Liquidated damages and penalties: where is the line drawn?

The High Court of Australia has recently confirmed that fees payable upon breach of contract will only be unenforceable as a penalty where the fee is out of all proportion with the party’s legitimate commercial interests.


In Paciocco v Australia and New Zealand Banking Group Ltd it was held that a late payment fee imposed by ANZ in a credit card agreement was neither a penalty nor a term prohibited by statute.


This decision gives further assurance to principals and contractors that clauses imposing agreed damages upon the occurrence of certain events (e.g. liquidated damages clauses) will remain enforceable.

The Penalty Claim

The test applied by the High Court was whether the fee was out of proportion to the interest which the fee was to protect.


ANZ successfully argued that it had a legitimate commercial interest in timely repayment by its customers, which included avoiding an increase in both operational and regulatory capital costs.


The High Court accepted the evidence of ANZ’s accountant that the potential cost to ANZ from late payment exceeded the amount of the late payment fee, and therefore it was not out of proportion with the interest protected.


Importantly, the High Court was of the view that where parties agree to an amount payable upon breach in circumstances where accurately forecasting the loss is almost impossible, the amount will be more likely to be enforceable as it reflects the commercial bargain between the parties.


In fact, ANZ admitted that the late payment fee was not a genuine pre-estimate of its loss as it had not made any contemporaneous calculation of its potential loss at the time of contract.


However the question posed by the High Court was not whether the fee was a genuine pre- estimate of loss, but rather whether it was penal in nature.


In this case, the High Court concluded that the fee was not penal.


The Australian Consumer Law Claim

The High Court also rejected the claim that the late payment fee breached statutory prohibitions against unconscionable conduct and unfair contract terms.


The mere fact that ANZ had exercised its superior bargaining power relative to its customers was insufficient to establish that it had acted unconscionably, particularly where the fee only became payable upon the customer’s default.

Similarly, the fee was not unfair as it was clearly disclosed at the time of contract and could be avoided by conduct that was not unreasonable (i.e. paying on time).


Effect on Liquidated Damages clauses

Although the decision specifically relates to late repayment fees in the banking industry, the underlying reasoning provides important guidance for parties in the construction industry.

As a consequence of the decision, it will be more difficult for a party to successfully argue a liquidated damages clause is unenforceable as a penalty.

The High Court’s decision follows the principles in  Grocon Constructors (Qld) Pty Ltd v Juniper Developer No. 2 Pty Ltd & Anor in which it was concluded that liquidated damages remained enforceable even where ‘perfect’ completion was required.


Implications on Unfair Terms in Small Business Contracts

From 12 November 2016, unfair contract terms in contracts where one party is a small businesses will be void and unenforceable due to the extension of consumer protection legislation.

In Paciocco, the High Court provided useful guidance on the types of terms that may be found unfair.

It was held that the late payment fee was not unfair as it was clearly disclosed at the time of contract and the fee could be avoided by timely payment. The amount of the fee was only one of many factors to be taken into consideration.

Contracting parties should keep this decision in mind when considering the impact of the new legislation on their small business contracts.


Where to from here?

This case serves a timely reminder for principals and contractors to review any fee-imposing clauses in their standard contracts to ensure that:

  • all legitimate interests are taken into account in the calculation of the fee;
  • to the extent possible, the fee reflects a genuine pre- estimate of the loss to such interests if the clause is breached; and
  • the clause is drafted on clear terms.

If these elements are taken into account, the enforceability of the clause will be maximised.

Principals and contractors should also obtain some relief from the finding that fee-imposing clauses will remain enforceable if evidence can be adduced at trial that the potential loss is not out of proportion to the fee imposed, even in circumstances where the fee was not based on a genuine pre-estimate of loss.

On the other hand, those parties who may find themselves liable under a liquidated damages or other fee-imposing clause, should ensure that they seek appropriate amendment at the time of contract, or face an uphill battle to have the clause overturned at a later date.


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