Beware of Penalty Clauses! But Are They Even Enforceable?

Introduction

When reviewing and entering into a contract, you must aware of any penalty clauses included and assess whether they can even be enforced against you.

A penalty clause is a term in a contract that imposes a penalty on a party that breaches a contractual obligation. It is important to know that penalty clauses are generally unenforceable under Australian law. However, it can sometimes be difficult to distinguish penalty clauses from other similar clauses that are enforceable.

What is a Penalty Clause?

A contract term that states that one party has to pay an amount upon a breach of contract may be a penalty clause. Penalty clauses are designed to deter breaches of contract, regardless of the actual harm suffered by the non-breaching party.

As such, penalty clauses are unenforceable because they are considered to be a form of punishment that imposes disproportionately high financial penalty on the breaching party.

However, there are very similar clauses used in contracts, called “liquidated damages” clauses, which are enforceable.

A liquidated damages clause is an agreement that a party in breach will pay the other party an amount which is a reasonable estimate of what the breach will cost the non-breaching party.

For a liquidated damages clause to be enforceable, it must be a “genuine pre-estimate”. This means that the amount cannot be random, even if it is agreed between the parties. There must be a genuine effort applied to calculating how much a certain breach would cost the non-breaching party.

Identifying Penalty Clauses

Unfortunately, it can be quite difficult to distinguish between a penalty clause and a liquidated damages clause. For instance, if a contract imposes a fee for late payment of an invoice, this clause could be an unenforceable penalty clause or, it could also reflect a genuine pre-estimate of damages.

If the late fee is set at the cost incurred to re-issue the invoice, it is likely that this would be considered reasonable and a liquidated damages provision as it is not intended to be a penalty.

Termination fees are another example worth considering. If a termination fee is set at an unreasonably high amount, then it is not a genuine pre-estimate of the non-breaching party’s actual losses resulting from the early termination. In that case it will be considered a penalty clause and will be unenforceable.

On the other hand, if the termination fee represents a reasonable estimate of the non-breaching party’s actual losses (such as the costs of finding a replacement for the terminated contract), then it may be enforceable as a valid liquidated damages provision.

To determine whether a particular term is a penalty clause, the court will consider the nature of the breach, the amount of the penalty, and the relationship between the parties.

It is important to note that whether a particular contractual provision is a penalty clause or not will depend on the specific circumstances of the case. As such, parties should carefully consider the potential risks and consequences of including such provisions in their contracts.

Considerations when Drafting Contracts

When drafting a contract in Australia, it is important to ensure that the purpose of a clause is not to punish or to deter a breach by imposing an artificially high fee.

In addition, consideration should be given as to whether it is necessary to impose a fee for a breach, when other alternatives (such as negotiation) might achieve the desired outcome.

However, these concerns should not prevent a drafter from including proportionate and necessary liquidated damages clauses in a contract, as these clauses can be vital to protect businesses against genuine losses.

When drafting a liquidated damages clause, it is wise to document the process of calculating the amount of damages that would follow from different types of breaches.

Including this documentation in the contract (or associated documentation) means that the contracting parties have all had an opportunity to consider whether the amounts imposed would constitute a reasonable pre-estimate. This will make it more likely that the clause will be enforceable in the future.

Case Study

The issue of penalty clauses has been the subject of several court cases in Australia, including the High Court decision in Paciocco v Australia and New Zealand Banking Group Limited [2016]. The case dealt with the issue of whether certain types of fees charged by the ANZ bank to its customers constituted penalty clauses and were therefore unenforceable.

The fees in question were late payment fees, over-limit fees, and dishonour fees charged by the ANZ bank on credit card accounts. The plaintiff argued that these fees were unenforceable penalty clauses because they exceeded the actual costs incurred by the bank because of the customer’s breach of contract.

The High Court held that the late payment fees and over-limit fees charged by ANZ were unenforceable penalty clauses, while the dishonour fees were not. The Court found that the late payment and over-limit fees were not genuine pre-estimates of the bank’s losses resulting from the breach of contract but were instead designed to deter customers from breaching the contract by imposing a disproportionate financial penalty. The Court therefore held that these fees were unenforceable as they were penalty clauses.

In contrast, the Court held that the dishonour fees charged by ANZ were enforceable because they represented a genuine pre-estimate of the bank’s costs in processing dishonoured payments. The Court found that these fees were not designed to punish the customer, but rather to compensate the bank for its actual losses resulting from the dishonoured payment.

Conclusion

Penalty clauses are generally unenforceable as they are considered to be a form of penalty on the breaching party rather than a genuine pre-estimate of loss suffered by the non-breaching party.

However, this should not prevent the inclusion of proportionate liquidated damages clauses in contracts. In such cases, it is important that the clause seeking liquidated damages to deter a breach should not impose an artificially high fee or penalty.

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