Yes, the law really does abhor a penalty

By Legal Eagle

Sinclair Davidson at Catallaxy has written a post on excessive fees charged by banks, and said this:

[The argument that the fees were designed purely to enrich the bank] is a bit hard to take. When you begin a banking relationship you normally sign a contract that includes the fees that you’ll pay for various services including the fee you pay for late payments or overdrawing etc. etc. This is a straight-forward contract.

Of course, in a competitive market we would expect these sorts of fees to be competed away and that is exactly what we see here. [my emphasis added]

He goes on to say that competition will cause banks to bring their fees down. I started to reply to the post in comments, and then when my comment had run to five paragraphs, including copious references to case law, I thought I’d better write a post instead…and it’s growed like Topsy. So here we are.

There are a couple of things I want to explain:

  1. The nature of the law against penalties in contract law;
  2. Why the class action litigants who are suing ANZ Bank for the imposition of fees have only succeed in one aspect of their claim thus far; and
  3. Why the argument that the market will fix these matters is simplistic.

By the end I hope that you will learn a little bit about how the law of penalties operates, and that the issue is not in the least a straightforward matter of contract law, contrary to Sinclair’s assertion above.

The nature of the law against penalties in contract law

We live in a liberal society. The general rule is that the common law favours freedom of contract: parties to a contract may include any terms they want in a contract, including remedies for breach of its provisions. So in Ringrow Pty Ltd v BP Australia Pty Ltd [2005] HCA 71; (2005) 224 CLR 656 (‘Ringrow‘) at [31] and [32], the unanimous High Court states:

The law of contract normally upholds the freedom of parties, with no relevant disability, to agree upon the terms of their future relationships … Exceptions from that freedom of contract require good reason to attract judicial intervention to set aside the bargains upon which parties of full capacity have agreed. That is why the law on penalties is, and is expressed to be, an exception from the general rule. It is why it is expressed in exceptional language.

The rule against penalties states that a stipulated contractual remedy for breach must not be a penalty, and must be a genuine pre-estimate of the losses suffered: see Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd [1915] AC 79 (‘Dunlop‘), affirmed by the Australian High Court in Ringrow. Lord Dunedin in Dunlop says that the essence of a penalty is where it imposes a payment of money in terrorem of the offending party (i.e. intended to frighten or intimidate); whereas the essence of a true liquidated damages clause is that it represents a genuine agreed pre-estimate of losses which may result from the breach. Dunlop holds that a number of matters indicate that a clause may be a penalty:

  • It is likely to be a penalty if sum stipulated is extravagant and unconscionable in comparison with the greatest loss that could conceivably be proved to have followed from the breach;
  • It is likely to be a penalty if the breach consists only of not paying a sum of money, and sum stipulated is a sum greater than the sum which ought to have been paid (which is the corollary of the last test); and
  • There is a presumption that it is a penalty (but no more) when a single lump sum is made payable on the occurrence of one or more or all of several events, some of which are serious and others are not serious.

However, a sum may be a genuine pre-estimate even if the consequences of the breach are such to make precise pre-estimates impossible. In fact, this is just the kind of situation where it is probable that the pre-estimate of damage was the true bargain between the party.

Added to this, other Australian High Court decisions have emphasised the fact that a penalty may be more likely where there is inequality of bargaining power: see eg, AMEV-UDC Finance Ltd v Austin [1986] HCA 83; (1986) 162 CLR 170 (‘AMEV‘). If a party does not have an opportunity to truly negotiate his or her contract then he or she does not really have a choice as to whether to be subject to a penalty. Mason and Wilson JJ said that:

The doctrine of penalties answers, in situations of the present kind, an important aspect of the criticism often levelled against unqualified freedom of contract, namely the possible inequality of bargaining power. In this way the courts strike a balance between the competing interests of freedom of contract and protection of weak contracting parties.

(AMEV was a case concerning a lease of certain plant and equipment, as many of the cases in this area are).

It should be noted for completeness that the High Court in Ringrow approved the statement by Mason and Wilson JJ in AMEV that the penalty must be ‘out of all proportion’ (at [32]).

Now, in the past banks often called dishonour fees and the like “service fees”, and argued that that customer defaults were costly, and fees allowed them to recoup these costs. This may have given the misleading impression that such fees really were service fees (as Sinclair seems to assert). But the law considers the substance of the fee, not the form or the name of the fee.

