A recent unanimous decision of the Court of Appeal (Interstar Wholesale Finance Pty Limited v Integral Home Loans Pty Limited [2008] NSWCA 310), in which Deacons acted for the successful appellant, has given some guidance on the law of penalties.

Termination on basis of reasonable opinion

A financial institution (Lender) had an agreement with a loan originator (Originator) for the Originator to provide loan origination and management services to the Lender. In return the Lender was obliged to pay the Originator an upfront fee and ongoing trail commissions.

The agreement allowed the Lender to terminate the agreement if the Lender formed the reasonable opinion that the Originator had engaged in deceptive or fraudulent activity. The Lender terminated the agreement under this power.

No penalty

In these circumstances, a particular clause of the agreement allowed the Lender to cease the payment of all ongoing trail commissions (Relevant Clause). The Lender exercised this right and ceased the payment of all amounts to the Originator.

The Originator claimed that the Relevant Clause was void as a penalty. The Court of Appeal decided that the Relevant Clause was not a penalty, for the following reasons:

  • The question of whether a clause is a penalty is one of construction of the contract.
  • The contractual provision must be assessed at the time of making the contract and not at the time of its breach. The events after the date of the agreement, particularly the circumstances of the agreement's termination, are not relevant to the construction of the contract or considering whether any of its clauses are penal.
  • The Court assumed (without deciding) that the law of penalties could apply to a payment of money, a transfer of property and a forfeiture of property or accrued contractual rights.
  • Although there is conflicting authority, the better view in Australia is that the doctrine of penalties is constrained to circumstances of breach of contract. A provision cannot be a penalty if it applies upon an event which is not a breach of the contract, such as the reasonable opinion of the Lender that the Originator had engaged in fraudulent activity.
  • In any event, the alleged penalty must be "extravagant and unconscionable in amount" or "out of all proportion" to the damage likely to be suffered as a result of the breach. In this case, the Court recognised the significant damage to the Lender's reputation which may be suffered in circumstances involving deceptive or fraudulent activity.

What then is a penalty?

On the basis of this judgment, a contract will contain a voidable penalty provision if:

  • The term is designed to terrify a party into complying with the agreement.
  • The term involves the imposition in advance of an ascertainable amount.
  • The ascertainable amount includes a payment of money, transfer of property or a forfeiture of property or accrued contractual rights.
  • The effect of the penalty is suffered by the defaulting party only upon breach of the agreement, as opposed to some other event which is not a breach of the agreement, such as the formation of a reasonable opinion.
  • Without regard to the actual consequences of the breach, the amount is extravagant and unconscionable or out of all proportion to the actual consequences suffered by the party not in breach of the agreement.

Tips for drafters

The judgment confirms that a clause can only be a contractual penalty if it applies upon a breach of the agreement. Accordingly, if a clause is drafted so that it applies in particular circumstances, where the other party has not promised that those circumstances will not occur, it cannot be a penalty. Clauses which apply upon one party forming a "reasonable opinion" will be useful in achieving this outcome.

A clause will be a penalty if it imposes consequences which are extravagant and unconscionable or out of all proportion to the damage suffered as a result of the breach. A drafter should carefully consider the likely consequences to one party of a breach of the agreement by the other, and ensure that the contract does not provide for consequences which are out of all proportion or extravagant and unconscionable.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.