The Victorian Court of Appeal has summarised the law of penalties in Melbourne Linh Son Buddhist Society Inc v Gippsreal Ltd [2017] VSCA 161 (23 June 2017) per Maxwell P, Kyrou JA and Cameron AJA.

Doctrine of penalties - brief background

The doctrine of penalties will render a damages provision of a contract unenforceable if the provision exceeds a genuine pre-estimate of the damage likely to be caused by the breach.

The other way it is commonly put is that ‘agreed damages are binding unless they constitute a penalty’. Parties to a contract may stipulate what sum shall be payable by way of damages in the event of a breach of the contract.

The High Court has recently addressed the test for what constitutes a penalty in Paciocco v ANZ Banking Group Ltd (2016) 258 CLR 525.

French CJ and Kiefel J said in Paciocco the question is “whether the provision is ‘out of all proportion’ to the interests of the party which it is the purpose of the provision to protect?” at [29] quoting AMEV v UDC Finance v Austin (1986) 162 CLR 170 at 190.

A good example of a penalty provision, for illustrative purposes, is a term in a chattel lease entitling the lessor to recover, on termination for breach, not only the costs and arrears of rent, but the total rent had the lease been fully performed. This has been held to be a penalty: O’Dea v Allstates Leasing System (WA) Pty Ltd (1983) 152 CLR 170 at 181.

A penalty is in the nature of a punishment for non-observance of a contractual stipulation, rather than a genuine recompense for loss resulting from a breach of the contract.

The law of penalties may apply in the case of a liquidated damages clause in a building contract, a lease, or a loan establishment fee in the case of Melbourne Linh Son Buddhist Society Inc v Gippsreal Ltd.

Melbourne Linh Son Buddhist Society Inc v Gippsreal Ltd [2017] VSCA 161

Facts

In Melbourne Linh Son, the Court of Appeal reviewed the trial decision, where it was found that a lender had been entitled to terminate a loan agreement for the borrower’s failure to settle the loan transaction within the time specified by the lender. The lender terminated the agreement and claimed liquidated damages.

The Court of appeal allowed the borrower’s appeal – finding that the lender was not entitled to terminate the agreement.

The Court of Appeal also considered the issue of whether the loan establishment fee of $26,625 was a penalty.

It was determined that the fee of $26,625 had no connection with any alleged breach of contract. The fee remained the same notwithstanding a significant decrease in the quantum of the loan from $1.7m to $500,000.

The $26,625 fee represented 1.5% of the $1.7m loan.

The $26,625 fee represented 5% of the loan - even when the loan was reduced to $500,000.

Decision

The majority comprising Kyrou JA and Cameron AJA held the loan establishment fee was a penalty at [195] and [198] because:

“In our opinion, the establishment fee of $26,625 is a penalty because it bears no relation to any possible damage to or interest of the [lender] arising from the putative breach of the Deed of Offer by the [borrower] and it is not commensurate with any legitimate commercial interest of the [lender] which is sought to be protected by that deed in the event of its breach…

The irresistible inference that arises from [the director’s] evidence and the inherent circumstances of the proposed loan transaction is that the fee of $26,625 was retained in order to punish the [borrower] for the inconvenience its conduct caused the [lender] in the lead up to 27 September 2013 rather than to protect any legitimate commercial interest of the [lender] arising from a breach of the Deed of Offer by the [lender].”

Maxwell P, in the minority, took a different view regarding the penalty question. He found that the penalty issue was not pleaded at trial, was not the subject of expert evidence – unlike Paciocco – and there was no evidence before the Court to permit the Court to make a determination.