If one consults Nicole Rich’s report for the Consumer Law Centre Victoria (and it is this report which sparked the moves of the banks on fees, in my opinion) she explains why bank fees could arguably be seen as penalties. In Chapter 2 of her report, she estimates that ’Australian banks could be charging between 5 to 16 times what it costs them to process a cheque dishonour’ and that ‘Australian banks could be charging between 64 to 92 times what it costs them to process a direct debit dishonour’. So you can see from this that it is difficult to argue that the “service fee” was a genuine pre-estimate of the losses that the banks incur as a result of cheque and direct debit dishonours. However, the added difficulty was that banks would not release the information to allow organisations such as the CLCV to estimate their true costs, suggesting that perhaps they had something to hide. Also clearly there was an inequality of bargaining position issue, with many bank customers not in a position to negotiate out of a penalty fee.

The class action against a bank which charged fees

It was a class action which inspired the newspaper article which went on to inspire Sinclair’s post which has now inspired this post. In the class action, Andrews v Australian and New Zealand Banking Group [2011] FCA 1376, certain customers of the Australian and New Zealand Banking Group (‘ANZ’) are suing ANZ in relation to a variety of fees the bank had charged them. The plaintiffs have been largely unsuccessful in their claim in relation to bank fees as penalties. At first instance, Gordon J of the Federal Court held that only late payment fees were capable of being characterised as a penalty, whereas honour fees, dishonour fees, overlimit fees and non-payment fees were held not to be penalties. You may be wondering why this is so given what I have said above? It hinged upon the need for a breach of contract to trigger the necessity to make the payment. So, for example, the High Court said in Ringrow at [10]:

The law of penalties, in its standard application, is attracted where a contract stipulates that on breach the contract-breaker will pay an agreed sum which exceeds what can be regarded as a genuine pre-estimate of the damage likely to be caused by the breach. [my emphasis added]

It was held that the law of penalties had no application to contractual payments that arose upon the occurrence of an event that did not constitute a breach of contract. Gordon J said that honour fees, dishonour fees, overlimit fees and non-payment fees were not incurred as a result of breach of contract.  Instead, the fees were payable because ANZ had met a request for a loan or an advance from a customer. For example, at [181] – [182], she said:

…A retail deposit customer does not breach his or her contract with ANZ when ANZ permits the customer to overdraw his or her account. The request is made by the customer. The bank decides whether to exercise its discretion and meet the request… If it does so, then the bank charges the fee – in this case, the Honour Fee – a fee that was not payable on breach of any term or condition of the contract between ANZ and Saliba [one of the plaintiffs] but on the bank meeting a request from a customer.

Put another way, the action in overdrawing the account was not a unilateral action by Saliba. It was an action that required the consensual conduct of the bank and the customer. That is not, and cannot be, conduct constituting a breach of some contractual obligation. If ANZ agreed to and approved a transaction that overdrew a customer’s account (thereby allowing the transaction to proceed), the customer could not then be in breach of its contract with ANZ. Once agreed and approved, the transaction fell within the express exception in the statement relied on by the applicants (a prior arrangement having been made and agreed with ANZ), or fell outside of the statement for the reason that ANZ had separately approved the transaction. Whichever way the transaction is characterised, a customer could not breach its contract with ANZ by giving a payment instruction to ANZ that had been allowed by ANZ. Of course, the additional borrowing of the customer was required to be repaid to ANZ; however, that borrowing was not a breach of contract. The Honour Fee was charged in respect of ANZ’s decision concerning the request for additional borrowing.

By contrast, credit card late payment fees were capable of being a penalty, as they were imposed when a customer failed to make a payment within the time stipulated (in other words, the contract had been breached).

If it had been found that the honour fees, dishonour fees, overlimit fees and non-payment fees were payable upon a breach of contract, would they have been held to be penalties? I suggest that they would be penalties, as on the face of it, they do not seem to reflect a genuine pre-estimate of the bank’s losses, and the real intention is to punish consumers for overdrawing accounts and the like. And there’s a disparity of bargaining power.

This case has gone on appeal to the High Court of Australia. I await the Court’s decision with the greatest of interest.

The market fixing the problem?

