How to avoid penalty clauses in contracts

Victoria_HawkinsTNAfter a recent court case underlined the importance of ensuring the reasonableness of commercial terms in contracts, here Special Counsel Victoria Hawkins explains what you need to be aware of to avoid penalty clauses in contracts.


After a recent court case underlined the importance of ensuring the reasonableness of commercial terms in contracts, here Special Counsel Victoria Hawkins explains what you need to be aware of to avoid penalty clauses in contracts.

If you are familiar with contracts, you will know that in the event of a breach, the non-breaching party may be entitled to claim as damages an amount that reflects their loss or damage. Where the contract sets out in advance the value of the damages entitlement, that amount must be a "genuine pre-estimate" of the loss that the non-breaching party will suffer if a breach occurs.Victoria_HawkinsLG

 If, instead, the damages entitlement is totally out of proportion to the maximum loss that the non-breaching party could suffer, a court is likely to strike the clause down as a penalty and therefore invalid.

 Contract terms which are unconscionable and amount to a penalty
This principle was discussed in the famous 100-year-old Clydebank Engineering case. Let's say you have a contract that says you agree to build a house for someone for $1 million within a year. The contract also says that if you don't build it within the year, you have to pay the other person $100 million. You don't build the house in time and so a breach of contract occurs.

However, the $100 million payable under the contract is a penalty because the amount recoverable is totally out of proportion to the maximum loss that the other person will suffer for late performance.

Any contractual obligation imposing an "unreasonable" detriment may be disputed
As a result of a recent High Court case, Andrews v Australia and New Zealand Banking Group Ltd, there is the potential for a far wider range of contractual obligations to be struck down as a penalty. In particular, it was previously thought that it was only payments triggered by a breach of contract that are at risk of being struck down as a penalty.

Now, any contractual obligation imposing an "unreasonable" detriment on a party to the contract may be the subject of dispute. What this means in practice is that standard terms in commercial contracts, involving payment obligations or other detriments, will need to be reviewed.

So, for example, in the IT industry, agreements often include payments triggered by failures to achieve pre-agreed performance levels, such as time frames for responding to requests for assistance. Parties to these contracts should now review these clauses to ensure that the amounts payable for not meeting agreed service levels reflect the loss the customer may experience.

You need to review your contracts
It is now more important than ever that you review your commercial arrangements. Specifically, contractual requirements that have been put in place to "enforce" performance of other obligations should not lead to a non-performing party suffering a detriment that is greater than the amount to which the other party is reasonably entitled. Otherwise your contract may be open to challenge.

This could prove to be commercially disruptive, particularly if the same contract has been entered into with many clients and forms part of your standard business practices.

We recommend that in commercial dealings, you closely scrutinise any payments or other "detriments" (such as obligations to transfer property or forfeit proprietary interests) to assess whether they represent a genuine pre-estimate of the other party's damage. Commercial dealings that are likely to be impacted include:

-       Service level agreements (such as those used in the IT industry, as discussed above).

-       Performance payment mechanisms (used in public private partnerships and facilities management contracts).

-       Fees applied to non-performance of obligations under leases and franchise agreements.

-       Fees charged under utilities contracts and telecoms services contracts.

-       Amounts payable under indemnities.

-       Contractual restraints in construction contracts.

Victoria Hawkins is a Special Counsel in the litigation team at Colin Biggers & Paisley.

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