13 October, 2016
Construction contracts typically include ‘liquidated damages’ provisions providing for payment of a specified amount to one party by the other if it fails to meet certain obligations. It is common, for instance, for construction contracts of all kinds to specify a daily amount payable by a contractor who fails to complete its scope of work by the date for completion. Where, for example, the contractor is engaged to provide specialised design or engineering expertise, and deliver an operational asset at completion, such as a power plant or a wind farm, the contract may well specify an amount payable if the asset fails to meet specified performance levels.
It is therefore also common for a contractor facing exposure to pay liquidated damages to allege, in an effort to avoid paying the specified amount, that the liquidated damages provision is a penalty and unenforceable as a result.
The High Court in Paciocco v Australia and New Zealand Banking Group Limited recently considered an appeal by a customer of the Australia and New Zealand Banking Group Limited (ANZ) against the decision of the
Full Court of the Federal Court that a late payment fee was not a penalty. As a result, the High Court’s decision helpfully examines the rule against penalties and how it is applied in Australia.
The High Court’s application of the rule against penalties to a bank fee should not hide the obvious interest of the decision to the construction industry given the ubiquity of liquidated damages provisions in construction contracts and the efforts to characterise them as penalties in order to challenge them.
The High Court’s decision highlights the significant difficulties faced by a party seeking to prove that a liquidated damages provision is a penalty and should not be enforced by a court.
Summary
In a much anticipated decision from the High Court on penalties, Mr Paciocco (the Appellant), who led the class-action appellants, was unsuccessful in a claim for the recovery of the late-payment fees he paid pursuant to the terms of contracts between him and ANZ in relation to two consumer-credit-card accounts. ANZ unilaterally determined the amount of the late-payment fees and admitted that this determination was not made by reference to the amount which would have been recoverable as damages at law.
The Appellant supported the first instance decision that the late-payment fees were extravagant when compared with the greatest loss ANZ could recover by way of damages at law, and as such unenforceable as penalties.
In opposing the High Court appeal, ANZ supported the Full Federal Court’s decision that the late-payment fees were not extravagant or exorbitant when regard was had to the legitimate interests of ANZ in the performance of the obligation and, as such, were not unenforceable penalties.
The High Court accepted that the late-payment fees were not shown to be penalties but were, rather, a valid protection of ANZ’s interests and accordingly dismissed this aspect of the appeal.
The Appellant also challenged the fees for reasons other than that they were penalties, but those arguments and findings are outside the scope of this article. It suffices to say, for now, that those challenges by the Appellant also failed.
Background
The Appellant held two credit card accounts with ANZ (one opened in June 2006, the other in July 2009) pursuant to which he incurred a number of late-payment fees.
The ANZ Credit Card Conditions of Use provided for ANZ to issue monthly statements of account. The account holder was required to make the minimum monthly payment shown on each statement by the due date shown on the statement (Minimum Monthly Payment). The Minimum Monthly Payment was ordinarily to be the greater of $10 or 2% of the closing balance shown on the statement, but to be the full closing balance if the closing balance was less than $10.
ANZ had the right to charge a late-payment fee to the account if the Minimum Monthly Payment was not paid by the due date (the amount of the fee being set by ANZ, as altered from time-to-time). Until December 2009, ANZ set the late-payment fee at $35; thereafter, ANZ set it at $20. ANZ did not determine the amount of the late-payment fee by reference to a sum that would have been recoverable as damages.
The ANZ Credit Card Conditions of Use permitted the account holder to close the credit-card account at any time by giving notice to ANZ, and for ANZ to change any term or condition by giving notice to the account holder.
The Appellant brought a claim for recovery of the fees, alleging that the fees were unenforceable as they contravened, amongst other things, the common law and equitable prohibitions of penalty clauses.
Proceedings below
Federal Court decision
At trial, the Appellant sought to identify the damage actually suffered by ANZ as a result of the late payments and the amounts needed to restore ANZ to the position it would have occupied had the late payments not occurred. The Appellant’s expert witness calculated the ‘operational costs’, being costs involved by ANZ's Collections Business Unit and other administrative costs, and estimated the average cost per default to have been $2.50, with a range from 50c to $5.50.
