Summary
- A penalty clause is a contractual term that imposes a financial or other consequence on a party for breaching the contract, usually exceeding the actual loss suffered.
- Under common law principles, penalty clauses are generally unenforceable because they are punitive rather than compensatory.
- Courts instead enforce liquidated damages clauses, which reflect a genuine pre-estimate of loss or protect a legitimate commercial interest.
- This guide explains penalty clauses in commercial contracts for Australian business owners, including enforceability and drafting risks.
- It is prepared by LegalVision’s business lawyers, a commercial law firm that specialises in advising clients on commercial contracts.
Tips for Businesses
Avoid drafting clauses that punish rather than compensate. Ensure any pre-agreed payment reflects a reasonable estimate of loss or a legitimate commercial interest. Clearly document how the amount was calculated and review clauses carefully to reduce the risk of them being unenforceable.
A penalty clause is a contractual term that requires a party to pay a specified sum or suffer a detriment if they breach the contract, typically to discourage non-performance. However, under common law, a clause will generally be unenforceable if it is excessive or out of proportion to the innocent party’s legitimate interest, as the law distinguishes between valid compensation for loss and provisions that are punitive in nature. This article explains what penalty clauses are, how they differ from enforceable liquidated damages, and when they may be invalid.
What is a Penalty?
A penalty is a clause that sets a harsh monetary punishment for the breach of a contract term, or failure to uphold contractual obligations. At first view, this type of clause may appear attractive to those who wish to ensure that the other party performs its obligations.
However, if the amount of money requested is greater than, or disproportionate to, the damage or loss that you actually suffer, there is the risk that this clause would be considered a penalty.
Is a Clause a Penalty?
According to the court, a clause is a penalty if it requests the payment of an amount that is “extravagant” and “unconscionable” in light of the most significant loss that the breach could have caused.
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The Paciocco v ANZ Case
In this case, the court needed to decide whether credit card late payment fees imposed by ANZ were penalties. The losses suffered by ANZ relating to late payment were no more than $3 per late payment event. At that time, ANZ was charging a late payment fee of $20.
Although the amount of the late payment fee was greater than the actual loss suffered by ANZ, the court decided that the late payment fees were not penalties. When determining whether a payment is “extravagant” or “unconscionable”, the court could take into consideration the effects of the late payments on ANZ’s financial interests.
These financial interests included:
- actual operational costs;
- loss provisioning; and
- regulatory capital costs.
The late payment fee was therefore not void. In deciding this, the courts allowed more flexibility in determining the amount a party may request.
Common Clauses That May Be Penalties
A clause will be a penalty if the payment it requires is unreasonable in relation to the loss suffered. Common scenarios where a clause may be a penalty include:
- a company that provides services at a set time issuing a fee for cancelling or rescheduling an appointment;
- a business entering a fixed term contract with another party requiring payment of an early termination fee;
- a party charging a fee for the other party’s failure to fulfill a particular task; and
- liquidated damages, which are often included in construction and leasing contracts.
The above examples provide you with clauses which may be considered a penalty. For the clause to be a penalty, the fee requested in each scenario will need to be “extravagant” or “unconscionable”.
Key Considerations When Drafting Commercial Contracts
When drafting your commercial contracts, there are a few important things to consider. These include the:
- amount the other party is to pay. When determining this amount, take into consideration whether it reflects your actual costs for rectifying the breach of the contract;
- wording of the contract. If it is necessary to include an obligation for the other party to pay a fee, consider stating that the amount is a genuine pre-estimate of the loss you may suffer as a result of the breach in the contract;
- bargaining position of each party. The court will consider the amount that the other party is required to pay and how “oppressive” it may be. Here, the court will consider each party’s bargaining power, and how the clause might advantage or disadvantage them; and
- possibility that the clause is a threat. It is essential to determine whether the clause requiring the other party to pay an amount would be deemed a threat to ensure the other party complies with its obligations. If it is a threat, it is likely that the clause will be a penalty.
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Key Takeaways
Penalty clauses may arise in various contracts, including construction contracts, leases and business terms and conditions. It is important to be aware of the law surrounding penalties, and to think about issues like:
- the respective bargaining positions of each party;
- whether the fee you wish to enforce is reasonable; and
- the actual cost of recovering the loss that a breach of contract will cause.
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Frequently Asked Questions
A penalty clause is a term that requires a party to pay an excessive amount if they breach the contract, often out of proportion to the actual loss suffered.
No. Courts generally do not enforce penalty clauses because they punish the breaching party rather than compensate the other party for genuine loss.
Liquidated damages are a genuine pre-estimate of loss and are usually enforceable, while penalty clauses impose excessive or punitive amounts and are not enforceable.
Courts assess whether the clause is proportionate to the innocent party’s legitimate interest. If it is excessive or punitive compared to the likely loss, they will treat it as a penalty.
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