Australia: Penalty Clauses In Broker And Management Agreements

Last Updated: 13 January 2009

The November 2008 judgement of the New South Wales Court of Appeal in the Integral Home Loans case provides further guidance for the mortgage industry in negotiating broker and management agreements.

As is usual in slower economic times, agreements prepared and signed in haste are being examined in greater detail to determine the respective rights of funders, brokers, and managers. The Integral decision will help that examination.

Origination and management agreements are vital contracts which often have a long life (the trail can last as long as the term of the mortgage). The amounts payable under these agreements can be significant and the risk of dispute is high.

These agreements should not be "set and forget". They need to be regularly reviewed to ensure they are up to date.

Key issues for consideration are:

  • who owns the customer?
  • under what circumstances can the trail or management fee be terminated?
  • what liability has the broker or manager for losses that are caused by the broker or the manager or their sub-originators?
  • does the lender have to wait until an actual loss is finally incurred before withholding trail to cover potential losses?

Obviously the interests of the lender on the one hand and the broker or manager on the other hand are not necessarily aligned.

The Integral case related to a mortgage management agreement originally with Interstar. Interstar stopped the management fee when it terminated management on the basis that Integral or its sub-originators had acted fraudulently. The lower court had held that Interstar could not stop the management fee as the provision entitling them to do so was void as a penalty.

The rule that penalties will not be enforced has been a long standing common law principle. A penalty is a provision in the contract that provides for an unrealistic payment (or possibly a forfeiture of property) consequent upon a breach of the contract. There are two elements involved:

  • there must be a breach of contract; and
  • the amount payable or forfeited must be excessive having regard to the innocent party's loss.

The Supreme Court decided that neither of these two tests were satisfied in the Integral case because:

  1. payment was not being stopped because of a breach of contract, but rather because the management had been validly terminated; and
  2. even if the termination was for breach of contract, forfeiture of ongoing management fees was not an excessive penalty having regard to the significant damage that could be incurred by Interstar, including reputational damage.

A key issue was whether the income was earned upon settlement of the loan or is only earned progressively as the management functions are performed. In Integral, the court held that the management fee was a fee for ongoing management, and so there was no loss of income for work already performed. This highlights a significant difference between origination agreements and management agreements. If a lender wants to bolster its ability to terminate trail, origination agreements should provide for ongoing duties, and make it clear that the whole income is not earned at the time of origination.

It is important to remember that relief against forfeiture is not the only legal principle under which the manager could have reviewed the agreement. Courts can also review agreements if any of the provisions are unconscionable. Unconscionability was not argued in the Integral case as it was considered that the two parties were quite sophisticated. The same conclusion may not be reached in relation to a broker agreement between a large bank and small family run broking firm.

So where does this leave somebody trying to draft origination and management agreements? There is still a risk that in some cases forfeiture of trail or management income could be struck down as a penalty.

As Gadens have previously pointed out, arguing about forfeiture after a loss is finally incurred (for example after a borrower is made bankrupt) may be far too late because there may be little trail left to forfeit and the broker may have few assets to satisfy any claim. Accordingly, lenders' agreements should provide that the lender can withhold (not forfeit) trail/management fees sufficient enough to cover the potential loss as soon as a loss event is identified, and appropriate that money once the loss is incurred.

Jon Denovan t +61 2 9931 4927 e
David Albrecht t +61 8 9223 9238 e
Danny Moore t +61 3 9617 8596 e
Peter Grotjan t +61 3 9617 8538 e

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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