Contractual Penalties – a change in landscape

Posted on October 26th, 2016

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contractual-penalties-a-change-in-landscapeTony Cavanagh is a Director at Mullane & Lindsay in Newcastle and specialises in commercial dispute resolution & litigation, and employment law.

The concept of a “penalty” in Australian law is relatively easy to state, but often difficult to apply in practice. In essence, where a contractual provision (or some collateral arrangement) imposes an obligation for breach of contract, that is disproportionate to the actual cost or loss resulting from the breach, it can be set aside as a “penalty”.

Take a simple example of a contract to purchase a car for $10,000.00. It has a condition that if the purchasers do not complete the purchase on a specified date they must pay $1,000.00 per day, in addition to the price, until settlement occurs. That additional sum is obviously disproportionate to the vendor’s actual cost of delaying settlement. By contrast, a provision that is a genuine pre estimate of the injured party’s costs or losses will not be a “penalty”. Using the ‘sale of a car’ scenario above, if the ‘price’ for a delayed settlement was set by reference to the vendor’s actual holding costs (for example if the vendor’s loan repayment was $10 per day and the ‘price’ of delay was also $10 per day) it can readily be seen that the additional payment is a genuine pre-estimate of loss.

In contracts for sale of land, a 10% deposit was historically required. As property prices have increased it is now common to provide for, say, 5% ‘up front’; with the other 5% payable if the purchaser breaches the contract. While that may superficially appear reasonable, there are a number of decided cases in which clauses of this kind have been unenforceable on the basis that they are “penalties”, applying the principle illustrated above.

The United Kingdom has recently taken a different approach to penalties. One of the cases that led to the UK position involved a car parking station. Its rules provided that if a customer overstayed a two hour free parking period, they would be charged 85 GBP. The particular individual overstayed by less than 60 minutes and was charged the 85 GBP. The fee was challenged as being unreasonable.

The Court accepted that the fee was not a genuine pre estimate of loss, but determined it was not out of proportion to the parking station owner’s “legitimate interest” – which the Court characterised as an interest in maintaining the turnover of parking spaces. That is quite different to being out of proportion to ‘the cost’ to the innocent party as a result of the breach.

Businesses which routinely enter contracts for the sale of goods or the supply of services (and particularly where those contracts have ‘structured’ deposit provisions, or include provisions that ‘price’ the consequences of a breach) would be prudent to regularly revisit how their contracts are drafted.

Tony Cavanagh is a Director at Mullane & Lindsay, and practises extensively in Commercial and other Litigation and Employment Law. If you require any assistance in these areas please contact Tony Cavanagh or contact our Newcastle office or Sydney office. 

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