King of the Pack Pty Ltd v Luong

Local Court of NSW|2011-09-23|Before: Gleeson CJ, Heydon JJ, Allsop P, Wilson JJ

JUDGMENT 1The sole point at issue in the present case is whether the contractual payment provided for in cl 19.5 of the contract is a penalty at common law or not. 2Cl 19.5 provides: 19.5 Early termination In the event that this Agreement is terminated by either party, prior to the expiry of the Term, you must, unless otherwise agreed by the parties, pay us: our Monthly Franchise Fee for the balance of the Term that would have been paid to us had this Agreement not been terminated; and our Early Termination Fee for our reasonable costs of Fixtures, Fittings, Plant and Equipment, which you acknowledge is a fair value for such a loss to our Business System." 3The early termination fee referred to is defined in cl 1.1 as: "Early Termination Fee" means an amount up to the fee specified in Item 18 of the Reference Schedule', and the fee specified in Item 18 is $15,000 (plus GST). 4The basic legal framework of penalties is well settled, and was described as follows in 2005 in the joint judgment of Gleeson CJ, Gummow, Kirby, Hayne, Callinan and Heydon JJ in Ringrow Pty Ltd v BP Australia Pty Ltd [2005] HCA 71 at [10]-[11]: 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. 11. The starting point for the appellant was the following passage in Lord Dunedin's speech in Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd ([1915] AC 79 at 86-87): "2. The essence of a penalty is a payment of money stipulated as in terrorem of the offending party; the essence of liquidated damages is a genuine covenanted pre-estimate of damage ... 3. The question whether a sum stipulated is penalty or liquidated damages is a question of construction to be decided upon the terms and inherent circumstances of each particular contract, judged of as at the time of the making of the contract, not as at the time of the breach ... 4. To assist this task of construction various tests have been suggested, which if applicable to the case under consideration may prove helpful, or even conclusive. Such are: (a) It will be held to be 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 ... (b) 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 ... (c) There is a presumption (but no more) that it is 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, some of which may occasion serious and others but trifling damage' ( Lord Ephinstone v Monkland Iron and Coal Co (1886) 11 App Cas 332 at 342 per Lord Watson)."

