in Business Contracts

Illegal penalty clauses – do you have one in your contract?

A limitation in Australian contract law is that a clause that seeks to impose a penalty on a contracting party cannot be enforced against that party. A penalty is a condition of a contract where a party who breaches the contract (usually for late payments of goods or services supplied) would be fined (or penalised) for the breach in such a way that is out of proportion to the breach.

For example, if you included a clause in your customer contract whereby you charge a fee of $10/day for late payment on a debt of $10 owed by a customer, and you attempt to collect $70 from the customer on top of the $10 owing because the customer was 7 days late, your claim will not be allowed to proceed because a penalty of $70 on a $10 debt which is overdue for 7 days is totally out of proportion to the loss suffered by you.

However, outside of such an extreme case, when is a penalty a penalty?

Recognising penalty clauses

Over the years, Australian courts have made various determinations on when a clause is a penalty clause:

  1. A penalty clause applies only when a breach of contract has occured, not before;
  2. Credit card late payment fees is not a penalty;
  3. Any fines imposed that are not “extravagant” or “unconscionable” in comparison to the loss incurred by the innocent party is not a penalty.
  4. Any amounts imposed which is considered a “genuine estimate” of possible damage suffered by the innocent party is also not a penalty.

Sources for decisions

The following sources provide reasons for determining whether a clause is a penalty clause or otherwise.

  1. Breach of contract requirement: In Interstar Wholesale Finance Pty Limited v. Integral Home Loans Pty Limited [2008] NSWCA 310, there was no penalty clause in relation to the termination of a contract by Integral Home Loans because they were entitled to terminate the contract if they reasonably believed there was fraudulent activity conducted by Interstar, and which they did.
  2. Credit card late payment fees: On 26 July 2016, the High Court of Australia handed down its decision in Paciocco v Australia and New Zealand Banking Group Limited (ANZ) [2016] FCA 28, which among other things, said that contracts which provide for such late payment fees are not penalty clauses because they did not impose “extravagant” or “unconscionable” amounts in comparison to loss incurred in respect of such late payment.
  3. “Extravagant” and “unconscionable” amounts or “non-genuine pre-estimate” of loss: The test for determining whether a clause can amount to a penalty clause is contained in Dunlop Pneumatic Tyre Company Ltd v New Garage and Motor Company Ltd [1915] AC 79, where the key factors to consider is whether the clause results in unfairness to the party in breach of the contract as the penalty amount would be excessive or extravagant.

As a business owner, seek legal advice before you decide to include a clause for late payment in your business contract as it may not be enforceable.