Pitfalls in negotiating settlement agreements: is the clause a penalty?

In disputes over unpaid debts it is common for a settlement agreement to require the debtor to pay an amount less than the full amount claimed.

The lower amount will be accepted by the creditor in full settlement, provided the debtor complies with the conditions of the settlement agreement. If the debtor fails to comply with the conditions, the settlement agreement often states that the debtor must pay the higher amount.

When a debtor fails to comply with a settlement agreement the debtor will commonly attempt to avoid liability by asserting that a particular obligation is a penalty that is unenforceable.

This issue has been considered recently by the Qld Supreme Court in Perpetual Trustee Company Limited v Aspley Specialist Centre Pty Ltd & Anor [2010] QSC 232 and by the NSW Supreme Court in Perpetual Trustee Company Limited v Mitchell [2010] NSWSC 825.

Types of clauses that are not penalties

It is well established that the following types of obligations are not penalties:

• A sum of money is payable by instalments and, if an instalment is not paid, the whole sum becomes immediately payable.
• A specified rate of interest is payable, but a lower rate of interest will be accepted if payment is made punctually.
• A creditor agrees to accept payment of part of a debt acknowledged by the debtor but, if certain conditions are not met, the full debt is payable.

In each of these cases the obligation is not a penalty because there is a present debt. By reason of an indulgence given by the creditor, the present debt is payable either in the future or in a lesser amount, provided certain conditions are met.

Aspley Specialist Centre

In Aspley Specialist Centre the landlord entered into a settlement agreement with the tenant where the tenant acknowledged that it presently owed the landlord $585,416.

The landlord agreed to accept a lesser sum if certain conditions were met. One of the conditions was the provision of bank guarantees to secure future lease obligations. If the tenant defaulted the tenant was required to pay the full amount of the debt less any amount already paid.

The court held the requirement to pay the full amount of the debt upon default by the tenant was not a penalty because there was an express acknowledgement by the debtor in the settlement agreement that they owed the amount of $585,416. The amount of $585,416 remained owing pending performance of the tenant’s obligations.

Mitchell

In Mitchell a consent judgment was entered against the mortgagor for $1,047,837.83.

In the consent orders, the mortgagee agreed not to enforce the judgment if certain conditions were met. One of the conditions required the mortgagor to sell the mortgaged property by a specified date and then pay $800,000 plus interest and costs to the mortgagee. If the conditions were not complied with, the mortgagee could enforce the consent judgment for the full amount.

The court held that the requirement to pay the full amount of the debt upon default was not a penalty because, due to the terms of the consent judgement, the mortgagor owed the full amount of $1,047,837.83 as a present debt.

A contrasting decision

The decisions in Aspley Specialist Centre and Mitchell can be contrasted with the decision in Zenith Engineering Pty Ltd v Queensland Crane & Machinery Pty Ltd & Anor [2000] QCA 221.

In Zenith the dispute related to the amount of $72,567.13 claimed under a contract to carry out engineering works. A defence was filed disputing liability for the amount claimed and a counter-claim was brought for alleged defective work.

After negotiations the case was settled. The settlement agreement required the defendant to pay $50,000 by instalments “in full settlement of the plaintiff’s claim and the defendant’s counter-claim”.

The settlement agreement provided “if any payment is not made on the due date, in respect of which time is agreed to be of the essence, the plaintiff will be entitled to enter judgment against the defendant for the full amount claimed in the amended claim plus interest and costs”.

The Queensland Court of Appeal held that the clause was unenforceable as it was a penalty.

The clause entitling the plaintiff to enter judgment for the full amount claimed plus interest and costs was neither in form nor in substance a present debt. It was merely an amount claimed. The obligation was a penalty because it sought the payment of a much larger sum than that had been agreed to be due and it was disproportionate to the loss suffered by the plaintiff as a result of a late payment of an instalment.

Implications for creditors

The cases demonstrate that, in a settlement agreement, it is important to include an express acknowledgement by the debtor that the total amount of the debt is a present debt due and owing by the debtor that will remain owing pending performance of the conditions stipulated in the settlement agreement.

It is also clear that, in deciding whether a clause is a penalty, the court will carefully analyse the terms of the settlement agreement to ascertain the substance and form of the settlement agreement.

Understanding the principles applied in determining whether a particular obligation is unenforceable because it is a penalty will assist in commercially negotiating the terms of a settlement agreement to avoid the risk of an obligation being successfully challenged at a later date by the debtor.