Contract damages – the rhetoric-reality gap

By Legal Eagle

In my chosen area of study, much ink is spilled on the topic of whether contract damages merely compensate for loss, or whether there are other exceptional measures of damages which may be employed (gain-based damages of various types, punitive damages etc).

Still, there are some things we agree on. If you look in a text on contracts, there is a general consensus that ‘penalty damages’ are not allowed. A contract may specify that a certain sum of damages is to be paid on breach (‘liquidated damages’), but if that sum is ‘out of all proportion’ or ‘extravagant, exorbitant, or unconscionable’ in the circumstances, it will be found to be penalty damages. The important question is how disproportionate the damages are from the loss likely to be suffered. Even if it is greater than the loss suffered, it will be enforced if it represents a genuine effort to estimate the cost of breach. Nonetheless, courts have held that an agreed sum cannot be a genuine pre-estimate of loss if it exceeds by a wide margin the greatest possible loss to be suffered from breach.

Of course, some of the law and economics scholars argue that we should allow penalty damages clauses to recognise a contractor’s ‘consumer surplus’ (i.e. the idiosyncratic value of the subject matter of the contract to the contractor). In their seminal 1977 article in the Columbia Law Review, Goetz and Scott give an example of the ‘anxious alumnus’, a mad-keen basketball fan who hires a bus to see his old college play, and who has purchased 25 tickets for himself and his friends. If the bus company breaches its contract, the loss to that particular contractor is far greater than it would be for an ordinary contractor because of the subjective value he places on seeing his team play. Therefore, he should be able to specify that they pay penalty damages if they breach. The bus company are in the best circumstance to know whether or not they can actually perform the contract, and therefore they are the most efficient party to insure against the contractor’s loss.

The use of penalty damages in an ‘anxious alumnus’ scenario, where an individual contractor places an idiosyncratic value on performance, is arguable. I can imagine that it might also be useful if I wanted my house to be a particular shade of blue – when I stipulated penalty damages, the house painter would become aware of the idiosyncratic value which I placed on my house being that colour, and it would provide him with an incentive to be extra careful in making sure he painted the house the right colour.

But what of the use of penalty damages in consumer contracts, where a consumer is very unlikely to be able to negotiate the terms of her contract, and the supplier of the service is vastly more powerful than the consumer? The supplier of the service can stipulate penalty damages and the consumer really has no choice to but to lump it, particularly if all other suppliers on the market have similar clauses in their contracts. This is not a clause which reflects the supplier’s idiosyncratic preference, it’s a money gouge, pure and simple.

Despite the law’s stance against penalty clauses in cases such as Dunlop Pneumatic Tyre Company Ltd v New Garage and Motor Company Limited and AMEV-UDC Finance Ltd v Austin, the use of such clauses is prevalent in consumer contracts. When I was young and green, I paid out a penalty on a mobile phone contract. I just couldn’t be bothered fighting the issue, and I suspect a lot of other people feel the same way. So there’s a rhetoric-reality gap between what the law of contract says, and what actually occurs on the ground level.

In light of the above, I was pleased to see a report in the ABC that a class action has been commenced against various banks:

A class action is being launched in Australia against local and foreign banks for repayment of dishonour and late fees.

Official figures show the banks collected nearly $1.2 billion in such fees in the 2008 financial year.

The class action, being run by a subsidiary of litigation funder IMF, will relate to honour and dishonour fees on bank accounts, and over limit and late fees on credit cards.

The big four banks – Commonwealth Bank, ANZ, National Bank and Westpac – recently scrapped or reduced many of those charges.

Financial Redress, the subsidiary behind the class action, says the claims will pursue exception fees deducted from accounts over the past six years.

It’s interesting to note that the banks have amended these penalties in recent years. Perhaps the rhetoric-reality gap may be closing. Next target, mobile phone companies?

Update: NAB has already been paying customers back because it incorrectly charged them an “exception fee” of $50 rather than $30.The question is why they should have to pay such a high “exception fee” in the first place when it bears no relation to any loss on the part of the bank.

20 Comments

  1. Posted May 14, 2010 at 9:19 am | Permalink

    Especially since the actual contractual loss to the bank is composed of a) miniscule fractions of a cent for the computation, and b) a few cents of forgone interest.

    As for the anxious alumnus and penalty clauses, I think it would be necessary to distinguish between clauses which are meant to punish the counterparty, and clauses which are meant to fulfill the objectives of the alumnus.

    So a punishment clause might be pays $X thousand on breach; a objective-support clause might supply tickets and transport to the next game.

  2. Mish
    Posted May 15, 2010 at 3:31 pm | Permalink

    So many service providers do this. Utility and phone providers in particular. Late fees really irk me. I regularly leave my bills til the last day, then pay them with the credit card, and pay the credit card bill on the last day so my money can stay on my mortgage as long as possible. But if I have an especially hectic day, and don’t get a chance to pay it (or, crime of all crimes, forget), then even if I’m only late by a day a fee of anywhere between $8 and $15 applies. For a $90 gas bill, that is extremely unlikely to be a genuine pre-estimate of loss. I tried arguing against it, but in vain.
    My fault to an extent (I accept my contractual obligation is to pay bills on time), but the fees charged are in law penalties, and are therefore unlawful. I am also happy about the class action, as hopefully it will make them think twice about taking advantage of their bargaining power by imposing exorbitant charges.

