Getting the balance right: default clauses and penalties

In two previous articles I have explored the penalties doctrine in the context of a default interest rate[1] and a loan establishment fee.[2] A common feature of the cases discussed in those articles was that the impugned provisions involved the payment of a sum of money as a consequence of a breach of contract. In contrast to those cases (and the majority of other penalties cases), the contractual stipulation under consideration in Kay v Playup Australia Pty Ltd[3] (Playup) provided not for the payment of a sum of money on breach, but the compromise of accrued contractual rights.

Deciding penalties cases generally involves a comparison between a contractually stipulated sum payable and the interest sought to be protected by it. Attempts are made to quantify the value, in monetary terms, of the interests sought to be protected for the purpose of that comparison.[4] Similarly, the challenge for the draftsperson is to make a genuine estimate of the value of the interest sought to be protected in the event of default.

Such a comparison is not possible where, as was the case in Playup, the contract provides for consequences other than payment of a sum of money on default. This arguably presents an opportunity for greater subjectivity in determining whether the contractually stipulated consequences of default are out of all proportion to the value of the interest sought to be protected.

As explored below, the outcome in Playup underscores the care which must be taken in drafting default clauses generally, and particularly where the contractually stipulated consequences of default are not the payment of a sum of money. The decision illustrates that, while a default clause that discourages a breach of a contract may be perfectly legitimate, discouragement by punitive means is not. The difference between the two is not always clear. Where an appropriate balance is struck may be influenced by views as to the scope of parties’ freedom of contract. This makes penalties cases particularly difficult to predict.

Background

Ryan Kay agreed to sell Playup Australia Pty Ltd (Playup) shares in his online gambling business, Bestbet. By the sale contract, Mr Kay gave various warranties in relation to financial and other matters relevant to his company, and also agreed to various restraints preventing him from competing with, or soliciting employees or customers of, Bestbet for 3 years.

Of the sale price of $1.6 million, $1 million was to be paid on completion and the balance by way of 24 monthly instalments of $25,000 (referred to in the contract as “the Deferred Payment”). The following default provisions were at the heart of the dispute:[5]

(b) In the event that any Deferred Payment monthly payment due and payable by the Buyer to the Seller is not paid within seven (7) days of its due date, and in this regard time shall be of the essence, then:

(i)All and any restraints of whatsoever nature otherwise imposed herein on the Seller or any Key Employee herein, are immediately void ab initio; and

(ii)All and any warranties of whatsoever nature otherwise provided herein by the Seller or any Key Employee herein, are immediately void ab initio; and

(iii)All outstanding and unpaid monthly payments of the Deferred Payment shall be due and payable by the Buyer immediately, and recoverable by the Seller immediately.

Following completion, a dispute arose as to whether a portion of the Deferred Payment was made on time. Mr Kay accelerated the debt and Playup, under protest, paid the balance of the Deferred Payment. Mr Kay, however, asserted that Playup had lost the benefit of the warranties and the restraints. Playup asserted that subclauses (i) and (ii) above were unenforceable penalties.

Focus on purpose

In Arab Bank Australia Ltd v Sayde Developments Pty Ltd,[6] McDougall J (with whom Gleeson JA and Sackville AJA agreed) observed that in Paciocco v Australia and New Zealand Banking Group Ltd[7] (Paciocco), Kiefel, Gageler and Keane JJ identified the “essence” of a penalty as being “a collateral stipulation, the (or a predominant) purpose of which is to punish the borrower for breach, and thus to compel performance”.[8]

One method of testing whether a stipulation is penal, as emerged from the reasons in Paciocco, was to ask whether the stipulated sum is out of all proportion to the maximum amount of damage that might be anticipated to follow from the breach.

The judge at first instance found that the words used in the impugned clause:

… do not permit the conclusion that the “sole” or even the “predominant” purpose of the clause was intended to punish Playup for failure to pay the Deferred Payments within seven days of their due date … [rather] the purpose was to focus Playup’s corporate mind, and the mind of [its] only director, on the high importance of making the Deferred Payment on time.[9]

His Honour concluded that “the predominant, if not the sole purpose of [the stipulation] was to ensure that the Deferred Payments were made on time.”[10]

Reference was made to statements in Cavendish Square Holding BV v El Makdessi; ParkingEye Ltd v Beavis[11] (Cavendish) to the effect that in the context of a negotiated agreement by two properly advised parties of similar bargaining power, the “strong initial presumption must be that the parties themselves are the best judges of what is legitimate in a provision dealing with the consequences of breach.” The judge at first instance referred also to remarks made in Ringrow Pty Ltd v BP Australia Pty Ltd; Ultimate Fuel Pty Ltd v BP Australia Pty Ltd; Nader-One Pty Ltd v BP Australia Pty Ltd[12] to the effect that the exceptional nature of the law of penalties was the reason that “[i]t is not enough [that the propounded penalty] should be lacking in proportion. It must be ‘out of all proportion’.”

Court of Appeal’s approach

The first step in the analysis of Brereton JA[13] was to confirm that the law of penalties was capable of application where the consequences of breach were not the payment of a sum of money or the transfer of property, but the deprivation of accrued contractual rights. Many of the leading cases articulate the relevant principles by reference to the payment of an agreed sum upon breach. There is, however, support to be found in Australian[14] and United Kingdom[15] authorities for the application of the penalties rule to the forfeiture of property or accrued contractual rights, and it was not suggested by either party that the penalties rule could not apply, as a matter of principle, to the deprivation of accrued contractual rights.

There were two points which persuaded Brereton JA that the clause under consideration was penal. First was the importance of warranties and restraints in the context of a business sale. They are, as his Honour observed, “a fundamental aspect of protection of the goodwill of the subject business, so as to ensure that the purchaser actually gains the benefit of the business”.[16] Second was the indiscriminate operation of the clause. It would be engaged where the non-payment of the deferred amount was total, or where there was merely a short delay in making payment of the last instalment. His Honour found these circumstances to be analogous to those described by Lord Dunedin in Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd,[17] where his Lordship stated that a presumption that a provision is penal arises where:

… a single lump sum is made payable by way of compensation, on the occurrence of one or more or all of several events, some of which may occasion serious and others but trifling damage.[18]

His Honour did not make reference to the observations in Paciocco to the effect that the presumption was a weak one[19] or not a presumption at all, rather merely indicative of a penalty.[20]

Conclusion

In Cavendish, Lord Hodge observed[21] the difficulty that parties encounter in penalties cases attempting to predict “the judges’ value judgment on whether a particular provision is exorbitant or unconscionable” and the commercial uncertainty that arises as a result. His Lordship’s observations are apt to describe the difference in approach at first instance and on appeal.

The judge at first instance gave primacy to the parties’ relatively similar bargaining power and, therefore, freedom to determine for themselves, by negotiation, the rights and liabilities which arise following a breach of contract. These circumstances (as observed by Brereton JA)[22] are not relevant to the question of whether a clause is penal. They are, however, circumstances that would usually be sufficient to repel the intervention of equity.

Penalties cases will remain difficult to predict, but one lesson that can be divined from the result in Playup is the importance of ensuring that default clauses are flexible enough to respond differently to breaches of varying magnitudes. This might be especially challenging where the consequences of breach include the forfeiture of accrued contractual rights.