By Jacqueline Monk, Special Counsel, and Bilgen Bayraktar Abali, Lawyer

We tend to think of penalties only in the context of fines (e.g. for speeding). However, certain clauses in a contract can also be deemed to be a penalty. Often such clauses are included by a party in an attempt to recoup their loss for any breach of the contract. Given the way that Australian contract law has developed, particularly in the last decade, it can be challenging to enforce these clauses, even if both parties were well aware of the provision at the time of signing.

A recent District Court of Queensland case (Zheng v Chen) is a good example of the importance of nominating a reasonable amount for default interest on a loan so as to ensure that it is enforceable.

What happened?

$350,000 was lent to a borrower to fund a property development. Interest accrued at 30% during the term of the loan and was payable along with the principal on the repayment date, being the first anniversary of the loan. Also, if the borrower failed to repay on time, default interest of 15% was payable on the total loan amount (principal + 30% interest). This default interest compounded monthly.

The Court found that the default interest rate of 15% was a penalty and therefore unenforceable. Key to the Court’s finding was:

• the fact that the default rate applied on a compounding basis; and
• that it applied to the total loan amount (rather than just the principal).

The penal nature of the clause was shown by the significant difference between the ‘non-defaulting’ payment amount and the amount the borrower had to pay after applying the default interest rate. It was also relevant that the loan agreement already contained an indemnity clause, which would operate to cover the lender for any loss suffered as a result of the borrower’s default.

Key Takeaways

It is now an established principle in Australian law that a contractual clause may be unenforceable if it is a penalty.

In deciding whether a clause is a penalty or not, Courts typically look to such things as:

• the amount of the penalty: whether it is in excess of the actual loss suffered or if it is unreasonable or excessive; and
• its purpose: whether the clause serves as a punishment rather than compensating for actual loss.

If the amount is deemed disproportionate or excessively punitive or is not a genuine pre-estimate of the loss resulting from the breach, it may be struck down as unenforceable. However, the enforceability of such clauses also depends on the specific circumstances of each case and the interest of the parties involved.

Excessive interest rates in loan agreements or an extravagant amount of liquidated damages are not the only provisions that can be considered penal. Other examples include:

• excessive discounts on the price of shares acquired from a defaulting shareholder under a shareholders’ agreement;
• late payment fees applied for overdue payments in consumer contracts or credit card payments if these are excessively high compared to the actual costs incurred by the lender;
• excessive financial penalties for breach of a non-compete agreement; and
• break fees that are significantly higher than the actual losses or costs incurred due to the early termination.

To ensure that your contract terms are enforceable and adequately protect you from breaches or late payments, it is crucial to seek proper legal advice before entering into agreements.

Walter Baden has broad experience in advising on commercial contracts and can assist you to ensure your agreements are sound and enforceable.