Penalty clauses in technology contracts

Many technology contracts provide for the payment of money if one party does not meet a defined level of service or fails to complete a task in a certain timeframe. When drafted incorrectly, such clauses may be unenforceable if they are deemed to impose a “penalty” on the other party.

The “doctrine of penalties” dictates that a clause of a contract may be void and unenforceable if it imposes an additional liability if one party breaches the contract. In order to be deemed a penalty clause the consequences must be out of proportion to the damage likely to be suffered as a result of the breach. It is therefore important to ensure that the consequence is a true pre-estimation of the loss suffered.  The difficulty of course is trying to make this assessment at the time the contract is made rather than at the time of breach.

In a recent case before the NSW Court of Appeal, the Court decided that a provision of an agreement is only a penalty clause if it is triggered upon breach of the contract and not upon the occurrence of another event during the life of the contract.

Interstar Wholesaler Finance Pty Ltd v Integral Home Loans Pty Ltd [2008] NSWCA 310

Background:

Integral was engaged by Interstar to introduce home loan customers to the Interstar product and to manage the ongoing customer relationship. Integral were paid trailer commissions by Interstar under their agreement.

Under the agreement, Interstar reserved the right to terminate the contract and cut off the trailer commissions if it considered in its reasonable opinion, that Integral engaged in deceptive or fraudulent activity in relation to an application or settled loan.

Integral submitted to the Court that the clauses purporting to cut off the trailer commissions were automatically void and unenforceable according to the doctrine of penalties.

The Decision:

The Court unanimously decided that the doctrine of penalties should be interpreted narrowly. The doctrine only applies to penalties arising from a breach of contract and not upon the occurrence of another event or circumstance.

The Court found that any commissions had not been fully earned by Integral because they were partly conditional on the ongoing management of the loans. As such, the clause that terminated the commissions is not considered a penalty clause.

The Court also noted that Interstar’s opinion that Integral engaged in deceptive or fraudulent activity was not a breach of contract by Integral but an event or circumstance in the context of the contractual relationship. In any case, the withdrawal of the commissions was not “out of all proportion” or “extravagant and unconscionable in amount” so as to be a penalty.

Application to potential penalty clauses in technology contracts

Many provisions that regularly appear in information technology contracts may be void if drafted poorly. In light of the above decision, a clause which specifies a consequence based on a particular event or a breach will need to be reviewed to consider its enforceability.  Some common examples are discussed below:

Service Level Agreement (“SLA”)

• An SLA may include a rebate or credit mechanism in the event that the provider fails to meet defined levels of service.
• A contravention of the SLA may be:
  • A breach of contract: The service credits could be deemed to be liquidated damages and the clause could be an unenforceable penalty.
  • A mere contractual event: The service credits will be enforceable.

Accelerated payments

• Payments that would otherwise be distributed across the term of a contract may be payable immediately if a certain event occurs.
• Depending on the drafting of the clause it may be deemed to be a penalty clause and therefore unenforceable.

Step-in and disengagement

• Step-in rights allow a customer to temporarily provide the service itself or engage a third party provider.
• Disengagement clauses allow for the permanent hand-over of services to the customer or a third party supplier.
• If such clauses specify and allocate costs or involve the transfer/sale of property that is used to perform the services, they may be unenforceable.

Forfeiture of rights

• An agreement may provide for the automatic revocation of a software licence or a similar right on the occurrence of a certain event.
• If the consequences are deemed to constitute a forfeiture of rights or property the clause may be considered an unenforceable penalty.

This development to the doctrine of penalties underlines the necessity for obtaining specialist legal advice when entering technology contracts.  It is clear that when drafting “penalty” type clauses extra care must now be taken to help ensure their enforceability.  Parties will need to pay special attention to whether a trigger, even if it constitutes a “penalty”, is a breach or other contractual event and ensure that the consequences of that event are drafted appropriately.

Authors:  Nick Rimington and Darren Sommers