By contrast, ANZ’s expert identified potential costs to the ANZ from late payments which impacted its financial position. He considered the maximum amount of cost that ANZ could conceivably have incurred and included not only the ‘operational costs’1 associated with the activities of ANZ's Collections Business Unit, as identified by the Appellant, but also other costs to ANZ’s financial interest such as ‘provisioning costs’ and ‘regulatory capital costs’2.
He estimated that average collection costs attributable to late payment exceeded $5 and the total average cost incurred by ANZ as in excess of $50 per late payment.
The primary judge's approach was to limit ANZ's ‘costs’ to actual damage incurred (which would have been recoverable as damages at law) and calculated the cost upon default at $3.00. Her Honour then contrasted this amount to the fees in question and found them to be extravagant and unconscionable, and therefore penalties at common law and in equity.
The Full Court of the Federal Court
ANZ appealed the first instance finding that the fees were a penalty.
The Full Court of the Federal Court allowed the appeal.
Allsop CJ delivered the principal reasons for judgment. In short, his Honour held that instead of undertaking an ex post inquiry of actual damage in assessing whether the fee was a penalty, as the primary judge had done,3 the correct approach was ‘to look at the greatest possible loss on a forward looking basis’ and to assess that loss by reference to the ‘economic interests to be protected.’4 As such, the Full Court held that ANZ’s expert evidence should have been considered and displayed precisely the sorts of interests which ought to be taken into account when considering the question of penalties.5
Allsop CJ concluded that when those interests were taken into account, the fees were not demonstrated to be extravagant, exorbitant or unconscionable, and were not penalties. ANZ’s appeal on this issue succeeded.
High Court decision
The Appellant appealed the Full Federal Court finding that the fees were not penalties to the High Court.
The High Court accordingly framed the question for decision narrowly as ‘whether the contractual stipulation for the late payment fee was unenforceable as a penalty at common law’ (emphasis added).6
To start with, the Court confirmed that the governing principles in terms of whether the late-payment fee was unenforceable as a penalty at common law were to be found in Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd7 and the recent High Court decision of Andrews v Australia and New Zealand Banking Group Limited.8
In traversing the governing principles, the majority (French CJ, Kiefel, Gageler and Keane JJ) noted the following considerations:
- A claimant contending that a sum is a penalty bears the onus of proving that the sum is in fact a penalty and faces a 'high hurdle'.9
- A penalty, by nature, punishes a party.10
- In the context of a contract, the term ‘penalty’ refers to a punishment, consisting of the imposition of an additional or different contractual liability, for non-observance of a 'primary' contractual stipulation.11
- A breach of contract is not required for the penalties doctrine to operate.
- A requirement to pay or do some other act may be a penalty, notwithstanding the fact that the obligation to pay is not enlivened by a breach.12
- Even if no pre-estimate of loss is made at the time the contract is entered into, a sum stipulated will not necessarily be a penalty.13 A sum reflecting, or attempting to reflect, other kinds of loss or damage to a party’s interests beyond those directly caused by breach will not, of itself, amount to a penalty.14
- Whether or not a stipulated sum is unconscionable or extravagant can only be gauged against the identified interests of the party in whose favour the stipulation is made.15 This is not limited to a comparison of the stipulated amount and the amount of damages flowing directly from the breach and recoverable at law.16 In particular, ‘for a party to stipulate for a more ample remedy than is available at law is not to visit a punishment of the other party.’17
- Crucially, the character of the alleged penalty is referable to the interests which the parties seek to protect. The question is whether the sum agreed is ‘commensurate with the interest protected by the bargain’.18 To be a penalty, a provision for the payment of a sum of money on default must be out of all proportion to the interests it purports to protect. A sum which is merely disproportionate to the loss suffered would not qualify as penal.19 It is insufficient that it should be ‘lacking in proportion’; rather, it must be ‘out of all proportion’.20
The majority accepted that ANZ’s interests extended beyond the recovery of compensation for loss and that it was legitimate for it to seek to protect those interests.21 This being so, the relevant question to be applied, then, was whether the late-payment fees were out of all proportion to ANZ’s interests in receiving timeous payment of the Minimum Monthly Payment. The majority held that even if ANZ’s expert evidence were ignored, the Appellant had failed to establish that the late-payment fees were out of all proportion and so penalties.22 Accordingly, the appeal
failed.
