A recent unanimous decision of the Court of Appeal
(Interstar Wholesale Finance Pty Limited v Integral Home Loans
Pty Limited  NSWCA 310), in which Deacons acted for the
successful appellant, has given some guidance on the law of
Termination on basis of reasonable opinion
A financial institution (Lender) had an
agreement with a loan originator (Originator) for
the Originator to provide loan origination and management services
to the Lender. In return the Lender was obliged to pay the
Originator an upfront fee and ongoing trail commissions.
The agreement allowed the Lender to terminate the agreement if
the Lender formed the reasonable opinion that the Originator had
engaged in deceptive or fraudulent activity. The Lender terminated
the agreement under this power.
In these circumstances, a particular clause of the agreement
allowed the Lender to cease the payment of all ongoing trail
commissions (Relevant Clause). The Lender
exercised this right and ceased the payment of all amounts to the
The Originator claimed that the Relevant Clause was void as a
penalty. The Court of Appeal decided that the Relevant Clause was
not a penalty, for the following reasons:
The question of whether a clause is a penalty is one of
construction of the contract.
The contractual provision must be assessed at the time of
making the contract and not at the time of its breach. The events
after the date of the agreement, particularly the circumstances of
the agreement's termination, are not relevant to the
construction of the contract or considering whether any of its
clauses are penal.
The Court assumed (without deciding) that the law of penalties
could apply to a payment of money, a transfer of property and a
forfeiture of property or accrued contractual rights.
Although there is conflicting authority, the better view in
Australia is that the doctrine of penalties is constrained to
circumstances of breach of contract. A provision cannot be a
penalty if it applies upon an event which is not a breach of the
contract, such as the reasonable opinion of the Lender that the
Originator had engaged in fraudulent activity.
In any event, the alleged penalty must be "extravagant and
unconscionable in amount" or "out of all proportion"
to the damage likely to be suffered as a result of the breach. In
this case, the Court recognised the significant damage to the
Lender's reputation which may be suffered in circumstances
involving deceptive or fraudulent activity.
What then is a penalty?
On the basis of this judgment, a contract will contain a
voidable penalty provision if:
The term is designed to terrify a party into complying with the
The term involves the imposition in advance of an ascertainable
The ascertainable amount includes a payment of money, transfer
of property or a forfeiture of property or accrued contractual
The effect of the penalty is suffered by the defaulting party
only upon breach of the agreement, as opposed to some other event
which is not a breach of the agreement, such as the formation of a
Without regard to the actual consequences of the breach, the
amount is extravagant and unconscionable or out of all proportion
to the actual consequences suffered by the party not in breach of
Tips for drafters
The judgment confirms that a clause can only be a contractual
penalty if it applies upon a breach of the agreement. Accordingly,
if a clause is drafted so that it applies in particular
circumstances, where the other party has not promised that those
circumstances will not occur, it cannot be a penalty. Clauses which
apply upon one party forming a "reasonable opinion" will
be useful in achieving this outcome.
A clause will be a penalty if it imposes consequences which are
extravagant and unconscionable or out of all proportion to the
damage suffered as a result of the breach. A drafter should
carefully consider the likely consequences to one party of a breach
of the agreement by the other, and ensure that the contract does
not provide for consequences which are out of all proportion or
extravagant and unconscionable.
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.
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We discuss whether certain clauses commonly found in ordinary commercial contracts could be considered to be penalties.
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