Penal­ties in Com­mer­cial Contracts

In Brief

In our pre­vi­ous issue, we exam­ined the gen­er­al law of penal­ties in con­tracts, par­tic­u­lar­ly in light of the recent High Court deci­sion, which held that cred­it card late pay­ment fees charged by ANZ were not penal­ties.[1] The sig­nif­i­cance of a clause being regard­ed as a penal­ty is that it is not enforce­able. If you missed last mon­th’s issue, you can find our pre­vi­ous arti­cle here.

In this mon­th’s issue, we dis­cuss whether claus­es which are com­mon­ly found in ordi­nary com­mer­cial con­tracts, such as share­hold­er and joint ven­ture agree­ments, could be con­sid­ered to be penal­ties even where they do not require one par­ty to make a finan­cial pay­ment to anoth­er, and what this could mean for you if you are con­sid­er­ing enter­ing into such contracts.

Whilst the High Court is yet to con­sid­er this top­ic, the issue was con­sid­ered by the NSW Supreme Court in Re Pio­neer Ener­gy Hold­ings Pty Ltd[2] (Pio­neer Case).

The Facts

In this case, Blue Oil Ener­gy Pty Ltd (Blue Oil) and Mor­gan Stan­ley Cap­i­tal Group Inc. (Mor­gan Stan­ley) entered into a share­hold­ers agree­ment and estab­lished Pio­neer Ener­gy Hold­ings Pty Ltd (Pio­neer) as a joint ven­ture enter­prise to under­take cer­tain con­struc­tion works. Mor­gan Stan­ley sub­scribed for 75% of the issued shares in Pio­neer and Blue Oil sub­scribed for 15%, each pay­ing $1 per share. There was a term in the share­hold­ers agree­ment which stip­u­lat­ed that if either par­ty failed to con­tribute its share of the fund­ing to the joint ven­ture, the non-default­ing share­hold­er could require the default­ing share­hold­er to trans­fer all its shares in the joint ven­ture enti­ty to the non-default­ing share­hold­er for $1.00.

Although Blue Oil made an ini­tial fund­ing con­tri­bu­tion to Pio­neer, fur­ther fund­ing was required and it failed to make the addi­tion­al con­tri­bu­tion to Pio­neer. It was assert­ed that this enti­tled Mor­gan Stan­ley to require Blue Oil to trans­fer all its shares in Pio­neer to it for $1.00.

The Deci­sion

Blue Oil con­tend­ed that the clause requir­ing it to trans­fer its shares to Mor­gan Stan­ley was unen­force­able as a penalty.

The defen­dants sub­mit­ted that the clause was not a penal­ty, par­tic­u­lar­ly because the rel­e­vant clause stat­ed that the par­ties agreed that the clause was not intend­ed to oper­ate as a penal­ty and the con­se­quence of the breach – name­ly the oblig­a­tion on the default­ing par­ty to trans­fer all its shares in the com­pa­ny to the non-default­ing par­ty for $1.00 – was a ​“gen­uine esti­mate of the loss and expense” that would be suf­fered by the non-default­ing par­ty as a result of the breach.

The court held that the clause was a penal­ty (and there­fore not enforce­able against Blue Oil) and the fact that the par­ties agreed to it and that the con­tract includ­ed lan­guage to sug­gest that it was a ​“gen­uine esti­mate of the loss and expense”, was not deter­mi­na­tive or con­clu­sive.[3]

The Pio­neer Case in light of the recent ANZ case

The Pio­neer Case is a deci­sion of the NSW Supreme Court, which means that the prin­ci­ples estab­lished from the case may be over­turned by a rul­ing of the High Court. Also, any future dis­putes regard­ing the enforce­abil­i­ty of penal­ties will, depend­ing on the facts of the case, need to fol­low the prin­ci­ples enun­ci­at­ed in that case. As not­ed in our pre­vi­ous issue, in the ANZ case, the High Court did not change the law relat­ing to penal­ties. It broad­ened the scope of the finan­cial inter­ests which may be con­sid­ered when deter­min­ing whether the finan­cial impli­ca­tions of a ​“penal­ties” clause are rea­son­able. Accord­ing­ly, if the Pio­neer case was decid­ed today, the deci­sion could be dif­fer­ent as the court would now be pre­pared to take into account all the finan­cial inter­ests of Mor­gan Stan­ley, when con­sid­er­ing whether the clause in ques­tion is reasonable.

What does this mean for you?

When enter­ing into a con­tract in which the fail­ure to per­form a par­tic­u­lar oblig­a­tion will trig­ger a finan­cial con­se­quence, one should not assume that the clause, if trig­gered, is like­ly to be an unen­force­able penal­ty. Remem­ber that, in light of the ANZ case, the courts are now pre­pared, when con­sid­er­ing whether the clause is rea­son­able, to take into account wide rang­ing finan­cial impli­ca­tions that the breach will have on the non-default­ing party.

Despite the above, some com­mon sense fac­tors to take into account if you are seek­ing to include a clause in a share­hold­ers agree­ment or oth­er com­mer­cial con­tract that requires a par­ty to sus­tain a finan­cial sanc­tion if it fails to do, or refrain from doing, some­thing, include the following:

• A clause which requires a pay­ment to be made upon a default, should be draft­ed so that the amount payable reflects the loss that will be suf­fered by the non-default­ing par­ty. It is also impor­tant to note that a pro­vi­sion can be a penal­ty even if the pro­vi­sion is not trig­gered by a breach of con­tract.[4]

• A clause which stip­u­lates that the par­ties express­ly agree that a pre­scribed amount is a gen­uine esti­mate of the loss and expense is not con­clu­sive of that fact.

• A clause which pre­scribes the same pay­ment irre­spec­tive of the cir­cum­stances sur­round­ing the breach and dif­fer­ences in the loss that will be suf­fered by the non-default­ing par­ty in light of those cir­cum­stances, may be held to be a penalty.

• An alter­na­tive may be to con­sid­er includ­ing a clause that seeks to incen­tivise a par­ty to com­ply with an agree­ment, rather than penal­is­ing the par­ty for a com­pli­ance failure.