Penalties in Property - The Fine Line in Motivating Contractual Performance

Questions of whether contractual payments are unenforceable penalties arise commonly in a range of real estate transactions, including property sales, leasing and property finance. There is often a fine line between strongly incentivising a counter-party to perform its contractual obligations and also ensuring that default provisions are not penal and therefore unenforceable.

Recent Decision

The recent decision of N & M Investments/Properties Pty Ltd v Australian Property Enterprise Pty Ltd [1] provides a good reminder of the principles governing penalties and the factors that will be taken into account in determining whether default payments constitute an unenforceable penalty or reasonable compensation in the circumstances.

In this case, a property funder sought to recover the following fees that became payable following a loan default:

• a $29,000 ‘Further Establishment Fee’; and
• a $75 per day ‘Default Loan Management Fee’.

The borrower argued that these default fees were penalties and not recoverable by the lender. 

The lender argued that the fees were reasonable for the following (among other) reasons:

• the Further Establishment Fee compensated the lender for its inability to re-deploy the loan to a new borrower that would pay an establishment fee; and
• the Default Loan Management Fee compensated the lender for the additional costs and expenses incurred by the lender in having to deal with a facility in default.

The Court summarised some of the principles derived from case law on penalties as follows:

• the fact that the amount of a payment stipulated to be made on breach of contract is set at a level which provides a negative incentive — even a very strong negative incentive — to perform the contract is not enough to justify the conclusion that a contractual stipulation served only to punish[2];
• in relation to stipulations that operate to require the payment of a sum of money, that the sum must be “extravagant and unconscionable” or “out of all proportion to the interests of the party which it is the purpose of the provision to protect” before it can be characterised as a penalty[3];
• the critical issue is “whether the sum agreed was commensurate with the interest protected by the bargain”[4]. Attention must be given to the interest or interests sought to be protected or advanced by the impugned collateral stipulation[5]; and
• there is a presumption that a fee is a penalty if it is payable on the occurrence of several events, some of which may occasion serious and others trifling damage.

The Court held that both of the fees were penalties. This is because:

• the default fees were payable following any event of default, some of which were minor and would not cause the lender any loss. This gave rise to a presumption that these fees were penalties;
• it could not be established by the lender that the fees were a genuine ‘pre-estimate’ of loss likely sustained by the lender (as distinct from third parties that managed the lender’s loans and arranged investment in the lender’s fund); and
• the Court took into consideration that the lender was already entitled to a higher rate of interest on default and could recover all costs associated with the default under the loan agreement.

Deposits

The law of penalties is also relevant when a deposit of more than 10% of the price is to be paid under a contract to purchase real estate.

Case law establishes a deposit of up to 10% of the price is reasonable and is appropriate compensation for a seller if the buyer does not complete.

However, any deposit that is greater than 10% must be justified in the circumstances. If a larger deposit cannot be justified, the release of the deposit to the seller may be a penalty.

The right to forfeit a deposits in excess of 10% must be justified by increased risk factors such as a long settlement period.

Leasing Incentives

Landords often require re-payment of some or all of the leasing incentives that is has provided if the tenant defaults. This can be a penalty in circumstances where damages for breach of the lease already compensate the landlord for breach of the lease.

It may be that fit-out incentives could be structured as a loan that is only repayable on breach under the lease. Whilst not entirely free from doubt, such a structure places the landlord in a better position to deal with the penalty argument.

For further information on when lease provisions may be a penalty, see our property update Obligation to Repay Lease Incentives Held to be a Penalty. 

Summary

The question of whether contractual payments are penal in nature can often arise in property transactions. Lenders, sellers and landlords should be alive to the fact that onerous default payments may not be enforceable. Lavan regularly advises on these issues in property transactions, so please don’t hesitate to contact us if you have any queries.