loss and the value of the interest being protected by the clause were important, as parties will not be able to claim additional damages or adequate damages in the circumstances.

The Australian position as set out in Andrews is in contrast to the approach recently adopted in the UK in Cavendish Square Holding BV v Talal El Makdessi; Parking Eye Limited v Beavis [2015] 3 WLR 1373. The UK Supreme Court rejected a clear delineation between penalty clauses and genuine pre-estimates of loss. The majority stated: 'The fact that the clause is not a pre-estimate of loss does not therefore, at any rate without more, mean that it is penal'. Under the UK approach, a clause that imposes an obligation on a defaulting party to pay an amount exceeding a genuine pre-estimate of loss might not be penal if the party has a legitimate interest in stipulating the sum. In that case an £85 parking charge was held not to be a penalty nor was a US$44million price reduction mechanism for breach of a restrictive covenant in business sale agreement. The court focused on the legitimate interests being protected rather than a genuine pre-estimate of loss. The court claiming that it is reluctant to interfere with a parties' bargain. It was also interesting to note that the penalty doctrine was held to be a common rule and not an equitable one.

Drafting Tips: Liquidated Damages clause

The Australian Contract Law Reporter has a table of do's and don'ts in drafting a liquidated damages clause.(18) However, below is an extract of that table with the more fundamental points to keep in mind when drafting a liquidated damages clause:

In relation to the amount of the LD:

• Specify an actual amount, a rate, a formula or other way to calculate the LD and the basis of its formulation (where possible)
• Focus on compensation when fixing an amount (especially for failure to pay)
• Consider whether to vary the fixed amounts due to circumstances (eg, extended delays or seasonal factors)
• Link the amount to the seriousness of breach, where possible
• Apportion the amount between stages of the project
• Reconsider the LD amounts when varying the contract
• Consider capping the LD amount, if appropriate. If applicable. Link the cap back to any exclusions/limitations to the LDs.

In relation to the LD clause itself:

• State the LD are genuine pre-estimate of loss or, if applicable, the actual loss is difficult to determine at time of the contract. If possible, explain the basis of the LD amount
• State the parties have equal bargaining power or have had an opportunity to consider the LD clause
• Consider exclusions or limitations or set off rights to the LD
• State that the LDs are without prejudice to rights on termination of the contract or to general common law rights
• Where applicable, draft the LD as a primary obligation eg a fee for service under the contract
• Draft incentive based on positive achievements
• Where more than one LD amount applies, clarify amounts are not cumulative but separate.

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 (19), the court has however provided new guidelines or test for when a penalty is a penalty. Various State courts have since had an opportunity to apply or consider Andrews case and appear to have somehow resorted back to the Dunlop test without affecting the Andrews test. There is still hope for the traditional view on penalties and the efficacy of a liquidated damages clause, after the Grocon Constructors case and the Court of Appeal in Paciocco. However, it still may be possible to draft a clause that might otherwise be a penalty, by associating the "fee" with a service or by linking the LD amount to the each event and each event cannot be breached more than once.

Footnotes

¹Andrews v Australia and New Zealand Banking Group Ltd [2012] HCA 30

²Grocon Constructions (Qld) Pty Ltd v Juniper Developer No 2 Pty Ltd [2015] QSC 102; BC201502942

³See for example, IAC (Leasing) Ltd v Humphrey (1972) 126 CLR 131

⁴Refer note 1

⁵Dunlop 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

⁶Refer note 5

⁷Refer Ringrow Pty Ltd v BP Australia Pty Ltd (2005) 224 CLR 656

⁸AMEV v UDC Finance Ltd v Austin (1986) 162 CLR 170 at 190

⁹Halsbury's Law of Australia [185-990]

¹⁰Refer note 1

¹¹Halsbury's Laws of Australia [185-992]

¹²Tyree A, "Fees and Penalties" (2014) 25 JBFLP 43

¹³Paciocco v Australia and New Zealand Banking Group Ltd [2014] FCA 35; (The cased was subsequently appealed to the full court of appeal see Paciocco v Australia and New Zealand Banking Group Ltd [2015] FCAFC 50. Note this case currently on appeal to the High Court of Australia – decision due in mid 2016)

¹⁴Andrews (HC)at [11]

¹⁵GWC Property Group Pty Ltd v Higginson & Ors [2014] QSC 264 per Dalton J

¹⁶[2012] FCA 1458

¹⁷[2015] QSC 204

¹⁸Refer Para [330-830]

¹⁹Refer note 12 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.