The Federal Court declines to expand the law of penalties

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16 December 2011

In a recent high profile decision, the Federal Court declined to expand the situations in which the law will strike down an agreed sum to be paid upon the happening of certain events (the law of penalties).

The Court in Andrews v Australian and New Zealand Banking Group Limited [2011] FCA 1376 confirmed that the law of penalties is a narrow exception to the general rule that the law seeks to preserve freedom of contract, and that breach of contract is a necessary element for the law of penalties to apply.

Although the decision relates primarily to the retail banking sector, it has general application to the construction industry, and in particular to liquidated and other damages regimes commonly contained in construction contracts.

Overview

The case concerned a class action brought against the Australian and New Zealand Banking Group Limited (“ANZ”) by its customers.  The Applicants sought a declaration that a range of fees for overdrafts, overdrawn accounts, dishonoured cheques and credit card late payments (“the Exception Fees”) were void or unenforceable as a penalty. 

The application was based on two alternative arguments:

  1. First, it was argued that the fees were incurred as a result of breaches of contract between ANZ and its customers, and therefore the law of penalties applies.
  2. Alternatively, the Applicants contended that breach was not a necessary element in the law of penalties, and that because the Exception Fees were payable on the occurrence of events that were the obligation or responsibility of the customer, the law of penalties applies.

Were the Exception Fees incurred as a result of breach of contract?

Justice Gordon considered each of the Exception Fees, the terms of contract between ANZ and its customers and the relevant regulatory framework.  Her Honour noted that contractual obligations must be construed in the context of the regulatory framework in which they are intended to operate and that the whole contract must be considered, with substance taking precedence over form.

Justice Gordon concluded that the overdrawn, dishonour and overdraft fees were not incurred as a result of breach of contract.  Instead, the fees were payable upon ANZ meeting a request for a loan or advance from a customer.

On the other hand, her Honour did find that the credit card late payment fees were capable of being a penalty, as they are a fee imposed by ANZ on a customer when it fails to make a payment within the time stipulated.  In other words, late payment fees were payable on breach.

The question of whether the credit card late payment fees were proportionate to the likely damage suffered by ANZ was deferred to a later hearing by the Court.

Is breach a necessary pre-condition to the law of penalties?

More relevantly to the construction industry, Gordon J considered whether breach is a necessary pre-condition to the application of the law of penalties. The Applicants argued that the law of penalties extends to strike down fees that are payable in circumstances where there has been no technical breach of contract but which were payable on the occurrence of an event: namely the customer overdrawing its account.

In her decision, Gordon J declined to expand the law of penalties.  Her Honour maintained that doing so would be contrary to the trend of freedom of contract and would have uncertain and potentially ambiguous results.

What does this decision mean for the construction industry?

The Federal Court has confirmed that the law of penalties is confined to situations where a contract stipulates that on breach the contract-breaker will pay an agreed sum (which sum exceeds what can be regarded as a genuine pre-estimate of the damage likely to be caused by the breach).

In drafting liquidated or other damages clauses in construction contracts, parties should be aware that the law of penalties will apply if a fee or other amount, such as liquidated damages, is payable on breach of contract.  In such instances, parties should then turn their minds to consider whether the damages are a genuine pre-estimate of loss and in proportion with the likely damage to be suffered as a result of the relevant breach.

At the same time, the Federal Court’s decision confirms that the law of penalties will not interfere with contractual provisions requiring payment of an agreed sum on the happening of an event that does not constitute a breach of contract.

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