Recent High Court decision changes application of the penalty doctrine

Corporate eBulletin - 10 May 2013

Summary

The recent High Court of Australia decision in Andrews v Australia and New Zealand Banking Group Ltd (Andrews) has ramifications well beyond the banking industry. It will have far reaching consequences in all contracts in which a fee or other penalty is imposed, regardless of whether the penalty is tied to a breach of contract or arises in another context, such as termination of a contract.

 

This decision has greatly expanded the scope of the "penalty" defence, and its application to "non-breach" scenarios will leave open to attack contract provisions in numerous contexts, including in construction and infrastructure agreements and telecommunications agreements which were previously thought to be enforceable.

 

Quick links

 

The "old" law

Mason and Dean JJ in Legione v Hately

"…a penalty is in the nature of a punishment for non-observance of a contractual stipulation and consists, upon breach, of the [insert] of an additional…liability…"

Under Australian law (indeed throughout the common law world) the penalty doctrine provides a defence to a party breaching a contract, if the contract imposes a fee or other penalty for breach which exceeds a genuine pre-estimate of damages to the other party caused by the breach.

It is the "penalty doctrine" that gave rise to the concept of enforceable liquidated damages in construction (and other) contracts.

Before Andrews, however, it was accepted that the penalty doctrine only provided a defence to fees or penalties which were imposed as a consequence of a breach, but not where they were imposed as a consequence of events which do not constitute a breach.

 

The "new" law

In Andrews all five High Court judges unanimously found that the penalty doctrine is not confined to the context of a breach of contract.

The Andrews case involved customer complaints that fees imposed by ANZ Bank were unenforceable penalties, even though they were not imposed as a consequence of any breach of contract by customers. Rather, the fees imposed were simply a consequence of events, such as the honouring or dishonouring of cheques and over limit fees.

The bank's entitlement to charge the fees was not tied to a breach by the customer, or to circumstances or an event that the customer had an obligation to avoid. It was simply a contractual entitlement to charge fees in certain circumstances.

The High Court in Andrews relied on equitable principles that have evolved separately to the common law principles of the "breach" based penalty doctrine. In exercising its equitable jurisdiction, the Court found that it could void a penalty even where there was no breach of a contractual promise.

There is no right of appeal from the Andrews decision and it is also likely that other common law jurisdictions (for example, New Zealand and Canada) will follow this approach.

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Scope of the Andrews decision

It remains to be seen how far reaching the decision will be in Australia. It certainly extends beyond the banking context and may also apply in the following situations. 

  • In standard construction agreements, liquidated damages are often stipulated as an agreed consequence of the failure of a contractor to perform an obligation. This falls squarely within the "breach" doctrine and will not be affected by Andrews. However, it has already been noted in a recent article in the NSW Law Society Journal that "time ban" clauses in standard construction contracts (which ban a contractor's entitlement to be paid for extra work or to recover damages for breach of contract by the principal) may be caught under the extended Andrews doctrine and would no longer be enforceable. 
  • More complex infrastructure project agreements and financing documentation related to infrastructure projects will need to be carefully reviewed to ensure that they do not contain fees or penalties for the occurrence of events (whether or not the provisions were an attempt to bypass the old penalty doctrine). 
  • It remains to be seen what consequences Andrews may have under commercial leases. Will a lessee still be held to its obligations under a commercial lease, or will a lessor be obliged to accept a lessee's repudiation, requiring the lessor to terminate and mitigate its loss? Presumably the Andrews doctrine will not extend to penalties that arise by operation of law. 
  • Presumably "take or pay" contracts in the energy and natural resources industries will not be outlawed but care will be needed in drafting them to ensure they are appropriately worded. 
  • Payments for early termination in service agreements and in IT and telecommunications agreements may now be seen as unenforceable penalties, if the payments exceed a genuine pre estimate of damage which the service provider will suffer as a consequence of early termination.

The telecommunications contract example is particularly interesting, as it is common for agreements to require the party terminating early to pay an amount equal to the gross revenue the contract would have generated for the life of the contract. After Andrews this may be seen as an unenforceable penalty.

 

Conclusion

The scope of the Andrews decision is likely to be very far reaching, and may give rise to a series of judicial determinations clarifying its application.

While the extension of the doctrine may seem reasonable, until the scope of the decision is settled there will continue to be uncertainty surrounding the enforceability of existing commercial agreements and in the documentation of new arrangements.

Authors
David Bradley, Partner
Laila Hamzi, Lawyer

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