What the decision means for you
Agreeing the amount payable in the event of a failure to comply with an obligation can be extremely useful and, unless challenged, will allow the innocent party to avoid the uncertainty and expense of litigation to prove its loss. This is an obvious reason for the widespread use of liquidated damages provisions by the commercial construction industry.
The High Court decision recognises that the parties themselves are in the best position to assess their risk and interests requiring protection when contracting, and that it is legitimate for a party to seek to protect its interests.
The decision also confirms that a party alleging that a contractual burden imposed upon it is a penalty is required to prove it and faces a high hurdle in so proving.
It will not be sufficient that a sum stipulated is more, or even considerably more, than the amount which would be recoverable by the innocent party had it sought to claim damages at law. Instead, the courts will only intervene when the burden imposed is so extravagant when compared to the interests which are sought to be protected that it serves no purpose other than to punish.23
1. Provisioning costs being expenses which ANZ recognised in its profit and loss account representing reductions in the value of customer accounts attributable to risk of default.
2. Regulatory capital costs being costs which ANZ incurred in funding capital which ANZ was required by applicable prudential standards to hold as a buffer against unexpected losses: and so was money ANZ could not divert to other profit making pursuits.
3. Paciocco v Australia and New Zealand Banking Group Limited [2015] FCAFC 50, [117].
4. PacioccovAustraliaandNewZealandBankingGroupLimited [2015] FCAFC 50, [169].
5. Paciocco v Australia and New Zealand Banking Group Limited [2015] FCAFC 50, [167].
6. Paciocco v Australia and New Zealand Banking Group Limited [2016] HCA 28, [74] per Gageler J.
7. [1914] UKHL 1; [1915] AC 79.
8. [2012] HCA 30; (2012) 247 CLR 205.
9. Paciocco v Australia and New Zealand Banking Group Limited [2016] HCA 28, [53].
10. Paciocco v Australia and New Zealand Banking Group Limited [2016] HCA 28, [118], [127].
11. PacioccovAustraliaandNewZealandBankingGroupLimited [2016] HCA 28, [22], [118].
12. Paciocco v Australia and New Zealand Banking Group Limited [2016] HCA 28, [4]. On this point, French CJ emphasised that, the position in Australia is at odds with that in the UK. There, the Full Bench of the Supreme Court, in Cavendish Square Holding BV v Talal El Makdessi [2015] UKSC 67, held that the doctrine of penalties is confined to cases arising out of contractual breach.
13. Paciocco v Australia and New Zealand Banking Group Limited [2016] HCA 28, [30].
14. Paciocco v Australia and New Zealand Banking Group Limited [2016] HCA 28, [30].
15. Paciocco v Australia and New Zealand Banking Group Limited [2016] HCA 28, [52].
16. Paciocco v Australia and New Zealand Banking Group Limited [2016] HCA 28, [33], [161].
17. PacioccovAustraliaandNewZealandBankingGroupLimited [2016] HCA 28, [283].
18. Paciocco v Australia and New Zealand Banking Group Limited [2016] HCA 28, [270].
19. Paciocco v Australia and New Zealand Banking Group Limited [2016] HCA 28, [54].
20. Paciocco v Australia and New Zealand Banking Group Limited [2016] HCA 28, [54].
21. Paciocco v Australia and New Zealand Banking Group Limited [2016] HCA 28, [68].
22. Paciocco v Australia and New Zealand Banking Group Limited [2016] HCA 28, [69].
23. Paciocco v Australia and New Zealand Banking Group Limited [2016] HCA 28, per Gageler [165] – [167].
For further information, please contact:
Elisabeth Maryanov, Herbert Smith Freehills
elisabeth.maryanov@hsf.com
