The Court of Appeal on penalties – orthodoxy strikes back?

By a 2-1 majority the Court of Appeal held that a loan establishment fee of $26,625 was a penalty, arguably bucking the trend of decisions since the High Court’s judgment in Paciocco.

Melbourne Linh Son Buddhist Society Inc v Gippsreal Ltd [2017] VSCA 161

 

Facts

The lender made a loan offer of $1,775,000 on terms, including that the borrower pay a loan establishment fee of 1.5% (which converted to a loan establishment fee of $26,625).

The loan amount was subsequently reduced to $500,000, but the loan establishment fee remained $26,625 (which, on the reduced loan amount, converted to a loan establishment fee of over 5%).

The borrower did not settle the loan transaction within the time specified by the lender, resulting in the lender terminating the agreement and claiming liquidated damages.

At trial, the Court held that the lender had been entitled to terminate the agreement.  The Court awarded the lender liquidated damages in the amount of $49,436.77, which amount included the loan establishment fee of $26,625.

The issue

The primary issue on appeal was whether the lender had been entitled to terminate the agreement.  The Court of Appeal unanimously allowed the borrower’s appeal on this issue.

It was therefore not strictly necessary for the Court to go on to consider the alternative grounds of appeal, which included whether the loan establishment fee was a penalty (this ground would have been ‘live’ if the Court of Appeal had decided that the lender had been entitled to terminate the agreement for the borrower’s breach in not settling the loan transaction within the time specified by the lender). The Court nonetheless considered this issue, and it is this aspect of the judgments that is of interest.

The judgments

The majority (Kyrou JA and Cameron AJA) held that the loan establishment fee was a penalty. They started by referring to the traditional position set out by the High Court in Ringrow Pty Ltd v BP Australia Pty Ltd (2005) 224 CLR 656 (Ringrow) which in turn adopted Lord Dunedin’s suggested ‘tests’ from Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd [1915] AC 79 (Dunlop): [164]–[168].  They then considered Paciocco v Australia and New Zealand Banking Group Ltd (2016) 258 CLR 525 (Paciocco), including the dissenting judgment of Nettle J, noting that the High Court held that a contractual term will not be a penalty if it protects the legitimate commercial interests of the non-defaulting party under the contract: [171]–[175].  The majority identified evidence adduced at trial relevant to that issue: [194]. It is not apparent from the judgment that the borrower, at trial, sought to discharge the onus of proving that the loan establishment fee was a penalty; rather, it seems that the lender pre-empted a challenge to its fees and adduced evidence from a director for that purpose. The majority paid particular attention to that evidence: recited at [63]–[69]. They subjected it to detailed scrutiny, and ultimately rejected it:  [196]–[201].  Their Honours concluded (at [195] and [198], emphasis added):

“In our opinion, the establishment fee of $26,625 is a penalty because it bears no relation to any possible damage to or interest of the [lender] arising from the putative breach of the Deed of Offer by the [borrower] and it is not commensurate with any legitimate commercial interest of the [lender] which is sought to be protected by that deed in the event of its breach

The irresistible inference that arises from [the director’s] evidence and the inherent circumstances of the proposed loan transaction is that the fee of $26,625 was retained in order to punish the [borrower] for the inconvenience its conduct caused the [lender] in the lead up to 27 September 2013 rather than to protect any legitimate commercial interest of the [lender] arising from a breach of the Deed of Offer by the [lender].”

President Maxwell dissented on the penalty issue.  His Honour referred to Paciocco and said (at [5]–[6], footnotes omitted, emphasis added):

“The essential inquiry is whether the party asserting the penalty characterisation has established that the amount stipulated is ‘out of all proportion to the interests of the party which it is the purpose of the provision to protect’.

What Paciocco highlights is that: ‘Interests of the innocent party beyond the protection of an award of unliquidated damages in the event of a breach of contract can justify a different conclusion. The protection afforded by the stipulation of an obligation to pay a specified sum of money in the event of a breach of contract might be to interests that the innocent party has in contractual performance which are intangible and unquantifiable’.”

His Honour said the penalty question had not been raised on the pleadings, and was not the subject of expert evidence (compare Paciocco), and held that there was insufficient evidence before the Court to enable the penalty question to be answered on appeal: [3], [9]–[12] and [15].

Comment

Traditional orthodoxy has been to compare a contractually-stipulated money sum to “the greatest loss that could conceivably be proved to have followed from the breach”: see Lord Dunedin’s ‘test 4(a)’ in Dunlop at 87.  As the High Court put it in Ringrow at [21], “In typical penalty cases, the court compares what would be recoverable as unliquidated damages with the sum of money stipulated as payable on breach”. In Paciocco, Nettle J (in dissent) followed the traditional approach, holding (at [343]) that it was a typical penalty case of the kind referred to in Ringrow.

The majority in Paciocco took a broader approach, holding that relevant “interests” may be broader than merely what might be recoverable in an action for damages for breach.  On that basis, they took into account not only the direct operational costs incurred by the bank in relation to late payments, but also the ‘costs’ of loss provisioning and increases in regulatory capital (which ‘costs’ were the subject of expert evidence at trial).

After Paciocco it was perceived that penalties might be few and far between – a lender could defend a challenge to its fees by comparing them to a broad range of tangible and intangible commercial interests in the performance of the contract, rather than comparing them merely to what might be recoverable by the lender as unliquidated damages consequent on a breach.

In this case, the majority applied Paciocco, but they did so in a way that revealed an emphasis on matters more akin to those raised in pre-Paciocco cases, i.e. matters concerning the consequences of a breach rather than anterior and arguably broader matters concerning the lender’s interests in performance (see, for example, the emphases in the quoted passages above).  In this sense, the majority’s decision echoes aspects of traditional orthodoxy and the dissenting judgment of Nettle J in Paciocco.

The majority’s approach has since been followed in two recent decisions in the Trial Division: first, by Riordan J in Simcevski v Dixon (No 2) [2017] VSC 531 at [18] and [31(b)] (a term which purported to forfeit 5% of the purchase price on rescission of a contract for the sale of land was held to be a penalty); secondly, by Mukhtar AsJ in Giasoumi v Ribbera [2017] VSC 631 at [93]–[107] and [119]–[120] (an establishment fee in respect of a loan that did not proceed was held to be a potential penalty – the matter was adjourned to allow the parties to adduce “evidence of the enquiry to be made according to Paciocco”).

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