By Russell Cocks, Solicitor
First published in the Law Institute Journal
It is a fundamental principle of contract law that any attempt to penalise a contracting party for breaching that contract will be unenforceable.
However the law also recognises a number of exceptions to this principle, notably the entitlement of a vendor of a contract of sale to forfeit the deposit paid by the purchaser if the purchaser fails to complete the contract. Such an outcome clearly operates as a penalty against the purchaser arising from breach of the contract, but such an outcome is accepted by the law as a reasonable consequence of the breach in the circumstances of the contractual relationship. The law reserves the right of the Courts to review the imposition of such a penalty in particular circumstances by allowing the penalised party (the purchaser) to apply to the Court to exercise the Court’s discretion to avoid forfeiture of the deposit where it would be just to do so.
A Court would not normally intervene to protect a purchaser from forfeiture of the deposit if the deposit is 10% of the purchase price; as such an amount is generally accepted as a reasonable pre-estimate of the vendor’s likely loss if the contract does not proceed. However, a higher deposit, such as 20%, might attract the Court’s discretion as it smacks of a penalty for breach. In such circumstances the vendor runs the risk that the Court might strike down the offending term in its entirety, in which case the purchaser would be entitled to a full refund, or the Court might, in the exercise of its discretion, order forfeiture of 10%.
A contractual term that provides that an amount of 10% shall be forfeited upon default might not be enforceable if the particulars of sale provide for a deposit of less than 10%.
Applying this principle to contractual terms that seek to impose penalty interest, one can immediately see the potential for a problem. By definition, the provision is imposing a contractual penalty for breach. Such a provision will be struck out unless the Court can be satisfied that the penalty is in fact a genuine pre-estimate of the losses likely to be suffered by the ‘offended’ party.
The 2008 contract of sale in common use in Victoria provides for interest to be paid upon default. Ordinarily this provision will be relied upon by the vendor to claim interest from the purchaser when the purchaser fails to settle on the due date. Less often, it is claimed by the vendor as a result of non-payment of the deposit. It might even be relied upon by a purchaser who is entitled to a refund of deposit upon valid termination of the contract.
In all such circumstances it is a penalty for breach of contract and therefore susceptible to the common law principle against contractual penalties. Its saving grace is that such a condition may be regarded as a genuine pre-estimate of the offended party’s likely losses arising from the breach. Failure to pay an amount due under the contract means that the offended party does not have the use of that money during the period of breach. It might reasonably be expected that the vendor would have made use of that money during that time, by investment or otherwise. Thus GC 26 provides that ‘interest at the rate of 2% per annum plus the rate for the time being fixed by section 2 of the Penalty Interest Rates Act 1983 is payable on any money owing…’. Reference to an objective measure (Penalty Interest Rates Act) might be seen as confirmation of the genuine nature of this pre-estimate.
But what of ‘renegade’ conditions that seek to amend this universally accepted standard? Conditions imposing the statutory rate plus 6% or even 4% run the risk of being held to offend the rule against penalties and not be saved by coming within the genuine pre-estimate exception. A rate of 5% per month for default has been held to be an unenforceable penalty. A higher rate of 25% per annum in a mortgage that provided for an acceptable rate of 16% was likewise unenforceable. The penalty in that case was a 56% increase on the acceptable rate. A penalty rate that added, say, 6% to a rate that would have otherwise been approximately 12% per annum (a 33% increase) certainly runs the risk of being struck out as a penalty.
And what of conditions that totally abandon reference to the objective statutory standard and unilaterally impose an arbitrary amount, such as 20% per annum? It is easy to see that a Court would find that such a condition is motivated by a desire to place the offending party ‘in terrorem’ rather than in any way being a genuine pre-estimate of likely loss. In such circumstances a Court might strike such a condition out entirely, such that no penalty interest would be payable. The drafter of such a condition would then be accountable to a very dissatisfied client.
Tip Box
Whilst written for Victoria this article has interest and relevance for practitioners in all states.