Effect of Payment being for Termination 5Before addressing these principles, it is necessary to consider the initial submission made on behalf of the plaintiff franchisor. It was argued for the plaintiff that a contractual payment in general, and the ETF in particular, could not amount to a penalty unless it was payable only on breach. Reference was made to paragraph 10 of the above quote from Ringrow, and to a passage from the judgment of Allsop P in Interstar Wholesale Finance Pty Ltd v Integral Home Loans Pty Ltd [2008] NSWCA 310 at [130] : In AMEV-UDC at 184, Mason and Wilson JJ said the following: Common to a number of the speeches in Campbell Discount was the view that the doctrine of penalties has no application to a stipulation which provides for the payment of an agreed sum on the happening of a specified event other than a breach of contract. The correctness of this view has since been affirmed by the House of Lords in Export Credits ...: see also IAC (Leasing) ... . The reason given for this limitation on the scope of the doctrine is that it has never been the function of the courts to relieve a party from a contract on the mere ground that it proves to be onerous or imprudent: Export Credits .... Unfortunately the proposition that the doctrine of penalties has no operation in relation to a sum agreed to be paid on the happening of an event which is not a breach of contract generates difficulties when an attempt is made to apply the proposition to the exercise of an option to terminate a contract which is conditional upon, or associated with, a breach of contract. (Footnotes omitted) 6The argument for the plaintiff was that the ETF was payable on termination of the contract, not necessarily upon breach of it, so that cl 19.5 could not, in accordance with this authority, amount to a penalty. 7This precise issue was addressed at some length by Allsop P in Interstar. However, his Honour's comments are strictly obiter as he and the other members of the court found that there was no breach of contract in that case to attract the doctrine of penalties. The issue in the present case is, to paraphrase the dissenting judgment of Dawson J in AMEV-UDC Finance Ltd v Austin (1986) 162 CLR 170 to which Allsop P made reference (at [133]), whether termination of a contract for breach should be treated in the same way as the breach itself for the purpose of determining whether a stipulated payment is capable of amounting to a penalty. 8Whilst the matter appears to be in some doubt given the division of opinion in the High Court of Australia in AMEV-UDC, no authority has been cited to me in which it has been clearly held that a contractual payment required on termination for breach has been regarded as outside the doctrine of penalties. On the other hand, the passage referred to above from the judgment of Dawson J in AMEV-UDC provides some support for the contrary position. Further support may be found in the judgment of Gibbs CJ in O'Dea v Allstates Leasing System (WA) Pty Ltd (1983) 152 CLR 359 where his Honour commented that: "There was some controversy as to the position when the owner's [franchisor's] right to terminate the contract and receive payment arose on the happening of a number of events, some of which were breaches and some of which were not, but it has now been settled in England that in such a case where the agreement is terminated by reason of a breach committed by the hirer [franchisee] , the sum payable will be a penalty unless it is a genuine pre-estimate of the loss suffered by the owner [franchisor] by reason of the breach: Cooden Engineering Co Ltd v Stanford; Campbell Discount Co Ltd v Bridge; Financings Ltd v Baldock. I respectfully agree with that conclusion." [Emphasis added; footnotes omitted] 9In the present case, the contract was capable of being terminated by the franchisor under cl 18.1 for a number of reasons that did not involve breach of any of its terms by the franchisee, including the franchisee's bankruptcy or by agreement, but there is no doubt that the franchisor chose to terminate the contract for alleged breach by the franchisee (see para 6 of the Statement of Claim) although such breach was denied. Applying the law as approved by Gibbs CJ in O'Dea it would follow that cl 19.5 is not precluded from being a penalty simply because the mechanism for invoking it was formal termination of the contract rather the breach that allegedly resulted in such termination. 10I return to the general principles. The process contained in cl 19.5 has a number of aspects. First, the definition of "Early Termination Fee" (ETF) means an amount "up to" the $15,000 plus GST specified in cl 1.1. But the contract contains no mechanism for determining what the ETF should be in any particular situation if it is not to be exactly $15,000 plus GST. This makes the franchisee's "acknowledgement" that the amount is a fair value for loss of the business system more than a little questionable since the amount the franchisor might demand is uncertain, although capped. 11Consequently, if the ETF is treated, as the plaintiff argued, as being fixed at nothing less than $15,000 plus GST, the same amount is payable regardless of when in its 5 year term the contract is terminated, so that termination 1 day after the contract is made will carry the same fee as would termination on the last day, 5 years later, before the contract expires. It would also leave the franchisor with all the property it provided to the franchisee, although some of that property will have undergone depreciation. In O'Dea , Wilson J observed that a clause of this nature would strongly support the defence to the claim, i.e. that the clause constituted a penalty. Whilst this is not necessarily the case under cl 19.5 if the franchisor chooses to demand a lesser fee, that would appear to be a matter solely within the franchisor's discretion, or perhaps subject to further agreement. However, the default position appears to be that the franchisor can demand $15,000 plus GST, and there would appear to be no obligation on, and little incentive for, the franchisor to reduce that amount. In such a situation it seems apparent that the clause is intended to operate in terrorem of the franchisee. 12Secondly, the ETF is payable by the franchisee if the agreement is terminated by either party. Consequently, even if the franchisor itself commits a fundamental breach of the contract, for example, by supplying no products at all to the franchisee, the franchisee remains contractually liable to pay the ETF if it quite legitimately terminates the contract. Whilst not strictly within the realm of the fundamental doctrine of penalties because this scenario does not involve a payment being made by the franchisee because of its breach of contract, this fact suggests that the purpose of the ETF is to compel the franchisee to adhere to the contract however poor the franchisor's performance might be for fear of having to pay a substantial "penalty": it operates as a deterrent against breach by the franchisee, rather than being in any way intended to compensate the franchisor for the effects of breach by the franchisee.

