Penalties: Spotting the Weakness in an Overreaching Contract

The general philosophy of contracts is that they are an accord between two parties, equally willing to be involved for a purpose and recording the basis on which they intend to engage with each other and outlining reasonable protections of their interests.

It is not always the case that parties entering contracts are, however, actually equal in their bargaining position and one party may feel more compelled to agree to a contract than the other because of some need. For example, an individual entering a loan agreement because of a need for money may feel they just have to accept contracts presented to them by lenders and when dealing with lenders loan documents will often contain some pretty heavy conditions, to protect the interests of the lender. The question is, when do those protections go too far?

If a clause in a contract goes too far, it may be regarded as a penalty and if that is the case may not be enforceable against the other party. It is where the clause is not designed to just compensate the innocent party for a breach, but where it seeks to actually punish the breaching party in an effort to scare them into complying with the contract.

The problem is, there is no hard and fast rule as to what constitutes a ‘penalty’, a particular clause will always need to be considered in the context of the contract and the situation it comes from. Rather than strict rules, courts have sought to develop ‘tests’ to measure individual clauses against. For instance:

1. 1. It will be held to be penalty if a clause calls for a sum that is extravagant and unconscionable when compared with the greatest loss that a plaintiff might suffer by the particular breach the clause is supposed to protect against.
   2. It may be held to be a penalty if the breach consists only in not paying a sum of money, and the sum stipulated is a sum greater than the amount that ought to have been paid.
   3. There is a presumption (but no more) that it is penalty when “a single lump sum amount becomes payable by way of compensation, on the occurrence of one or more or all of several events, where some of those events might be serious but some are only small or trivial.

The simplest example comes again from looking at a lending/borrowing relationship. When entering into a relationship with a lender, we must be aware that money is their business and unlike other fixed or solid assets, is often harder to protect. So if a borrower defaults on the loan, the lender is not only deprived of the interest on that loan, but is also unable to use the money on some one else’s loan and therefore make money on that loan too.

That means if a loan agreement for say $50,000 has a clause that says, if you fail to pay us back our money on time your interest rate goes from 6% to 12% as a default rate, that would not be regarded as a penalty because that represents the lenders reasonable loss brought about by the failure to pay on time.

If, however, that clause were to say, on failing to pay on time the rate goes from 6% to 12% PLUS you must pay a further fixed sum of $100,000, that result would clearly be well over and above what any lender could say their genuine loss would be.

By way of another example, suppose an individual signs up to a labour hire agreement, and there is a clause in that contract that says:

In the event you are engaged on a job and you wear clothing not properly marked with our logos, we may terminate your engagement, cease to pay you from the date of your termination and recover from you the sum of $20,000.”

There can be no reasonable argument that a labour hire operator would lose $20,000 just because one of their labourers wore a regular t-shirt instead of one of their branded polos. So, making a humble labourer pay $20,000 would clearly be a penalty and unenforceable.

When considering a clause in a contract ask the question, what right is this clauses seeking to protect and is the consequence of breaching that protection a real estimate of what the innocent party is likely to suffer. If even being generous you think it goes over an above, it may well be a penalty and as such voidable.

In our current legal landscape, with the introduction of new Unfair Contract legislation a penalty clause may result in more than just being declared void. If the contract is a standard form contract and at least one of the parties is an individual or a small business (fewer than 100 employees or less than $10m turnover), then a penalty clause will generally be regarded as an unfair contract term and the new legislation means that not only will the clause be void but the party that drafted the clause may be liable for a penalty of their own, for an individual that may be up to $2.5m or if a company the greater of up to:

1. 1. $50 million
   2. 3 times benefit received by the unfair clause; or
   3. 30% of that company’s adjusted turnover.

Potentially then, a party trying to rely on a penalty clause, may themselves become the victim of a statutory penalty clause.

So if you are signing up to a contract, read the clauses carefully to determine if they are fair and if you are the one trying to rely on such a clause make sure it only goes just far enough to protect your legitimate interests!

This publication covers legal and technical issues in a general way. It is not designed to express opinions on specific circumstances. It is intended for information purposes only and should not be regarded as legal advice. Further professional advice should be obtained before taking action on any issue dealt with in this publication.