Legal update - Unenforceable penalty clauses: Australian Federal Court gives important new guidance

13 April 2015

Last week the Federal Court of Australia released its judgment in Paciocco v Australia and New Zealand Banking Group Limited (ANZ) [2015] FCAFC 50.  The Court overturned the 2014 decision of Gordon J by holding that credit card late payment fees charged by ANZ were not penalties and were therefore enforceable.

The case is, of course, relevant to the bank fees litigation on both sides of the Tasman.  However, its significance is wider than that litigation.  The case provides some useful guidance on how the New Zealand courts may, in the future, approach the rule against penalties in relation to a wide range of agreements.

In overturning Gordon J's judgment, the Court held that:

  • A fee is a penalty (as opposed to a liquidated damages amount) if it is not a genuine pre-estimate of loss.  However, as long as a fee is not extravagant, exorbitant or unconscionable it can be a genuine pre-estimate of loss, even if the parties have not set the fee by reference to the likely loss and even if the extent of the actual loss suffered could vary considerably depending on the circumstances.

  • Extravagance should be assessed looking forward, at the time that the parties entered into the contract, not – as Gordon J had done – by applying a backward-looking test that looks at actual loss.  The onus to prove extravagance is on the party seeking to set aside the fee.

It is important to note that the judgment is by the Federal Court, which is inferior to the High Court.  As a consequence, it could not differ from or amend the judgment of the High Court of Australia in Andrews v ANZ [2012] HCA 30; 247 CLR 205.  The High Court held in Andrews that it is not necessary (in Australia at least) for a fee to be payable for a breach of contract for the rule against penalties to be engaged.  A fee may be penal in equity where it is in the nature of a security for, and in terrorem of, the satisfaction of a primary stipulation.

The Andrews decision has been subject to considerable academic criticism.  For businesses, the principal risk created by Andrews is that it potentially widens the scope of the rule to affect a number of common contractual mechanisms – examples are "take or pay" contracts in the energy and natural resources industries, service rebate mechanisms and rights to terminate a contract that carry with them a loss of accrued rights (eg loss of a trailing commission) or require a payment (eg early termination fees).

Although that uncertainty remains:

  • The Paciocco decision does suggest that the courts will have a real focus on the construction of the clause and that if a clause can be construed as a fee for an additional benefit, the rule against penalties should not be engaged (and the question of the fee's extravagance never arises).

  • The equitable doctrine of penalties applied in Andrews and Paciocco has not yet been adopted in New Zealand.

The litigation funder for the class action has indicated that it is likely that Mr Paciocco will seek leave to appeal the decision to the High Court of Australia, and in New Zealand the bank fees litigation is yet to be heard.  In addition, later this year the UK Supreme Court is due to hear an appeal of the decision in El Makdessi v Cavendish Square Holdings BV [2013] EWCA Civ 1539, which addressed some of the same issues as Andrews and Paciocco (although not the controversial Australian equitable penalties doctrine).

So although the Paciocco decision may be cause for relief for businesses employing contractual clauses that, under the wider Andrews equitable approach, might be challenged as a penalty, the status of the rule against penalties in New Zealand remains very much a case of "watch this space".  Unless Andrews is reversed in Australia, it seems likely that the arguments run in the Australian High Court and Federal Court will be tested sooner or later by New Zealand litigants who face what they consider to be onerous contractual stipulations falling short of classical liquidated damages clauses.