When is a penalty clause not a penalty clause?

The recent High Court case on bank fees, Andrews v Australia and New Zealand Banking Group Limited [2012] HCA 30, has garnered much media attention. Beyond the immediate impact on banks' terms and conditions, the decision has implications for a wide range of contracts, particularly in other financial services contexts, construction and major projects IT and services contracts generally.

What is a penalty clause?

Parties to a contract obviously have an interest in keeping the other side to the bargain. The traditional view is that a penalty clause penalises a party for breaching the contract by requiring it to pay a specified sum that is extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved to have followed from the breach (for example it is not a genuine pre-estimate of the damage suffered by the other party). If a clause is a penalty, it is void.

The High Court has importantly held that a clause can be a penalty even if it is not triggered by a breach of the contract. This widens the type of clauses that might fall foul of the ban on penalties.

The High Court did not state, other than in general terms, when a contractual stipulation would be a penalty. Generally, it seems a collateral stipulation can be categorised as a penalty if:

• it imposes an additional detriment on a party upon failure of a primary stipulation;
• it is security for and in terrorem of the satisfaction of the primary stipulation (meaning it is to force the party to perform its obligations); and
• compensation can be made for the failure of the primary stipulation.

The collateral stipulation is enforceable only to the extent of that compensation. So, a payment in respect of non-performance of a condition which is not the subject of a contractual promise could be characterised as a penalty if compensation can be made for the failure to perform that condition.

What are the features that make it less likely that it's a penalty?

First, if the sum to be paid under the clause is a genuine pre-estimate of the loss to be suffered as a result of the non-observance of the condition, then that can suggest it is not a penalty.

Secondly, the High Court suggested (without firmly determining the issue) it might not be a penalty if the contractual stipulation gives rise to an additional obligation. An example of this can be found in an old case involving film distribution. The exhibitor was only allowed to show the film once. If it showed the film again, it had to pay a sum equivalent to four times the original fee. The court did not characterise this as a penalty, but as an option which the exhibitor could exercise and pay for, because the stipulation gave rise to an additional obligation.

What is the significance of the ANZ v Andrews decision?

The significance of the decision is that it may mean that provisions in contracts which have relied solely on the fact that the event which triggers them is not a breach of contract so as to fall outside the penalty regime may no longer fall outside the penalty regime and will need to be reviewed.

These provisions include:

• service level abatement clauses in major projects, construction, IT and service contracts;
• provisions in financial services contracts which apply if the contract is in arrears or overlimit;
• rights to terminate a contract which carry with them the loss of accrued rights – for example the loss of a future trailing commission; and
• fees payable on contingent events in business and consumer telecommunications, utilities and financial services contracts such as early termination fees, switch fees and break costs.

Please contact us if you have any queries or would like to discuss the impact of the judgment further.