I am afraid that I profoundly disagree with Sinclair’s statement that competition between the banks is what brought fees down. That is not what brought fees down. The occurrence that brought fees down was Ms Rich’s report pointing out that the fees were extraordinary and in no way reflected the pecuniary losses suffered by the bank as a result of the customer’s actions. Once it had become known that the banks were on a nice little lurk charging customers fees which in no way reflected the cost to the bank of the conduct, then consumers and the press got angry and realised that they wuz robbed. It was then that the market swung into action, with National Australia Bank dropping its fees first, followed by the other banks.

I do not think it can truly be said that such fees reflect the services the bank gives to customers. If you pay for a service, there’s a notion that the price of the service in some way reflects the effort or detriment that the other party has put to in performing that service. Bank fees (whether they are penalties in the legal sense or not) do not reflect the true cost or worth of the bank’s actions in any sense. They are really about two things. First, it could be said that they provide an incentive for customers not to overdraw or have a dishonoured cheque etc, and they punish customers who do engage in this conduct. Secondly, they are about making a margin of profit from customers who have the misfortune of overdrawing their account. The customers are not in a position to negotiate different terms, and the banks essentially have them over a barrel. Now, before Sinc accuses me again of wanting something for nothing, if the banks want to charge fees which genuinely reflect the costs and services provided, I would have no problem with that, but these fees do not do that in my opinion.

It goes without saying that one of the things which makes the market work effectively is information, and where there is information asymmetry, the market is not as efficient. And information is one of the things which your average consumer just does not have. The average consumer didn’t (and still doesn’t) know anything about the relationship between a dishonour fee and the cost to the bank of dishonouring a cheque, or about about the law against penalties. The average consumer couldn’t (and still can’t) argue with the bank or push back: these contracts are generally standard form. And until NAB moved on fees, the banks had been charging all these fees for years with no ramifications. The market was just not fixing the problem. This was in part because it was hard to move banks if you didn’t like it. For example, banks often charged an exit fee on customers who attempted to move their mortgage accounts, although this has since been banned. However, once people knew information about bank fees, the situation changed. But the market itself did not operate to provide that information.

You can’t have fair competition if there are a number of players who have a large degree of control on the banking market and who all decide simultaneously to charge unfair fees. It is also true that if a small group of consumers are disproportionately affected, then it is difficult to see how the market will respond. As Penndragon, one of the commenters at Catallaxy, said:

This sort of thing is wrong and will continue if only a small group are affected, particularly if the penalty relates to some minor transgression that can be used as justification. Economics and markets will have limited effect if at any one time only a small group is affected. The long law-breaking history of these charges shows that market forces are especially inefficient in protecting small groups from small pernicious penalties masquerading as fees.

I agree with this entirely.

Finally, I should deal with the suggestion in Michael Pascoe’s article that it is somehow illegitimate or greedy to attempt to sue banks for fees that they may have wrongfully imposed, and that Maurice Blackburn are grubby ambulance chasers. To the suggestion that Maurice Blackburn are doing this partly for the money, I say…well, duh! That’s what we lawyers do. That’s how we make our living, much as you may dislike us for it. But that doesn’t mean that they’re not doing it out of principle as well. Further, I’ve never seen anything particularly wrong with the notion of litigation funding (despite the fact that I love the name of the tort of champerty). Finally, as a remedies and restitution lawyer, I have no problem whatsoever with the proposition that if the bank has illegitimately charged customers fees, then they should be made by the court to pay those fees back to customers (subject, of course, to defences). Isn’t that what law is all about, surely?

30 Comments

  1. kvd
    Posted August 16, 2012 at 5:36 am | Permalink

    Excellent post LE! Thank you. This is the sort of thing which makes me keep coming back to this blog. Well done.

  2. Posted August 16, 2012 at 5:49 am | Permalink

    Great great post. I saw a report of the argument before HCA for leave, so I’m delighted to get such a comprehensive discussion!

    Tnx

    Eoin

  3. Posted August 16, 2012 at 5:51 am | Permalink

    The doctrine of penalties is a pretty fragile thing. It only catches those contracts drawn without an eye on the doctrine as they draft. For example, where a loan agreement charges a much higher rate of interest if the debtor fails to make a payment on time, that will be struck down as a penalty; but if the loan agreement is drawn so that it charges the higher rate of interest but gives a discount if payments a made on time, that is fine.

