Pub­li­ca­tions

Penal­ties in Contracts 

Penal­ties in Contracts

The basic prin­ci­ple of Aus­tralian con­tract law is free­dom of con­tract. How­ev­er, like free­dom in gen­er­al, free­dom of con­tract is sub­ject to limitations.

One such lim­i­ta­tion is that a pro­vi­sion in a con­tract that seeks to impose a penal­ty on a con­tract­ing par­ty, is not enforceable.

What is a penalty?

In its basic form, a penal­ty is a require­ment in a con­tract where­by one par­ty, who breach­es a cer­tain clause in the con­tract, is oblig­ed to pay a sum of mon­ey to the par­ty who is not in breach. The courts have his­tor­i­cal­ly tak­en the view that if the amount to be paid to the inno­cent par­ty bears no rela­tion­ship to, or is much greater than, or is out of all pro­por­tion to, the dam­age or loss suf­fered by the inno­cent par­ty, the oblig­a­tion to make the pay­ment will be regard­ed as a penal­ty and, as such, not be enforceable.

ANZ bank charges

On 26 July 2016, the High Court of Aus­tralia hand­ed down its deci­sion in Pacioc­co v Aus­tralia and New Zealand Bank­ing Group Lim­it­ed (ANZ)[1]. One of the ques­tions the court had to con­sid­er was whether cred­it card late pay­ment fees charged by ANZ are penal­ties. If a penal­ty, the bank would not be allowed to charge such fees.

The court had to con­sid­er and deter­mine what is the appro­pri­ate test to deter­mine whether an amount required to be paid by one par­ty to anoth­er is a penalty. 

The court referred to the test expound­ed in 1915 in the Dun­lop Pneu­mat­ic Tyre case[2]. In this case, the court for­mu­lat­ed the test of whether a pay­ment is a penal­ty as being whether the pay­ment is extrav­a­gant” and uncon­scionable” when com­pared to the great­est loss that could con­ceiv­ably be proved to have fol­lowed from the breach.” In oth­er words, if the amount to be paid is plain­ly exces­sive in com­par­i­son to the inter­est of the inno­cent par­ty that is sought to be pro­tect­ed, the pay­ment would be regard­ed as a penalty. 

Also, where it is not pos­si­ble or extreme­ly dif­fi­cult to pre­dict what the amount of the loss to the inno­cent par­ty would be, then so long as the amount of the pay­ment was a gen­uine pre-esti­mate” of the pos­si­ble dam­age that the inno­cent par­ty would suf­fer, the amount would not be con­strued as a penalty. 

In the ANZ case, the late pay­ment fee was fixed at $35 until Decem­ber 2009 and from then, at $20. In the court of first instance, the pri­ma­ry judge accept­ed that whilst the actu­al loss­es suf­fered by ANZ could not be pre­cise­ly deter­mined, they were prob­a­bly no more than $3 for each event of late pay­ment— clear­ly much less than the $20 or $35 charged as a late pay­ment fee.

The High Court held that the late pay­ment charges were not penal­ties and dis­missed the appeal with costs.

Why was the ANZ late pay­ment fee not a penalty?

The High Court did not devi­ate from pre­vi­ous author­i­ty. It is still accept­ed that a pay­ment will be a penal­ty if the amount is extrav­a­gant or out of all pro­por­tion to any legit­i­mate inter­est of the inno­cent party.

How­ev­er, what the High Court made clear is that when con­sid­er­ing whether the amount is exces­sive or out of pro­por­tion to the dam­age or loss suf­fered by the inno­cent par­ty, the ques­tion is not what the inno­cent par­ty could recov­er in an action for breach of con­tract, but rather whether the costs to the inno­cent par­ty and the effects upon its finan­cial inter­ests by the default can be tak­en into account in assess­ing whether the pay­ment is a penalty. 

In the ANZ case, the court accept­ed that when cred­it card pay­ments are late, the added costs to the bank and also the effect late pay­ments have on its oth­er finan­cial inter­ests may be tak­en into account. For exam­ple, it was accept­ed that late pay­ments on cred­it cards impact­ed upon ANZ’s oper­a­tional costs, loss pro­vi­sion­ing and reg­u­la­to­ry cap­i­tal costs. As such, when tak­ing into account these fac­tors, the court was sat­is­fied that the late pay­ment fee was not out of pro­por­tion to the legit­i­mate finan­cial inter­ests that the bank was seek­ing to protect.

Con­clu­sion

The High Court has giv­en a boost to free­dom of con­tract, by effec­tive­ly broad­en­ing the range of finan­cial inter­ests one may con­sid­er when deter­min­ing whether a pay­ment is out of all pro­por­tion to the finan­cial costs of the inno­cent par­ty. Cer­tain­ly, the con­sid­er­a­tions are not lim­it­ed to a nar­row set of met­rics. Instead, the entire busi­ness of the inno­cent par­ty and how it could be affect­ed by the breach, may be tak­en into account.

In our next issue we will con­sid­er whether some claus­es that are typ­i­cal­ly includ­ed in com­mer­cial con­tracts, such as share­hold­ers agree­ments, could be con­sid­ered to be penal­ties even where they do not require one par­ty to pay an amount to another.


[1] [2016] HCA 28.

[2] Dun­lop Pneu­mat­ic Tyre Com­pa­ny Ltd v New Garage and Motor Com­pa­ny Ltd [1915] AC 79.