Penalty clauses in contracts
What are penalty clauses?
A penalty clause is a clause in a contract that sets out a predetermined amount of compensation to be paid in the event of a breach or supposed breach of the contract that is out of all proportion to the loss suffered by the other party.
Clauses specifying predetermined amounts of compensation can be quite common in contracts and can include clauses that apply administration fees, termination fees, monthly fees or penalties and deposits, in some circumstances. So, they are not always explicitly set out to be a ‘penalty clause’.
It’s important to note that if a clause is found to be a penalty clause, then it will not be enforceable or legal, particularly in light of the new unfair contracts legislation. Courts apply a test of whether the clause is a genuine pre-estimate of the loss suffered by the innocent party, or if it is designed to punish the party in breach.
Enforceability of penalty clauses
In Australia, the case of Andrews v Australia and New Zealand Banking Group Ltd (2012) 247 CLR 205 changed the understanding of what a penalty clause is. The Andrews case determined that a clause can be considered a penalty, even without a breach of contract.
In this case, the High Court held that a clause will be considered a penalty if it imposes a detriment on the party in breach that is out of proportion to the legitimate interests of the innocent party. The Court also noted that a clause will not be considered a penalty if it is a genuine pre-estimate of the loss that would be suffered in the event of a breach.
Further cases in Australia have considered penalty clauses. One notable case is Paciocco v Australia and New Zealand Bank Group Ltd (2014) 309 ALR 259 where the High Court considered fees charged by ANZ for overdrawn accounts and late credit card payments. The Court ruled that certain types of fees were unconscionable and constituted penalties, making them unenforceable as they were not genuine pre-estimate of the bank’s loss.
Factors considered by Courts
Australian Courts consider several factors when determining the enforceability of a penalty clause, including:
- Proportionality: The amount specified in the clause should be a genuine pre-estimate of the loss likely to be suffered by the innocent party. If the amount is extravagant or unconscionable, it is more likely to be considered a penalty. Examples of genuine pre-estimates of loss include things like fees that have already been paid that you cannot recoup, such as annual licensing fees or hours already spent working on a project.
- Commercial justification: The clause should serve a legitimate commercial purpose, such as compensating the innocent party for losses that are difficult to quantify. If the clause is purely punitive, it is more likely to be considered a penalty.
- Unconscionability: If the clause is oppressive or unreasonable, it may be deemed unconscionable and therefore unenforceable.
- Public policy: Penalty clauses that are contrary to public policy, such as clauses that seek to penalise a party for exercising their legal rights, are unlikely to be enforceable.
Impact of unfair contract terms - Australian consumer law
Under the Australian Consumer Law (ACL), which is contained in Schedule 2 of the Competition and Consumer Act 2010 (Cth), penalty clauses in consumer contracts are subject to additional scrutiny. The ACL prohibits unfair contract terms, including terms that are excessively one-sided or that impose a disproportionate penalty for breaching the contract. Courts have the power to declare such terms void and unenforceable.
It is likely that clauses that impose a penalty merely for not doing something and are not grounded in reality, would be considered an unfair contract term and thus a breach of the new unfair contract legislation in the ACL. The ACL imposes significant penalties for these breaches.
Does my contract have unfair or unenforceable penalty clauses?
If a clause simply sets out a number or dollar amount for failing to comply with it or for not doing a certain act, that cannot be justified by reference to actual loss incurred, then there may be a reasonable chance that this could be deemed a penalty, and could also be an unfair contract term under the ACL.
Parties should carefully consider the terms of any penalty clause or fees paid in their contracts and seek legal advice if necessary. We suggest having your contracts reviewed for penalty clauses and compliance with the new unfair contract terms.
