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The Law of Penalties - court modernises "ancient, haphazardly constructed edifice".

03 July 2017

Contracts often contain clauses providing that one party must pay a certain amount to the other party if the first party breaches the contract – for example, if a payment is not made or an obligation is not performed on the due date. The Courts have refused to allow recovery of these amounts if they regard them as “penalties”.

Historically the Court might find the amount a penalty if it was not a genuine pre-estimate of the damages the innocent party was likely to suffer as a result of the breach but was a threat being held over the contract breaker to force that party to perform an obligation; put another way, the amount would be a penalty if it was extravagant and unconscionable in comparison with the greatest loss that could follow from the breach.

In recent cases the Courts have restated the principles to be applied in determining whether a payment is a penalty or not. The focus is now on the legitimate commercial interests of the innocent party rather than whether the purpose of the clause is to deter breach and whether the amount is a genuine pre-estimate of loss. This is determined by examining the words of the agreement at the time the contract is entered into.

The recent NZ case

In the recent case of Wilaci Pty Limited v Torchlight Fund No 1 LP (in receivership)([2017] NZCA 152) our Court of Appeal found that a late payment fee of $AUD500,000 per week on an $AUD37 million loan was not an unenforceable penalty. (The case was decided on New South Wales and all figures that follow in are AUD.)

In 2012 Torchlight was in a “very tight liquidity situation”. It needed funds urgently to meet its obligations to the Bank of Scotland. As no commercial lender would consider lending because of the exceptionally high level of risk involved, the loan was presented to Wilaci (a company not in the business of making commercial loans) as a “small albeit juicy transaction”. Eventually Wilaci agreed to lend Torchlight $37m on the following basis:

- The $37m loan and $320,000 was to be repaid after 60 days
- A $5m fee was to be paid after 120 days
- A late payment fee of $500,000 per week was payable if Torchlight failed to pay the loan and interest after 60 days.

Torchlight failed to make the payments when they were due and a period of delay, described as one of “endless excuses and broken promises”, followed. In 2014 proceedings were issued.

The Court stated that the question before it was whether the effect of the late payment fee was exorbitant or unconscionable when regard was had to Wilaci’s legitimate commercial interests in due performance of the loan contract. The Court concluded that that the late payment fee was properly payable. Its predominant purpose was not to punish and it was not out of all proportion to the legitimate interests of Wilaci. As a consequence Torchlight was ordered to pay the late payment fee which was nearly as much as the original loan amount of $37m. The Court commented that the scale of debt Torchlight faced was a consequence of choices Torchlight had made for itself.

How will this finding apply in other cases?

Although this case signals a shift towards the Courts upholding these types of payments and refusing to interfere with the parties’ freedom to contract with each other as they see fit, the context in which this decision was made (as noted by the Court) needs to be considered: both parties were substantial commercial entities who were economically astute and independently advised; each stood to make substantial returns; there was an exceptionally high risk to Wilaci; and the late payment fee was lower than the equivalent credit cost of the interest and $5m fee payable. In a different context (such as a consumer contract) the application of the legal principles could result in a different outcome.

 

Please email me at barbara.mcdermott@nwm.co.nz with your ideas for future articles. Keep an eye out for next month's column, where I will discuss another relevant rural legal issue.


Barbara McDermott is a partner of Norris Ward McKinnon, specialising in commercial and rural law. With offices in Hamilton and Huntly, we have friendly, expert legal advisors ready to help you with your business and personal legal matters.

 

Barbara McDermott