King of the Pack Pty Ltd v Luong [2012] NSWSC 785 | Case summary

Judgment 1HER HONOUR: On 23 September 2011 Brown LCM entered judgment for the defendant, Van Hao Luong, on a statement of claim where the plaintiff company, King of the Pack Pty Ltd (as franchisor) claimed damages in the amount of $28,967.21 (plus interest) from the defendant (as franchisee) for breach of a franchise agreement ("the Agreement"). The plaintiff was ordered to pay the defendant's costs. 2The question in dispute in the lower court was whether Clause 19.5 of the Agreement (the clause pursuant to which part of the damages claimed were calculated) was a contractual penalty and therefore unenforceable at the suit of the plaintiff company. After referring in detail to the relevant authorities, and what the Magistrate accurately identified as settled principles, he determined that, properly construed, Clause 19.5 was a penalty. 3The plaintiff company appeals that decision. 4The grounds of appeal identify what are submitted to be multiple errors in the Magistrate's approach to that question and in his reasoning to the conclusion that the clause was unenforceable as a penalty. The grounds condensed into two questions: (a) whether Clause 19.5 of the Agreement, as a matter of construction, is capable as constituting a contractual penalty; and (b) whether the Early Termination Fee, provided for in Clause 19.5, did not constitute a genuine pre-estimate of the damage that the plaintiff company might suffer on breach where it resulted in termination of the contract. 5The appeal is governed by ss 39 and 40 of the Local Court Act 2007 which provide that an appeal to this Court may only be taken as of right on a question of law alone and that questions of mixed fact and law require a grant of leave. 6Whether a contractual clause requiring payment of a stipulated sum is a penalty is a question of construction (Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co Ltd [1915] AC 79 at 86 - 87) and therefore amenable to the appellate jurisdiction of this Court under s 39 the Local Court Act as a question of law. 7Counsel for the defendant submitted that because it was necessary for the Magistrate to construe the operation of Clause 19.5 by reference to the evidence for the purposes of determining whether or not it amounted to a genuine pre-estimate of damage and was unenforceable as a penalty for that reason (the second issue identified by the plaintiff as constituting error), the appeal necessarily involved a mixed question of fact and law, and that a grant of leave was required under s 40(1). Counsel also submitted that since no application was made for a grant of leave, and even if an application were made there were no special factors in favour of leave being granted, leave should be refused. Counsel referred to Ashi Pty Ltd v Karasco Investments Pty Ltd [2009] NSWSC 780 and Pratten v Johns [2010] NSWSC 327) to inform that question. 8The plaintiff's counsel did not seek to persuade me that leave should be granted to agitate the second question raised by the appeal or that the question involved a pure question of law such that leave was not required. 9I am satisfied that a correct analysis of the second question raised by the appeal involves a mixed question of fact and law and that no proper basis has been laid for a grant of leave permitting it to be agitated under the summons. Even were there a basis for considering a grant of leave (and none has been suggested), having regard to the Magistrate's detailed analysis of the evidence and his factual findings which, in my view, are well supported by the evidence, I would not have found error in his approach or his conclusions in any event. On one reading of his reasons in the judgment, some of his findings concerning the second issue raised by the appeal are purely factual findings which are beyond the reach of the appellate jurisdiction of this Court under the Local Court Act.