    One very common example of this fragility arises in the context of settling litigation. If a compromise deed provides that the parties settle on the basis that the defendant pays a discounted amount, but becomes liable for the full amount of the claim if he doesn’t pay in accordance with the compromise deed, that will be struck down as a penalty. On the other hand, if the compromise deed provides that the defendant accepts liability for the full amount but gets a discount if he pays by a certain date, that is not liable to be struck down. An example of that ishere.

    For that reason, I’m not sure that it is correct to say that the law looks at the substance of the fee. The law in this area (at least in Oz) is quite formal. I think it probably justifies either abandonment of the doctrine or statutory reform of it. I’m not one ordinarily to advocate judicial activism to the extent of abandoning a doctrine, however, it seems to me that the doctrine doesn’t really exist if it can be so easily subverted.

    On that basis, the reasoning of Gordon J doesn’t sound all that problematic to me (from a legal perspective). That said, I would be surprised if there is not something in the Bank’s terms and conditions which require the customer to keep the account in a positive balance.

  4. Posted August 16, 2012 at 5:54 am | Permalink

    One question I’d be interested to hear answered is how any fee can ever be a genuine pre-estimate by the parties of the damages likely to be suffered if a bank is offering standard terms and conditions with no opportunity to negotiate on things like that. Surely it would be very difficult to say that the customer has really turned his mind to the question of whether fee genuinely reflects the bank’s likely loss?

  5. Sinclair Davidson
    Posted August 16, 2012 at 5:56 am | Permalink

    I have linked back to this piece – not sure if the system will update that.

  6. Posted August 16, 2012 at 6:02 am | Permalink

    For once, it seems to have worked, Sinc! (Although I must not tempt fate – our feed on Networked blogs has turned its toes up, with the result that our American readers are finding out about posts… eight hours late. Gah).

  7. Pedro
    Posted August 16, 2012 at 6:31 am | Permalink

    Yes Nick F, there are inconsistencies galore. Lease incentives are another one. It is common for the incentive provision to say that the incentive is lost or has to be repaid if there is any breach of the lease.
    What always shocks me is that other lawyers have to be convinced it is a likely penalty.

    Ringrow is a great case, but it remains difficult to tell when something is a penalty and when it is not.

    The ANZ appeal will be interesting, like Nick, it is time to apply the substance and not the form in this area. The general principle behind the penalty rule makes sense.

  8. Posted August 16, 2012 at 9:12 am | Permalink

    LE, having obtained your agreement, I’m embarrassed to say, there’s probably some sloppy thinking in that bit from my comment that you extracted. I haven’t looked at the cases, but I imagine a genuine pre-estimate is a pre-estimate which, on the circumstances disclosed in the contract, looks like a decent approximation of what damages would actually be suffered, rather than a figure or formula backed up by earnest negotiation.

    I think the HCA will uphold Gordon J’s judgment. The bit you’ve extracted sounds right to me, but I should go and read the whole thing. The only hiccup might be the existence of some term which makes it a breach to overdraw your account.

    I think Gordon J’s judgment really underlines my earlier point: the doctrine is so easily defeated that it is virtually pointless.

  9. Andrew Reynolds
    Posted August 16, 2012 at 10:15 am | Permalink

    LE,
    From my past experience in banks I would have to agree with you on this one. The “fees” being applied are well known to be substantially over the cost of service provision.

    I should add, though, that there is one additional issue you have not touched on, probably because it is not one that is well understood outside the industry – and I am not entirely sure it is relevant in any case.

    The simple cost of service provision is not the only cost involved in these fees, though. When an account is regularly trading outside limits (ie. in contractual breach) it is frequently an early indicator that the client is likely to default on their obligations – a situation that obviously is likely to cost the bank a large amount. To an extent (and definitely not to the extent of 16 times the cost) these fees are also there to cover this risk as well.

    I still remember the reaction from bank senior management when I suggested that they actually do charge the correct amount, though. It was not terribly understanding.

    BTW – the banks do have hard internal data on the true cost (including the credit risk I mentioned above). The data is held as “ABC” reports – Activity Based Costing. The discovery process should be simple – ask for those costings for each of the service fees.