  3. Chris
    Posted May 15, 2010 at 9:14 pm | Permalink

    Can companies get around not being able to apply large late fees by instead offering large discounts for those who pay on time (and of course adjusting what they charge appropriately)?

    Mish – I used to do the same until I did some calculations on just how much money I was saving by delaying payment by a few days – say you manage to always have $500 extra (and for most that would be a pretty high estimate) in your bank account than you wouldn’t otherwise have if you paid the bills as you received them. That’s saves you about $25/year for a lot of hassle and one or two late fees puts you behind. I think its really only worth doing if you have cash flow problems.

    So these days I just pay as soon as the bills come in and setup auto-pays wherever possible which often are configured to automatically pay on the due date anyway.

  4. Patrick
    Posted May 16, 2010 at 6:12 am | Permalink

    We pay all our bills on credit card or bpay, and thanks to my wife’s financial discipline, pay the credit card out of my monthly salary on receipt.

    She’s never missed a beat, and we even get frequent flyer points out of it.

    On the broader consumer/vendor disparity I think it sounds like a good argument for litigation funders!

  5. Nick Ferrett
    Posted May 16, 2010 at 6:50 am | Permalink

    LE, I think the real problem with the penalties doctrine is how easy it is to avoid. Usurers have long used the discount system suggested by Chris @4. As long as the repayment clause says “You will pay interest at 15% per month, but if you pay by the due date, you will only have to pay at 10% per month”, the term will not be characterised as a penalty. That is, to my mind, one of the law’s most egregious triumphs of form over substance.

    Zenith Engineering v Qld Crane and Machinery [2001] 2 Qd R 114 covers the issue.

    My instinct is that the class action has pretty good prospects. It will be very difficult to demonstrate that the fees constitute genuine pre-estimates of damage, particularly on an objective basis.

  6. Nick Ferrett
    Posted May 17, 2010 at 5:46 am | Permalink

    If the class action succeeds, it will have to involve restitution for unjust enrichment. If the clauses entitling the banks to charge default fees are construed to be penal, then (subject to limitations statutes), the banks will have to give restitution on the basis that the customers paid under a mistake (i.e., a mistaken belief that they were contractually bound to do so). That’s right isn’t it?

  7. Peter Patton
    Posted May 17, 2010 at 2:23 pm | Permalink

    Personally, I think shareholder activism is the next front in democratic exertion in this country. Every single one of us is compulsorily a part of these giant super funds, there must be opportunities for mobilization to influence the boards.

    I predict contingency fees will be allowed within 2 years. Then watch, the corporate boards straighten up.

  8. Peter Patton
    Posted May 17, 2010 at 2:26 pm | Permalink

    The next target for a huge class action is by customers of Telstra hell bent on getting billions for their extortionate over-charging, and atrocious billing management systems.

  9. Nick Ferrett
    Posted May 17, 2010 at 2:43 pm | Permalink

    @Peter, I agree. But it will be much wider. There will be all sorts of corporations large and small crapping themselves if the class action against the banks succeeds.

    @LE, I think we have already established that you and I are on separate sides of the fusion divide.

  10. Peter Patton
    Posted May 17, 2010 at 3:01 pm | Permalink

    But we really need to start winding back the “limited” part of public limited companies, and allow clawbacks from these vampires.

  11. Nick Ferrett
    Posted May 17, 2010 at 3:13 pm | Permalink

    Don’t agree with that. I think, on balance, that the economic benefits of limited liability for corporations outweigh the detriments; James Hardy notwithstanding. In the end it’s all just allocation of risk and there are lots of people who benefit from the protection of capital investment that limited liability provides.

  12. Peter Patton
    Posted May 17, 2010 at 3:40 pm | Permalink

    Nick, I probably don’t either. I was being polemical to state a general point.

  13. Nick Ferrett
    Posted May 18, 2010 at 6:32 am | Permalink

    Just read it. Very entertaining and I notice you got a celebrity responding.

    I think it identifies the difficulty with the approach of academics (and particularly restitution academics) to explanation of the law. What they want is not to treat like cases alike; the law already does that (subject to some allowance for human error). What they in fact want is to treat nearly alike cases alike and they want to rewrite the law to do it.

    The instinct is an understandable one. It would make life much easier for everyone if the law was less complex and there were uniform responses to similar problems, but that raises to issues.

    First, the judgment as to what are similar problems is at least a little subjective. In any event, you will never completely escape the blurring at the outer edges of particular categories of case.

    Secondly, and more fundamentally, stare decisis is really a political construct rather than a rule of law. It is the basis for the political authority of judges. It is an important restraint on their power. Rather than having judges rewrite the law based on a view about what the law should be (as restitution lawyers seem to want), that function should be left to the legislature.

    But then I’m a guy who thinks the single best judgment out of the High Court in the last 15 years is Gummow’s judgment in Roxborough.

  14. Nick Ferrett
    Posted May 18, 2010 at 8:02 am | Permalink

    Hey, it ticks all the boxes for me. Slight tinge of atavism. Slight tinge of Cnut (which, incidentally is how a dyslexic spells Gummow). Reference to Posner (whom I idolise). Healthy dose of shit-stirring.

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