In the recent case of Paciocco & Anor v Australia and New Zealand Banking Group Limited ("Paciocco") [2016] HCA 28, the High Court considered whether credit card late payment fees charged by a bank were considered to be penalties.

Where a contract specifies an amount payable to one party for breach of a contract term, often referred to as a liquidated sum, and that sum is not based on a genuine pre-estimate of the damage suffered by the breach, the clause can be deemed a penalty, and unenforceable. The clause must reflect a negotiated level of risk that the parties agree to bear on breach of contract. Differentiating between a liquidated sum and a penalty, will be a matter of construction, judged at the time of contract formation.

In the case of Dunlop Pneumatic Tyre Company Limited v New Garage and Motor Company Limited [1915] AC 79 (approved in Ringrow Pty Ltd v BP Australia Pty Ltd (2005) 222 ALR 306) the court held that where the sum is extravagant and unconscionable, in comparison to the loss anticipated as at the date of contract to arise from the breach, the term will be a penalty. In evaluating whether liquidated damages are 'extravagant and unconscionable', the Court will also consider the degree of disproportion between the liquidated sum and the loss likely to be suffered by the innocent party, and the nature of the relationship between the contracting parties including relative bargaining power, and sophistication.

In Paciocco, Mr Piciocco and his company commenced an action against the ANZ, after they were charged 'exception fees'. Exception fees included late payment fees, over limit fees, honour and dishonour fees in relation to their accounts with the ANZ, effectively claiming that the fees were penalties. At first instance, Justice Gordon of the Federal Court found that the credit card late payment fees were the only fee penal in nature.

On appeal to the Full Federal Court held that the late payment fee to be neither extravagant nor unconscionable when compared to the greatest conceivable loss flowing from the breach. Mr Piciocco appealed to the High Court on the basis that the Full Federal Court erred in holding the late payment fee was not a penalty. The High Court said the question was not what the innocent party might recover in an action for breach of contract, but rather whether the costs of the innocent party, and the effects upon its financial interest by the default, could be taken into account in assessing whether a payment is a penalty. That is, whether the sum is 'out of all proportion' to the interests of the party it seeks to protect. The Court accepted that the late payments on credit cards impacted on ANZ's operational costs, loss provisioning and regulatory capital costs and when taking all of those factors into account, it was satisfied that the late payment fee was not a penalty and not out of proportion with the legitimate financial interests of ANZ. Interestingly, the Court accepted that the banks interests extended to maintaining and enhancing its revenue stream for profit.

The approach taken by the Court and the decision leads to consideration of other types of commercial contracts, which contain default provisions that may be argued, in the event of a breach, to be a penalty and unconscionable or extravagant and ultimately unenforceable. Re-drafting may be necessary to make clear that whatever the penalties sought to be imposed for default, to include an explanation of the broader costs or impact to innocent party in dealing with the default, of the legitimate financial interests of the innocent party, and possibly the legitimate business interests sought to be protected, to give weight to the reasonableness of these provisions.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.