  10. Posted August 16, 2012 at 2:38 pm | Permalink

    I would have been surprised if the banks don’t have at least a decent idea of how much the penalty costs them to process.

    I suppose we could assume it takes one COBOL programmer a year to implement each charge. Fully loaded cost is, say, $200,000. Then factor in the cost of mainframe licensing, an operations centre. Divide by actual execution time of the relevant code (mainframes are generally billed out to large institutions on this basis anyway). Say 100 milliseconds per charge, perhaps a few cents. Let’s say 10c.

    Now suppose that 1 in 5 customers are hit with a charge per year. A bank with 1 million customers will see 200,000 such charges per year. Base cost of operations is $20,000, amortise the cost of development over 5 years for $40,000 per year. So the yearly cost is $60,000.

    Suppose the fee is for $1. The bank raises $200,000 from the fee. Their cost is covered and then some.

    I’m going to go out on a limb here and say that they’re completely full of shit on this one.

  11. Posted August 16, 2012 at 2:43 pm | Permalink

    However, from the bank’s perspective, they know that headline figures are what sell the business. Highest savings interest, lowest loan rates.

    What would work better from a marketing point of view is to reframe the process entirely. Instead of having a fixed account fee and levying charges for various events, “give a discount” on a single fixed fee for customers who remain within the parameters you set.

    It’s a well understood technique. The classic study was done on petrol stations. Do you say you have a surcharge for credit cards? Or offer a discount for cash payment? Financially, to both the buyer and the petrol station, it is identical. But the cash discount attracts customers, the credit card surcharge deters them.

    (Why yes, I happen to be reading a book on approximately this topic at the moment)

  12. kvd
    Posted August 16, 2012 at 3:51 pm | Permalink

    [email protected] you are missing the very valid point that Andrew raised about pattern-matching, default history etc. There’s things that computer logarithms miss – like why people miss deadlines, why a payment is a few days late but always made up; it takes a human to understand even simple things like the loan payment is sometimes three days before wage transfer, but the payment is always made, if a little late.

    This is nothing really to do with LE’s post, but sometimes I think what “we’ve gained” by all this anonymisation of service is the loss of the personal evaluation of individual circumstance – which was basically how banks thrived, and were respected for their contribution, in the “good old days”.

    I don’t particularly miss the lack of personal service, but I do respect just how effective it was compared to the present day “client delivery”.

  13. Posted August 17, 2012 at 9:47 am | Permalink

    kvd;

    You’ve drastically underestimated what modern data mining and complex event processing can do. (It’s “algorithms”, by the way). I’d be very surprised if bank computers hadn’t taught themselves about paydays by now.

    In fact some banks in the US got in trouble for having software which rearranged the order of transactions to maximise these sorts of charges.

  14. JC
    Posted August 17, 2012 at 1:08 pm | Permalink

    I think what “we’ve gained” by all this anonymisation of service is the loss of the personal evaluation of individual circumstance – which was basically how banks thrived, and were respected for their contribution, in the “good old days”.

    Oh yea, really? I know about those times. Those were the “good” old day when you had to keep a certain balance with one particular bank and then grovel to the bank manager for a mortgage loan and kept on tenterhooks while he decided to push the application upstream or not.

    I’ll choose the present day thanks.

  15. kvd
    Posted August 17, 2012 at 2:30 pm | Permalink

    Thanks Jacques. Must have had a rush of blood to the head, what with logarithms and thinking computers were possibly less efficient. Won’t happen again, ’till the next time 😉

  16. kvd
    Posted August 17, 2012 at 2:31 pm | Permalink

    [email protected] your comment says more about your history than mine. But it doesn’t surprise.

  17. JC
    Posted August 17, 2012 at 2:48 pm | Permalink

    [email protected] your comment says more about your history than mine. But it doesn’t surprise.

    Yea KVD. I can see how the groveling part would pique your interest.

  18. kvd
    Posted August 17, 2012 at 2:56 pm | Permalink

    Yea KVD. I can see how the groveling part would pique your interest.

    JC if you’ve had to go through that sort of process then I’m sorry for you – but it was not part of my experience up until the financial supergods discovered they weren’t. And if you’re talking more recent history then I can’t comment because I haven’t had the need.

