Penalties Revisited: When Protective Measures Become Punishing Measures

The facts

The applicant, Melbourne Linh Son Buddhist Society Inc (Linh Son) is an incorporated association bringing together members of the Melbourne Vietnamese community who follow the Buddhist faith. In 2013, subsisting entirely on donations from its members, Linh Son experienced difficulty obtaining long term financial assistance from banking institutions. The respondent, Gippsreal Ltd (Gippsreal) is the responsible entity of a registered managed investment scheme, offering first mortgage real estate investment loans to borrowers who might not otherwise qualify for loans from major banks. 

In August 2013, Gippsreal offered finance to Linh Son in the amount of $1,775,000. Gippsreal subsequently sent Linh Son a ‘Deed of Offer of Finance’, stipulating a loan establishment fee of $26,625 (equating to 1.5% of the loan advance amount of $1,775,000). Complications in relation to the property to be mortgaged as security for the loan saw the approved loan amount reduce to $500,000. Despite this reduction, the loan establishment fee remained at $26,625 (consequently amounting to 5.32% of the loan advance). Linh Son failed to settle the loan agreement in the timeframe stipulated, and the agreement was subsequently withdrawn by Gippsreal. Proceedings were commenced, with Gippsreal claiming liquidated damages which included, among other things, the amount of $26,625 for the establishment fee.

At first instance, the trial judge found that Gippsreal had been entitled to terminate the loan agreement, and was consequently awarded damages in the amount of $49,436.77 (which included the amount claimed for the establishment fee). Interestingly, the judge did not consider it necessary to determine whether the establishment fee constituted a penalty.

The appeal

The primary issue on appeal was whether Gippsreal was entitled to terminate the loan agreement. Although their finding that Gippsreal was not entitled to terminate the agreement made it unnecessary to consider Linh Son’s additional grounds of appeal, their honours went on to consider these grounds, including whether the loan establishment fee would be considered a penalty.

A brief history of the law of penalties in Australia

In examining whether the establishment fee constituted a penalty, the Court provided a useful outline on the law of penalties in Australia.

The judges commenced their discussion with the principles espoused by Lord Dunedin in Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd [1915] AC 79, which provided that:

  1. the essence of a penalty is a payment of money stipulated as in terrorem of the offending party, whereas the essence of liquidated damages is a genuine, covenanted pre-estimate of damages; and
  2. the question whether a stipulated sum constitutes a penalty or liquidated damages is a question of construction to be decided upon the terms and inherent circumstances of each particular contract.

Further, the judges acknowledged the utility of the tests proposed in Dunlop, suggested to assist with the necessary task of construction:

  1. it will be held to be a penalty if the sum stipulated for is extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved to have followed from the breach;
  2. it will be held to be a penalty if the breach consists only in not paying a sum of money, and the sum stipulated is a sum greater than the sum which ought to have been paid; and
  3. there is a presumption that it is a penalty when a single lump sum is made payable by way of compensation, on the occurrence of one or more or all of several events.

The judges, while accepting that the principles in Dunlop continue to remain authoritative with respect to the law of penalties in Australia, were careful to reiterate that such principles were not exhaustive and should not be considered rules of law. The Court proceeded to acknowledge clarification of these principles by the High Court in recent years.

The principles in Dunlop were adopted by the High Court in Andrews v Australia and New Zealand Banking Group Ltd (2012) 247 CLR 205, where the Court emphasised that a penalty is in the nature of a punishment for non-observance of a contractual stipulation. Further, the High Court in Ringrow Pty Ltd v BP Australia Pty Ltd (2005) 224 CLR 656 adopted the tests outlined in Dunlop, but opined that it is not enough that the sum be ‘lacking in proportion’ to the loss likely to be suffered as a result of a breach, rather, the sum must be ‘out of all proportion’ to the likely loss.

The recent case of Paciocco v Australia and New Zealand Banking Group Ltd (2016) 258 CLR 525 was examined in detail by the judges in the present case. The majority of the High Court in Paciocco 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. Further, contrary to the position stated in Dunlop, a Court is not limited to considering only such loss as is recoverable as damages for that breach, but is instead entitled to take into account detriment to other commercial interests which the non-defaulting party has legitimately sought to protect. The Court also touched on the dissenting judgment of Justice Nettle, who found it necessary to depart from the principles established in Dunlop only where the innocent party’s interest could not be quantified.  

Melbourne Linh – the new frontier?

In Melbourne Linh, the Court found that the establishment fee constituted a penalty and was therefore unenforceable by Gippsreal:'

“…because it bears no relation to any possible damage to or interest of [Gippsreal] arising from the putative breach of the Deed of Offer by [Linh Son] and it is not commensurate with any legitimate commercial interest of [Gippsreal] which is sought to be protected by that Deed in the event of its breach”.

In reaching their conclusion, the Court paid particular attention to the evidence given by Gippsreal at trial, which ultimately revealed that the establishment fee ‘had nothing to do with the protection of any of its legitimate commercial interests’, but was retained ‘in order to punish [Linh Son] for the inconvenience its conduct caused’.  So, in the Court’s view, the increase of the establishment fee from 1.5% to 5.32% of the loan amount could not be attributed to any genuine estimate of the loss that might arise from Linh Son’s breach, rendering the fee ‘extravagant and unconscionable and all out of proportion to the likely loss that [Gippsreal] might suffer as a result of a breach.’

Finally, Gippsreal’s submission - that the establishment fee was incapable of being characterised as a penalty given that was fixed in value – was rejected.  The Court considered that neither the fixed value of the amount nor the fact that Linh Son had agreed to pay it had no bearing on whether the establishment fee is a penalty.


Post Paciocco, it was anticipated that penalty clause cases would become less common, with the scope to claim contractual stipulations having been substantially widened. In defending a penalty, a party could now call upon a broad range of ‘legitimate commercial interests’ which may result from a contractual breach, and as a result, a mere disproportion between the stipulation and the maximum anticipated damage was no longer sufficient to indicate the existence of a penalty. This position was a far cry from Dunlop and Andrews, where the essential test was a comparison between the contractual stipulation and the greatest loss that could conceivably be proved from a breach.

The present case, though not a rejection of the principles in Paciocco (with the majority endorsing and applying same), arguably tends towards the traditional approach articulated in Dunlop and the dissenting judgment of Nettle J in Paciocco. Having found the evidence tendered by Gippsreal failed to establish the fee as protecting their legitimate commercial interests, the majority found that the principles established in earlier cases were sufficient in determining the fee was a penalty.

To that end, contracting parties intending to rely on the principles established by Paciocco should ensure that any relevant interests (tangible or otherwise) which may legitimise a contractual stipulation for breach can be substantially evidenced. Failure to provide such evidence may see the courts favouring the traditional orthodoxy established in earlier cases.