Liquidated damages or penalties: higher threshold for enforceability

The cases of Andrews and Others v Australia and New Zealand Banking Group Ltd (2012) (Andrews) and Re Pioneer v Energy Holdings Pty Ltd [2013] (Pioneer) significantly expanded the penalty doctrine in Australia.

What should be taken from the cases is that:

• a court may hold that a provision is a penalty even if it is not triggered by a breach of contract; and
• provisions requiring compensation to be provided by one party to another should be proportionate to the potential loss suffered.

Express agreement between parties that compensation is reasonable will not necessarily oust the doctrine of penalties.

The cases should be carefully considered when negotiating liquidated damages or any other compensation provisions in commercial agreements.

Provisions that incentivise parties to meet deadlines and carry out their obligations, as opposed to compensating a party where another party does not fulfil stipulated obligations, are more likely to be enforceable as such provisions may avoid the issue of penalties altogether.

Andrews

In Andrews the High Court held that, contrary to the established position, the penalty doctrine is not confined to obligations arising from a breach of contract and extended the reach of the doctrine to compensation arrangements, whether or not associated with a breach of contract.

The court looked at the obligations of customers to pay fees to ANZ upon the happening of a number of events, including overdrawing an account. Overdrawing the account was not a breach of contract and therefore the fees charged were not associated with a breach by the customer. However, the court held that the fees could still be characterised as penalties.

Pioneer

Pioneer was concerned with an exit mechanism in a shareholder agreement for a joint venture project between Blue Oil Energy Pty Ltd (Blue Oil) and Morgan Stanley Capital Group Inc. (Morgan Stanley).

The agreement required Blue Oil to contribute funding to the project and if it failed to do so, Morgan Stanley could exercise a right to acquire all of Blue Oil’s shares in Pioneer for $1.00.

Morgan Stanley tried to enforce their option to acquire Blue Oil’s shares for $1.00 at a time when the shares were worth approximately $13 million.

Blue Oil claimed that the provision was unenforceable because it amounted to a penalty.

Morgan Stanley submitted that the provision was not intended to punish Blue Oil and therefore did not amount to a penalty. Morgan Stanley also argued the provision was included for ‘good commercial reason’ because, unless it acquired all of Blue Oil’s shares in Pioneer, it would be left with a project that was partially completed and of little value.

The court held that the exit mechanism needed to be proportionate to any resulting loss and, if it was not, the compensation provisions were punishment for default and therefore a penalty.

In coming to this conclusion, the court considered Lord Dunedin’s comments in Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd [1915], where his honour stated that an attribute of a penalty is ‘if the sum stipulated for it is extravagant and unconscionable in amount by comparison with the greatest loss that could conceivably be proved to have followed from the breach’.

The court compared the circumstances in Pioneer with those of CRA Ltd v NZ Goldfields Investments [1989], where, upon a breach occurring, the defaulting party had to transfer its interest in the joint venture at fair market value minus 5%. The ‘good commercial reason’ for the 5% was because there was a 60-day notice period during which the joint venture could get into ‘serious commercial bother’ to the burden of the remaining party.

The notice period in Pioneer was only 20 days and the court noted a transfer for nominal value was significantly different to applying a 5% discount and there were no provisions taking into account the amount already invested in the joint venture by Blue Oil.

Please contact a member of our team if you would like further information or advice on the impact of these cases.