  19. Jonathan Ray
    Posted August 20, 2012 at 1:50 am | Permalink

    It was held that the law of penalties had no application to contractual payments that arose upon the occurrence of an event that did not constitute a breach of contract

    That completely takes the teeth out of the prohibition against penalties because the same exact penalty is either legal or illegal depending on whether the contract calls it a breach.

    BTW, IMO, late payment fees and the like should not, in combination with actual interest, exceed the maximum interest rates imposed by usury laws, since that completely takes the teeth out of usury laws.

  20. Posted August 20, 2012 at 7:20 am | Permalink

    [email protected], that seems like the type of contract the unfair contracts section (23-28) of the ACL is supposed to deal with.

  21. Mel
    Posted August 31, 2012 at 3:13 pm | Permalink

    My local video store charges $2 for a video and a late fee of $4 per night. I guess this constitutes a penalty and a breach of the law of contract.

    Thanks for also skewering the glib libertarian argument about how the market operates. The “market” is a social institution that is seamlessly embedded with a culture, time and place just like every other social institution. My sociology education was disappointing in many ways but at least it taught me that.

  22. Posted August 31, 2012 at 6:54 pm | Permalink

    Has a video store ever actually sued to get payment of their late fees?

  23. John H.
    Posted August 31, 2012 at 9:45 pm | Permalink

    Has a video store ever actually sued to get payment of their late fees?

    Not sure, but they do have a black list

  24. Posted February 15, 2013 at 7:52 am | Permalink

    G’day,
    I was just searching the net looking for information about the legality of fees when I found this discussion. I wanted to tell you about my experience with Flexirent. I am currently renting a laptop from Flexirent. On the 3rd of each month a payment of $177 is debited from my account. I did not have the full amount in my account for the last payment. I realised this a day after it was due. As soon as I realised I made sure there was enough money to cover the payment.
    I assumed that Flexirent would attempt a second debit. When I signed the contract there was mention of a dishonour fee that would be charged if there was insufficient funds. I was not sure of the amount but I had $217 in the account. I thought that it would be more than enough cover the $177 amount due and any dishonour fee. Didn’t take into account that although the total balance was $217 the amount available was only $205 (Don’t ask me why).
    I received a sms today from Flexirent asking me to call them. When I did they said that I had missed apayment and I would now have to pay $237. I asked why $237 they said that because I missed my first payment there was a dishonour fee of $30 making a total of $207. They had then waited until today 15/2/13 to attempt another debit…but because the new amount was $177 plus $30 dishonour fee…I once again had insufficient funds in my account so I would be charged another $30 dishonour fee…bringing the total to $237. I argued that I had in fact not dishonoured my payment because I did have sufficient funds to meet the payment…but that their dishonour fee had pushed the total up therefore placing me in a position that the second attempt at debiting the account was again unsuccessful. They did not inform me of the new total therefore how could they expect me to be sure that I had sufficient funds to meet the payment. Their first dishonour fee had then caused the second dishonour fee.
    the person on the line would not wave either fee but said that she would defer the fee to my next payment. I stuck to my guns and argued that the second fee was not fair and possibly illegal. I was put on hold and after a short while she returned and said that the second fee would be waived but I should be aware that this is the first and last time it would happen. The woman told me that my conversation was being recorded and that I must agree in words that I would never ask for a waiver of a dishonour fee again…sorry for the long winded post. I guess what I’m really asking is the second dishonour fee legal…or even the first one?

5 Trackbacks

  1. […] the original here: Skepticlawyer » Yes, the law really does abhor a penalty var addthis_config = […]

  2. By The law abhors a penalty | Catallaxy Files on August 16, 2012 at 5:54 am

    […] Look what you made me do, Sinc. […]

  3. By Cost and penalty at Catallaxy Files on August 16, 2012 at 8:28 am

    […] Eagle tells us the law: … the essence of a penalty is where it imposes a payment of money in terrorem of the […]

  4. […] day, Sinclair Davidson and I were debating the nature of bank fees and whether they were penalties. In that post, I noted the case of Andrews v Australian and New Zealand Banking Group [2011] FCA 1376 where […]

  5. […] not a breach of contract. I’ve already outlined the law against penalties in some detail in this earlier post. In short, parties are allowed to stipulate the amount payable for certain breaches of contract […]

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