Key extracts from the majority decision

Twelve key paragraphs bear reading:

[164] Traditionally, the law of penalties has been invoked where a term of a contract stipulates that on breach of the contract, the party in breach will pay an agreed sum which exceeds what can be regarded as a genuine pre-estimate of the damage likely to be caused by the breach.[75] It is an exception to the principle that the law of contract upholds the freedom of parties, with no relevant disability, to agree upon the terms of their future relationships.[76] If an impugned term of a contract is a penalty, the general rule is that such a term will be unenforceable.[77]

[165] In Andrews v Australia and New Zealand Banking Group Ltd,[78] the High Court discussed the historical development of the law of penalties at common law and in equity and concluded that equitable relief against penalties had not been subsumed into the common law and that the rule against penalties was not limited to cases arising out of a breach of contract.[79]

[166] Although, as Andrews demonstrates, the principles governing the law of penalties have a long history, they are generally considered to have been authoritatively stated by Lord Dunedin in Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd.[80] Lord Dunedin formulated the principles as follows:

Though the parties to a contract who use the words ‘penalty’ or ‘liquidated damages’ may prima facie be supposed to mean what they say, yet the expression used is not conclusive. The Court must find out whether the payment stipulated is in truth a penalty or liquidated damages. This doctrine may be said to be found passim in nearly every case.
The essence of a penalty is a payment of money stipulated as in terrorem of the offending party; the essence of liquidated damages is a genuine covenanted pre-estimate of damage ...
The question whether a sum stipulated is penalty or liquidated damages is a question of construction to be decided upon the terms and inherent circumstances of each particular contract, judged of as at the time of the making of the contract, not as at the time of the breach ...
1. To assist this task of construction various tests have been suggested, which if applicable to the case under consideration may prove helpful, or even conclusive. Such are:
  
  (a)  It will be held to be penalty if the sum stipulated for is extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved to have followed from the breach ...
  
  (b)  It will be held to be a penalty if the breach consists only in not paying a sum of money, and the sum stipulated is a sum greater than the sum which ought to have been paid ...
  
  (c)  There is a presumption (but no more) that it is a penalty when ‘a single lump sum is made payable by way of compensation, on the occurrence of one or more or all of several events, some of which may occasion serious and others but trifling damage’ ...

On the other hand:

(d) It is no obstacle to the sum stipulated being a genuine pre-estimate of damage, that the consequences of the breach are such as to make precise pre-estimation almost an impossibility. On the contrary, that is just the situation when it is probable that pre-estimated damage was the true bargain between the parties...[81]

[167] The principles in Dunlop have been adopted by the High Court on numerous occasions.[82] However, while those principles remain authoritative with respect to the law of penalties in Australia,[83] they are not exhaustive and are not to be treated as either rules of law or equivalent to statutory provisions.[84] In recent years, the High Court has clarified some aspects of those principles.

[168] In Ringrow,[85] the High Court considered proposition 4(a) in Dunlop and stated that, in considering whether a sum is extravagant and unconscionable and thus a penalty, it is not enough that it be ‘lacking in proportion’ to the loss likely to be suffered as a result of the breach of the contract.[86] Rather, in order to be a penalty, the sum must be ‘out of all proportion’ to the likely loss.[87]

[169] In Andrews and Paciocco v Australia and New Zealand Banking Group Ltd,[88] the High Court emphasised that a penalty is in the nature of a punishment for non-observance of a contractual stipulation.[89]

[170] In Andrews, the High Court held that, where the impugned contractual term requires the payment of an agreed sum, the critical issue in deciding whether the term is a penalty is ‘whether the sum agreed was commensurate with the interest protected by the bargain.’[90]

[171] Paciocco involved the question whether fees charged by a bank to a customer for payments which were late, and thus in breach of the relevant loan contract, were penalties. The High Court held that a contractual term will not be a penalty if it protects the legitimate commercial interests of the non-defaulting party under the contract.[91] Relatedly, the Court held that, in determining whether a sum payable is out of all proportion to the likely loss to be suffered as a result of a breach of contract, a court is not limited to considering only such loss as is recoverable as damages for that breach.[92] Rather, a court is entitled to take into account detriment to other commercial interests which the non-defaulting party has legitimately sought to protect.[93] This is because the question to be decided is whether a provision for the payment of a sum of money on default is out of all proportion to the legitimate commercial interests of the party which it is the purpose of the provision to protect.[94]

