1 December 2015

UK's highest court provides guidance on contractual penalty clauses

This guidance by the UK Supreme Court will almost certainly influence the way that Australian courts approach a penalty.
Australia Corporate/Commercial Law
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Key Points:

We can expect to see much greater focus by Australian courts on any legitimate interests of the party seeking to enforce the provision that extend beyond the recovery of its loss.

A recent decision of the highest court in the United Kingdom has provided some well needed guidance on how the rule against contractual penalties should be applied to modern commercial contracts (Cavendish Square Holding BV v Talal El Makdessi; ParkingEye Limited v Beavis [2015] UKSC 67).

While the decision is not binding on Australian courts, it will be highly persuasive. The UK Supreme Court also queried certain aspects of the recent Andrews decision on contractual penalties by Australia's highest court.

What is the rule against penalties?

The rule against penalties renders unenforceable any provisions in contracts which are characterised as a penalty.

The problem is the way the rule has developed; there is now considerable uncertainty regarding the enforceability of many provisions in modern contracts, including break-fees chargeable for early repayment of a loan, performance-based payment regimes where the amount payable depends on the standard or quality of performance, time-bar provisions, and "take or pay" regimes, to name but a few. In contracts between properly advised parties of comparable bargaining power, the parties themselves are best placed to agree what should be the consequences of particular actions - and the courts should be very slow to interfere with the agreed arrangements.

The criticism in the Cavendish decision

The rule against penalties was described by several of the Lords as "an ancient, haphazardly constructed edifice which has not weathered well". They attributed this unsatisfactory situation to the practice of courts to treat the four tests articulated by Lord Dunedin in the seminal case of Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd [1915] AC 79 as "immutable rules of general application that cover the field".

This approach has caused the rule against penalties to "become a prisoner of artificial categorisation, itself the result of unsatisfactory distinctions: between a penalty and a genuine pre-estimate of loss, and between a genuine pre-estimate of loss and a deterrent."

Such an approach is fine, they said, when applied to a simple liquidated damages clause. But the tests don't work well when applied to more complex clauses. For more complex clauses, it is necessary to apply the rule against penalties at a more fundamental level, by focusing on whether the prescribed consequences of a breach are "unconscionable" or "extravagant". The true test is whether the relevant clause imposes a detriment on the contract breaker out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary provision.

In many cases, the interest of the innocent party will rarely extend beyond compensation for the breach, and the four tests of Lord Dunedin will be adequate to determine the clause's validity. But in other cases, compensation for breach is not the only legitimate interest that the innocent party may have in the performance of the defaulter's primary obligations. Cases on this topic reveal that other legitimate interests might include:

  • the interest of a car park manager in deterring car owners from staying more than two hours in a shopping centre car park, and in generating an income stream to pay for its services. Deterrence is not penal if there is a legitimate interest in influencing the conduct of those using the car park which is not satisfied by the mere right to recover damages for breach of contract, and the sum charged those who over-stay is not out of all proportion to the interests of the car park manager or owner;
  • the interests of a purchaser of a business in the observance of restrictive covenants preventing the former owner from competing against the business, designed to protect the purchased goodwill in the business;
  • the interest of a tyre manufacturer in deterring its distributors from price-cutting and thereby harming to the tyre manufacturer's business in other locations;
  • the interests of a lender in raising the interest rate under a loan agreement upon a default by the borrower, to reflect the greater credit risk of such a borrower; and
  • the interests of a government in ensuring the timely delivery of torpedo boats for its Navy.

Criticism of the Australian High Court's decision in Andrews

The Australian High Court decision in Andrews extended the rule against penalties to situations that don't involve a breach of contract.

Andrews concerned fees charged by banks including where the bank allowed a customer to draw in excess of the customer's available funds or agreed overdraft limit. Several of the Lords were critical of the decision:

  • "[the reasoning] is not in fact consistent with the equitable rule as it developed historically";
  • "the High Court's redefinition of a penalty is, with respect, difficult to apply to the case to which it is supposedly directed, namely, where there is no breach of contract";
  • "the High Court's decision does not address major legal and commercial implications of transforming a rule for controlling remedies for breach of contract..."

However, other Lords noted that the extension of the rule was consistent with the recommendations of numerous Law Reform Commissions.

How will this affect us in Australia?

It is unlikely that the High Court will wind back its decision to extend the application of the rule to situations not involving a breach of contract. It is also unlikely that Parliament will attempt to reform this aspect of contract law in a wholesale manner[1] any time soon.

However, the guidance provided by the UK Supreme Court will almost certainly influence the way in which Australian courts approach the analysis of whether a contractual provision should be declared unenforceable on the basis that it is a penalty.

Going forward, we can expect to see much greater focus by Australian courts on any legitimate interests of the party seeking to enforce the provision that extend beyond the recovery of its loss. We can also expect to see less interference in contracts freely negotiated between commercial parties of similar bargaining power - which is a good thing.

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1 Various Australian Parliaments have enacted laws designed to ensure that performance-based payment regimes in significant government contracts are legally enforceable, despite the rule against penalties. See, for example, section 16AD of the Passenger Transport Act 1990 (NSW).

Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this bulletin. Persons listed may not be admitted in all states and territories.

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