A genuine pre-estimate of damage? 13Allsop P in Fermiscan Pty Ltd v James [2009] NSWCA 355 defined the question thus: 134 The issue for resolution, through the process of construction of the contract and an examination of the inherent circumstances is whether the clause was contractually intended to operate as a deterrent against breach, the object of the clause being to prevent the commission of a breach of the contract by coercing compliance ("in terrorem" - see point 2 in Lord Dunedin's statement of principle) or whether it was intended as an agreed pre-estimated sum representing compensation to be paid upon breach and thus addressing the consequences of breach: Dunlop at 86-87, Waterside Workers' Federation at 129; and see also Luong Dinh Luu v Sovereign Developments Pty Ltd [2006] NSWCA 40; [2006] NSW Conv R 56-146 at [30] (Bryson JA, with whom Handley JA and McColl JA agreed). 14A "genuine pre-estimate of damage" is not a genuine pre-estimate of the maximum possible damage the party might suffer but, according to Lord Dunedin's principle 4(a), is based upon a comparison between the contractual payment required and "the greatest loss that could conceivably be proved to have followed from the breach": see Interstar per Allsop P at [146]. 15In seeking to establish that the ETF did amount to a genuine pre-estimate of damage, the plaintiff referred to Exhibit 3 paras 2(a)-(e) and para 3. It was asserted that these paragraphs itemised the setup costs incurred by the plaintiff franchisor as part of its contractual obligations to the defendant franchisee. These costs totalled $18,818.77. As I understand the plaintiff's case, it was these costs that were to be recouped via the ETF in the event of termination of the contract. No reference was made in argument to the ETF having any particular relationship to other damages that the plaintiff franchisor might suffer if the franchisee breached the contract, and it is expressly confined in cl 19.5(b) to "reasonable costs of Fixtures, Fittings, Plant and Equipment". 16It is noteworthy that only paragraphs 2(a) and 2(b) contain any specific reference to the items being for the franchisee's business. There is no evidence to indicate that all of these items were necessarily supplied to every franchisee, nor that items with these costs were supplied to the defendant. 17It was argued for the defendant franchisee that the ETF could not constitute a genuine pre-estimate of damage since the actual damage likely to be suffered could not be realistically calculated. In response to this submission, it is appropriate to note a further part of Lord Dunedin's principles, paragraph 4(d), which was referred to in Fermiscan at [152]: "On the other hand: ... (d) It is no obstacle to the sum stipulated being a genuine pre-estimate of damage, that the consequences of the breach are such as to make precise pre-estimation almost an impossibility. On the contrary, that is just the situation when it is probable that pre-estimated damage was the true bargain between the parties." 18The question remains whether this was a genuine pre-estimate of damage. As noted above at [10] the franchisee's contractual acknowledgement of this in cl 19.5 can be given little weight. In Interstar at [149], Allsop P cited with approval the observation of Lord Dunedin that: "I think Elphinstone's Case ... or rather the dicta in it, do go to this length, that if there are various breaches to which one indiscriminate sum to be paid in breach is applied, then the strength of the chain must be taken at its weakest link. If you can clearly see that the loss on one particular breach could never amount to the stipulated sum, then you may come to the conclusion that the sum is a penalty." 19This clearly entails an objective assessment of the projected effect of the clause in question. Allsop P in Interstar also approved (at [152]) the concept that: Where the sum is payable for more than one breach (some of which breaches are trivial and some of which are not), it may be that, looked at objectively, the provision for the stipulated sum will be penal. This is clearly so in the present case: the ETF is payable on termination for any number of breaches, some of which are trivial and some serious (see clause 6.2 for a wide range of obligations on the franchisee that could generate trivial or serious breaches of contract), yet the ETF remains the same $15,000 if the franchisor elects to terminate the contract. To apply Lord Dunedin's test (above at [18]) a breach of the obligation to attend a training course (cl 6.2(i) - an event of default under cl.17.1(c)) or to keep all original documents for at least 7 years, two years beyond the life of the contract itself (cl 6.2(s)), could never cause loss to the franchisor amounting to $15,000. Similarly, other events of default, such as set out in cl 17.1 (such as filing two reports late within a 12 month period: cl 17.1(h)), could never per se cause loss amounting to that figure. 20Considering that cl 19.5 is limited to loss of "Fixtures, Fittings, Plant and Equipment", could the ETF be a genuine pre-estimate of damage that could be suffered by the franchisor as a result of a breach of contract that affected that property? 21Some of this property is subject to specific provisions of the contract that operate on termination. Under cl 19.2 all "intellectual property" items (that might constitute "equipment") must be returned to the franchisor, together with some apparent "equipment" such as forms, stationery, advertising material and other printed matter. Signage must also be removed (cl 19.4), although there is no obligation to return it. This would suggest that the signage is of no continuing value to the franchisor. "Manuals" are only on loan and must be returned. The "Business System" is only provided on a "right to use" basis (cl 2), and must also be returned, as claimed in these proceedings originally. 22Taking account of the above, it can clearly be seen that, in the words of Lord Dunedin, "the loss on one particular breach [such as those referred to at [19] above] could never amount to the stipulated sum". In fact, all of the relevant characteristics of cl 19.5 point towards it being intended to operate in terrorem to compel adherence to the contract by the franchisee, not to operate as a genuine pre-estimate of the damage the franchisor might suffer on a breach that results in termination of the contract. I am satisfied that cl 19.5 constitutes a penalty at common law, and is unenforceable.

Jurisdiction 23After judgment was reserved on 26 August 2011 an issue arose as to the effect of cl 25 of the contract, being a clause governing choice of law and choice of forum, and establishing that the laws of Queensland were to govern and that disputes "may be instituted, heard and determined in a court of competent jurisdiction in Queensland". The parties agreed in the following terms: "The parties agree that the laws of Queensland are not relevantly different (particularly in terms of any statutory variation of the law with respect to penalties) from the common law in the authorities cited to the Court. The parties agree that the Local Court of NSW has jurisdiction to hear and determine the present proceedings".

Decision and orders 24Consequently I give judgment for the defendant on the claim. I note the cross-claim was settled on 26 August 2011. 25On 26 August 2011 the parties agreed that costs were to follow the event. I therefore order the plaintiff to pay the defendant's costs as agreed or as assessed. Magistrate R A Brown Blacktown Local Court 23 September 2011 DISCLAIMER - Every effort has been made to comply with suppression orders or statutory provisions prohibiting publication that may apply to this judgment or decision. The onus remains on any person using material in the judgment or decision to ensure that the intended use of that material does not breach any such order or provision. Further enquiries may be directed to the Registry of the Court or Tribunal in which it was generated. Decision last updated: 28 September 2011

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