[172] In Paciocco, Kiefel J (with whom French CJ agreed) held that it may be inferred from the policy of the law of penalties — which is to render unenforceable contractual terms whose purpose is to punish the defaulting party — that a sum stipulated for payment on default is a penalty if it bears no relation to the possible damage to or interest of the innocent party.[95]

[173] In Paciocco, Gageler J stated that the ultimate question of whether a contractual stipulation imposing a detriment on a party in the event of non-observance of another stipulation is a penalty is reflected in a ‘very useful’[96] formulation of principle by Wilson J in O’Dea v Allstates Leasing System (WA) Pty Ltd.[97] That formulation was as follows: Is the stipulation ‘a genuine pre-estimate of the [innocent party’s] probable or possible interest in the due performance of the principal obligation’ or a penalty inserted ‘merely to secure the enjoyment of a collateral object’?[98] Gageler J elaborated as follows:

To ask whether a stipulation serves merely to secure the enjoyment of a collateral object is to ask whether the conclusion objectively to be drawn from the totality of the circumstances is that the only purpose of the stipulation was to punish: to impose a detriment on a contracting party in the event that a principal contractual stipulation is not observed, in order to deter non-observance of that principal stipulation ...

... To ask whether a stipulated payment is a genuine pre-estimate of the innocent party’s probable or possible interest in the due observance of the principal contractual stipulation is to ask whether an interest which the innocent party has in the observance of that principal stipulation explains the stipulation for payment as having a purpose other than to punish the offending party. Such an interest of the innocent party in the observance of a principal contractual stipulation need not be an interest in respect of which the offending party would otherwise be compelled to compensate the innocent party at law (or in equity) in the event of non-observance.

Where the stipulated detriment is in the form of an obligation to pay a specified sum of money in the event of a breach of contract, a comparison of the specified sum with the amount of the unliquidated damages which might be expected to be recovered by the innocent party in an action for breach of contract will often be probative of whether the only purpose of the stipulation is to punish. Such a comparison might sometimes be decisive. Not always.[99]

[174] In Paciocco, Keane J said that the terms ‘extravagant’ and ‘unconscionable’ in proposition 4(a) in Dunlop function as pointers towards the punitive purpose which imbues the challenged provision with the character of a punishment.[100] He went on to say that the question to be addressed in order to distinguish a penalty from a provision protective of a legitimate interest is ‘whether the sum or remedy stipulated as a consequence of a breach of contract is exorbitant or unconscionable when regard is had to the innocent party’s interest in the performance of the contract’.[101]

[175] Nettle J dissented in Paciocco. He adopted the following propositions. First, ordinarily the only legitimate interest of an innocent party in the performance of a primary obligation is in its performance or in some appropriate alternative to performance.[102] Secondly, in the case of a ‘straightforward damages clause’, the innocent party’s interest will rarely extend beyond compensation for the breach and, therefore, in such a case, it is to be expected that the Dunlop tests will usually be ‘perfectly adequate’ to determine whether a provision is a penalty.[103] Thirdly, ‘[i]n typical penalty cases, the court compares what would be recoverable as unliquidated damages with the sum of money stipulated as payable on breach’.[104] Fourthly, the law of penalties is not concerned with whether an obligation is properly to be conceived of as a punishment but with whether an obligation to make a payment on breach of a contractual or other principal obligation is of an amount which is grossly disproportionate to the foreseeable consequences of the breach, and that the gross disproportion is in itself sufficient to render the obligation ‘unconscionable’ and therefore unenforceable.[105]

[176] In deciding whether a term of a contract is a penalty, the operation of the term must be considered as a matter of substance. Labels and statements of intention that are used by the parties are not determinative of the question. If the term, considered objectively, operates as a penalty then it will be unenforceable, regardless of the intention of the parties in making it.[106]