High Court Broadens the Scope of 'Penalty Clauses'

Could a clause be void and unenforceable by reason of being a penalty?

Do you issue contracts in which a fee is either imposed for a breach of the contract or that may arise for termination of the contract? Generally, commercial contracts are construed and applied in accordance with their terms as the parties are free to determine the terms between them. However, special treatment is given to “penalty” clauses within a contract as such clauses may be void and unenforceable. The recent High Court decision of Andrews v Australia and New Zealand Banking Group Ltd 2012 (“Andrews”) expands the penalty principle and the implications of this decision for your contracts are discussed below.

What is a penalty?

Prior to the Andrew’s decision, a penalty in a contract arose where a contract stipulated an amount that is payable by one party to the other in the event of a breach that:

  1. is in the nature of a “punishment”; and
  2. exceeded what would be regarded as a genuine pre-estimate of loss or damage. 

In circumstances where a clause contained these elements, that clause would be void and unenforceable. This is often referred to as a penalty doctrine.

Andrews Decision

The High Court in the Andrews decision for the first time ruled unanimously that the penalty doctrine is not confined to where there are payments due to a breach of contract. In the Andrews decision, the High Court held that the penalty doctrine could also apply to other scenarios in an agreement such as termination of contract provisions where there is no breach and where an amount is payable simply due to contractual entitlements for fees to be paid in certain circumstances. These circumstances may include late payment fees or fees that are charged for an additional accommodation or service provided to a party.  

In this case, ANZ entered into contracts with customers containing clauses that imposed fees as a consequence of events such as cheques being honoured or dishonoured, overdrawn accounts and credit card payments in excess of approved limits. The High Court found that there was no breach of contract by the customers because:

  1. ANZ had a discretion as to whether or not to allow the accounts to be overdrawn;
  2. Customers had 25 days to pay the late payment fees before there was a breach.

In considering whether the clauses were a penalty, the High Court did not accept that the late payment fee was an additional charge in connection with the operation of the account, being the increased risk to ANZ when repayments were not made within the stipulated timeframe. The additional fees were held to be penalties.

Impact of the decision on contracts

The outcome of the Andrews decision means that organisations should review and evaluate contracts containing clauses that impose fees on their customers. For example, consideration needs to be given as to whether or not the fee in an agreement is:

  1. to secure payment of a primary obligation by the party subject to the fee; or
  2. truly a fee for further services.

If it is to secure performance of an obligation, it will only be enforceable if it is a genuine pre-estimate of the damages suffered by that party’s non-performance of the contract. 

If the fee is truly for further services it will not constitute a penalty. 

If you have any questions or if you need assistance in the review of your contracts, please contact our experienced lawyers (02) 9895 9200.