Penalty Provisions – Can contracts impose penalties for breach?

Many contracts include provisions requiring a party to pay a particular amount (i.e. liquidated sum of damages) if they breach the contract. In Australia, contractual provisions which require payment of a liquidated sum of damages for breach are only enforceable if they are not penalty provisions. These types of provisions frequently arise in a range of business-to-business and business-to-consumer contracts. Recently, a High Court case against ANZ Bank has clarified the law in this area.

What is a penalty provision?

A contractual provision imposes a ‘penalty’ if it imposes a condition if a provision of the contract is breached, and the condition causes an additional detriment to the breaching party to the benefit of the other party. However, a provision will not be classified as a penalty if it only requires payment of a liquidated sum of damages for breach. A liquidated sum of damages must be a genuine pre-estimate of losses arising from the breach. This could be provided by a specified sum, or a formula for calculating the sum. This sum cannot be ‘out of all proportion’ to the interests which are damaged by the contractual breach.

The ANZ Bank litigation

Since 2010, ANZ Bank customers have been running a class action against the bank, claiming it overcharged tens of thousands of customers ‘late fees’ for credit card payments. The customers argued that the fee of up to $35.00 (later dropped to $20.00) for each late payment constituted an unfair penalty as the actual cost to the bank was only a small proportion of this sum. In 2014, Justice Michelle Gordon agreed with the customers, finding that the fees were “extravagant, exorbitant and unconscionable” penalties as the fees exceeded the $0.50 – $5.50 cost to ANZ Bank for each late payment. In 2015, the Federal Court overturned this decision. Interestingly, they took into account a broader range of operational costs to the bank, including the impact of the late payment on provisioning for bad debts and regulatory capital.

In July 2016, the High Court put an end to the long-running legal battle and upheld the Federal Court’s decision that ANZ Bank was entitled to charge fees of up to $35.00 for late payments. A majority of the High Court held that the costs to banks for later payments should provide for soured loans, debt collection costs and holding of regulatory capital. The court did not limit ANZ Bank’s ‘costs’ to the damage caused by the late payment but also took into account the effect of the late payment on the bank’s financial interests. Therefore, in assessing liquidated damages clauses, courts can have regard to more than just the losses directly arising from the breach.

Application of unfair contracts legislation

Penalties are not only unenforceable at common law, but could be characterised as ‘unfair’ under consumer protection law. Under the Australian Consumer Law, a contractual provision could be characterised as ‘unfair’ if it specifies a one-sided penalty to one party for breach or termination of a standard form contract. Currently, the Australian Consumer Law regulates unfair standard form contracts with consumers. In November 2016, this will be extended to standard form contracts with businesses which are defined in the legislation as ‘small businesses.’ If the court finds that a contractual provision is ‘unfair,’ it will be invalidated and unenforceable. For more information about unfair contract provisions, see our guide to reviewing unfair contract terms.

There is a fine line between enforceable liquidated damage clauses and unenforceable penalty provisions. Drafting provisions of this nature is affected by a range of complex legal issues. If you wish to rely upon liquidated damages clauses in your contracts, you must engage an experienced commercial lawyer to prevent these provisions from being characterised as unenforceable penalties. We have many years of experience in reviewing contracts containing these issues and drafting enforceable liquidated damages clauses.

Our expert solicitors can help you draft or review contracts to ensure they do not contain unenforceable penalty provisions. Please contact our Newcastle and Sydney lawyers on (02) 4929 7002 or fill out an enquiry form on our website.