Penalties in Commercial Contracts
In our previous issue, we examined the general law of penalties in contracts, particularly in light of the recent High Court decision, which held that credit card late payment fees charged by ANZ were not penalties. The significance of a clause being regarded as a penalty is that it is not enforceable. If you missed last month’s issue, you can find our previous article here.
In this month’s issue, we discuss whether clauses which are commonly found in ordinary commercial contracts, such as shareholder and joint venture agreements, could be considered to be penalties even where they do not require one party to make a financial payment to another, and what this could mean for you if you are considering entering into such contracts.
Whilst the High Court is yet to consider this topic, the issue was considered by the NSW Supreme Court in Re Pioneer Energy Holdings Pty Ltd (Pioneer Case).
In this case, Blue Oil Energy Pty Ltd (Blue Oil) and Morgan Stanley Capital Group Inc. (Morgan Stanley) entered into a shareholders agreement and established Pioneer Energy Holdings Pty Ltd (Pioneer) as a joint venture enterprise to undertake certain construction works. Morgan Stanley subscribed for 75% of the issued shares in Pioneer and Blue Oil subscribed for 15%, each paying $1 per share. There was a term in the shareholders agreement which stipulated that if either party failed to contribute its share of the funding to the joint venture, the non-defaulting shareholder could require the defaulting shareholder to transfer all its shares in the joint venture entity to the non-defaulting shareholder for $1.00.
Although Blue Oil made an initial funding contribution to Pioneer, further funding was required and it failed to make the additional contribution to Pioneer. It was asserted that this entitled Morgan Stanley to require Blue Oil to transfer all its shares in Pioneer to it for $1.00.
Blue Oil contended that the clause requiring it to transfer its shares to Morgan Stanley was unenforceable as a penalty.
The defendants submitted that the clause was not a penalty, particularly because the relevant clause stated that the parties agreed that the clause was not intended to operate as a penalty and the consequence of the breach – namely the obligation on the defaulting party to transfer all its shares in the company to the non-defaulting party for $1.00 – was a “genuine estimate of the loss and expense” that would be suffered by the non-defaulting party as a result of the breach.
The court held that the clause was a penalty (and therefore not enforceable against Blue Oil) and the fact that the parties agreed to it and that the contract included language to suggest that it was a “genuine estimate of the loss and expense”, was not determinative or conclusive.
The Pioneer Case in light of the recent ANZ case
The Pioneer Case is a decision of the NSW Supreme Court, which means that the principles established from the case may be overturned by a ruling of the High Court. Also, any future disputes regarding the enforceability of penalties will, depending on the facts of the case, need to follow the principles enunciated in that case. As noted in our previous issue, in the ANZ case, the High Court did not change the law relating to penalties. It broadened the scope of the financial interests which may be considered when determining whether the financial implications of a “penalties” clause are reasonable. Accordingly, if the Pioneer case was decided today, the decision could be different as the court would now be prepared to take into account all the financial interests of Morgan Stanley, when considering whether the clause in question is reasonable.
What does this mean for you?
When entering into a contract in which the failure to perform a particular obligation will trigger a financial consequence, one should not assume that the clause, if triggered, is likely to be an unenforceable penalty. Remember that, in light of the ANZ case, the courts are now prepared, when considering whether the clause is reasonable, to take into account wide ranging financial implications that the breach will have on the non-defaulting party.
Despite the above, some common sense factors to take into account if you are seeking to include a clause in a shareholders agreement or other commercial contract that requires a party to sustain a financial sanction if it fails to do, or refrain from doing, something, include the following:
A clause which requires a payment to be made upon a default, should be drafted so that the amount payable reflects the loss that will be suffered by the non-defaulting party. It is also important to note that a provision can be a penalty even if the provision is not triggered by a breach of contract.
A clause which stipulates that the parties expressly agree that a prescribed amount is a genuine estimate of the loss and expense is not conclusive of that fact.
A clause which prescribes the same payment irrespective of the circumstances surrounding the breach and differences in the loss that will be suffered by the non-defaulting party in light of those circumstances, may be held to be a penalty.
An alternative may be to consider including a clause that seeks to incentivise a party to comply with an agreement, rather than penalising the party for a compliance failure.