Most people think they are protected if they have contracts which contain clauses that outline the consequences if a party defaults on their obligations. However, they may be using contracts which contain unenforceable penalty clauses. An often litigated issue is whether the clauses dealing with the default payments create a penalty. If this clause is found to be a penalty, then this provision is unenforceable and the consequences can be significant.
The recent case of Simcevski v Dixon (no 2)  VSC 531 deals with this issue in the context of a sale of real estate. The principals of this case, however, can be applied to all contracts.
- Mr Dixon (the Seller) terminated a contract for sale of land because the purchaser had failed to settle.
- Mr Simcevski (the Purchaser) had paid 5% of the purchase price as a deposit – this was $175,000.
- A clause in the contract stated that if the contract was brought to an end by a default notice given by the Seller that (amongst other matters) “the deposit up to 10% of the price is forfeited as the vendor’s absolute property, whether the deposit has been paid or not.”
- The Seller claimed another $175,000, being the additional 5%.
The question before the Court was whether the additional 5% was a penalty? If the additional 5% was a penalty, then the Seller would not be entitled to the additional $175,000.
The Seller’s arguments
- It was difficult, if not impossible, to predict the loss that the Seller would suffer in the event the Purchaser failed to settle the property. They asked the Court to consider factors including the small deposit, the substantial period until settlement, the possible soil contamination and the anticipated closure of the Seller’s business.
- The additional $175,000 was not extravagant or an unconscionable sum and that for it to be a penalty it must be “out of all proportion” with the Seller’s likely losses.
The Purchaser’s arguments
- There was no relationship between the 5% and the pre-estimate of damage for breach. This was because there was an absence of any justifiable pre-estimate of damage – the 5% lacked any connection with damages at all.
- The 5% did not have any relationship with the Seller’s likely losses.
The Court’s findings
- The Court confirmed the following are the issues they consider when determining whether a clause is a penalty:
- “a contractual term will not be a penalty if it protects the legitimate commercial interests of the non-defaulting party.”1; and
- whether it is a “genuine pre-estimate of the [innocent parties] probable or possible interest in the due performance of the principal obligation or a penalty inserted ‘merely to secure the enjoyment of a collateral object’?”2
- In this case, the obligation to pay the further sum of 5% did not even purport to be by way of deposit (the words “the deposit up to” were removed).
- The additional 5% was a penalty because it did not protect the legitimate commercial interests of the Seller.
- The Vendor was not entitled to the additional $175,000 on top of the deposit already paid.
How is a deposit different to a penalty?
Deposits are usually not considered a penalty. This is because the purchaser is not limited to recovering the deposit – they are entitled to also recover any short fall on the sale (less the deposit).
In all contracts (not just property related contracts), the default clauses should:
- Be drafted after taking account of an estimate of the losses of the non-defaulting party if a default occurs – a Court will need to be shown that the amount claimed is proportional to the anticipated losses.
- Where possible, explicitly express the default clause to be a genuine pre-estimate of the cost to protect the commercial interests of the non-defaulting party.
- Give consideration of the losses included, not only those that are recoverable for breach of contract, but also the detriment to other commercial interests which the non-defaulting party is seeking to protect.
- Consider carefully whether you are better seeking a higher deposit (if commercially realistic).
The law of penalties is complex and it is important to have the default clauses carefully drafted prior to entering into the contract – if your default clause is found to be unenforceable, it can be a very expensive lesson!
If you have any questions or concerns relating to contracts that you are currently using or entering in to, please don’t hesitate to contact Catherine Ballantyne on 03 9242 4766 or firstname.lastname@example.org
Melbourne Linh Son Buddhist Society Inc v Gippsreal Ltd referring to the High Court case of Paciocco
Melbourne Linh Son Buddhist Society Inc v Gippsreal