The Penalty Doctrine: Focus on Substance Not Form Says The High Court of Australia
When is a contractual term a penalty? Traditionally, a penalty has been characterized as a provision that results in unconscionable and disproportionate compensation for breach of contract. The recent decision of Australia’s High Court in Andrews v. Australia and New Zealand Banking Group Ltd (“Andrews”) has widened the scope of the common law penalty doctrine to include a fee payable regardless of whether the event triggering its enforcement constitutes a breach of contract. This is a case to watch for its potential impact on contract drafting and interpretation.
Andrews is a class action against Australia and New Zealand Banking Group Inc. (ANZ) brought by ANZ customers. The customers challenged the imposition of certain service fees charged by the bank and sought repayment of all or part of the fees. The class argued that the fees imposed by ANZ for certain banking services (such as over-draft protection) were penalties and therefore void and unenforceable. The class further argued that the fees were penalties even though the event triggering the fees (e.g.: overdrawing on an account) was not prohibited by the contract and therefore did not constitute a breach. In fact, the contract permitted certain customer conduct but actively discouraged the conduct by imposing a monetary fee payable on the occurrence of that event.
ANZ asked the Court to adopt the more traditional approach to penalty provisions stating that the fees were not triggered by a breach of contract but charged to deter certain conduct deemed undesirable by the bank. Therefore, said ANZ, the rule against penalties was not engaged.
The Federal Court of Australia and later Australia’s High Court considered the issue of whether a term imposing a fee for behaviour not resulting in a breach of contract could be characterized as a penalty.
The Federal Court of Australia concluded that ANZ’s fees were not penalties. Gordon J. stated:
The law of penalties is a narrow exception to the general rule that the law seeks to preserve freedom of contract, allowing parties the widest freedom, consistent with other policy considerations, to agree upon the terms of their contract. Equity, however, continues to play a role in the law of penalties, a law which is confined to payments for breach of contract.’ (see para 4) [emphasis added].
By contrast, the High Court of Australia unanimously held that:
The primary judge erred in concluding, in effect, that in the absence of contractual breach or an obligation or responsibility on the customer to avoid the occurrence of an event upon which the relevant fees were charged, no question arose as to whether the fees were capable of characterisation as penalties. (see para. 78).
The High Court held that a fee or stipulation in a contract could not be shielded from characterization as a penalty simply because the event triggering its enforcement was not a breach. Rather, a fee or stipulation may be found to be penal if, in substance, it is out of proportion to the obligation that it seeks to secure. This applies in circumstances involving the performance (e.g.: late payment on credit card balance) or non-performance (e.g.: overdraft fee for bank’s consideration (and refusal) to permit overdraft because customer did not meet credit criteria) of an obligation. In the result, the High Court emphasised substance of a provision over its form, and confirmed the law of penalty as an equitable remedy against provisions that are in substance penal.
A notable distinction between a fee for security and a fee for service, however, was drawn by the High Court. Citing Metro-Goldwyn-Mayer Pty Ltd v Greenham,  2 NSWR 717, the High Court confirmed that a fee is not a penalty when it is charged for a service or additional accommodation, rather than a security for an existing obligation.
In Metro-Goldwyn-Mayer, the contract governing the screening rights of film exhibitors conferred the right to one screening only. Exhibitors were required to pay four times the original fee for each additional screenings. A majority of the New South Wales Court of Appeal found that the fee for additional screenings was not a penalty because it was a fee for an added right (the right to screen the film more than once). Jacob J.A. wrote:
Upon such an approach it seems to me that cl. 56 is properly regarded as one providing for an additional hiring fee in the event of an additional showing of a film. It may well be intended by the agreement that such an additional showing should be strongly discouraged. For this reason a very large hiring fee compared with the original hiring fee is provided. However, that does not make the clause a penalty clause: cf. Bridge v Campbell Discount Co. Ltd.,  1 All E.R. 385;  A.C. 600.
This decision was cited with approval by the High Court in Andrews.
In short, the analysis of whether a term is penal should focus on the effect of the provision and whether, in substance, it results in a remedy that is disproportionate to the harm suffered.
The Andrews case is significant for its potential impact on terms of a contract that require compensation payable upon a specified event regardless of whether the event is a breach of contract.
Going forward, it will be of benefit to those drafting contracts to give due consideration to whether a term may be characterized as a payment for a service or right, rather than as compensation for a breach.
While this case has not yet been considered in Canada, the Andrews decision will certainly be persuasive in our courts. Time will tell how Australian courts, and ultimately Canadian courts, treat the penalty doctrine under similar circumstances.
Andrews v. Australia and New Zealand Banking Group Ltd.,  HCA 30
Court File No.: M48/2012
Date of Decision: September 6, 2012
Australia High Court common law penalty doctrine contractual term