The first issue: The contractual construction argument 16It cannot be seriously doubted (and it was not for the purposes of the proceedings below or on appeal) that if an agreed damages clause fixes a sum which is intended to be a disincentive to breach and is not a genuine pre-estimate of loss or damage, it is invalid and unenforceable as a penalty: O'Dea v Allstates Leasing System (WA) Pty Ltd [1983] HCA 3; 152 CLR 359 at 397. 17In his careful and considered reasons for decision the learned Magistrate confirmed his understanding of that basic principle in the following way: The 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 Aust Pty Ltd [2005] HCA 71; 224 CLR 656: [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: 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'. 18Before applying those principles the Magistrate dealt with an initial submission advanced by the plaintiff company in seeking to defend Clause 19.5, namely that because the ETF was payable on termination of the Agreement and not necessarily upon breach of it, and because the doctrine of penalties has no application where the payment of an agreed sum is on the happening of a specified event other than a breach of (because it is not a payment agreed in advance as being payable upon breach of the contract), Clause 19.5 was not a penalty. (It is this question that is comprehended by the first issue for determination on the appeal.) 19In support of that submission (both here and in the court below) counsel relied upon a number of passages in the judgment of Allsop P in Interstar Wholesale Finance Pty Ltd v Integral Home Loans Pty Ltd [2008] NSWCA 310; 257 ALR 292 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. 20Importantly, in the balance of paragraph 130 the President noted that Mason and Wilson JJ considered that the difficulties that they identified were resolved by the Court in O'Dea - a decision upon which the defendant's counsel placed considerable reliance on the appeal and by which it was submitted the Magistrate was bound. 21The Magistrate observed, correctly, that the Agreement was capable of being terminated by the plaintiff company as franchisor under Clause 18.1 for reasons that did not involve breach of any of its terms. He was nonetheless satisfied that the plaintiff company had elected to terminate the contract for breach, as reflected in the correspondence referred to in [15] above. The Magistrate then applied the law as he considered he was bound to apply it, consistent with the reasoning of Gibbs J in O'Dea. In that case his Honour followed three decisions of the Court of Appeal in England and concluded that the doctrine of penalties can be invoked where the agreement is terminated by reason of breach, rather than upon the breach itself: ...There was some controversy as to the position when the owner's right to terminate the contract and receive payment arose on the happening of any 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, the sum payable will be a penalty unless it is a genuine pre-estimate of the loss suffered by the owner by reason of the breach: Cooden Engineering Co. Ltd. v. Stanford (1953) 1 QB 86 ; Campbell Discount Co. Ltd. v. Bridge (1962) AC 600 ; Financings Ltd. v. Baldock (1963) 2 QB 104 . I respectfully agree with that conclusion... 22On the appeal the defendant's counsel submitted that the question that the plaintiff company sought to put in issue before the Magistrate was decided by the High Court in O'Dea and that the learned Magistrate would have been in error if he had declined to follow it, unless High Court authority clearly directed to the contrary (see Farah Constructions Pty Ltd v Say-Dee Pty Ltd [2007] HCA 22; 230 CLR 89). Counsel also submitted that the facts in O'Dea were analogous to the facts in the present case (in the sense that the penal consequences to the hirer in O'Dea only became operative upon termination of the lease and not upon the breach that grounded the termination of the lease) which also reinforced the correctness of the principled approach the Magistrate applied to the question. 23The plaintiff's counsel relied upon a further passage from Interstar in support of the submission that the doctrine of penalties did not apply in this case, where at [126] his Honour said: Intermediate appellate courts in Australia have dealt with the governing principles of the law of penalties on the basis that payment being conditioned on a breach of contract is an essential element. 24In addition to the submission that this paragraph must be read in the context of the question with which the Court considered in Interstar, namely whether intermediate and High Court authority supported an extension of the doctrine of penalties beyond breach of contract (as found by the primary judge), the defendant's counsel submitted that properly understood the President was doing nothing more than observing that breach of contract is a necessary element in determining whether in a particular case a clause is penal and for that reason unenforceable. He submitted that if the element of breach is present (that is to say, in construing the clause under consideration in the particular circumstances in which it is invoked that it is necessary for a breach to occur before the penalty payment is payable) then the prerequisite has been met. The Magistrate held that there was a proper basis on the evidence to find that Clause 19.5 had the necessary element of requiring breach as a precondition to the fee becoming payable in the circumstances under consideration. 25The defendant's counsel further submitted that the plaintiff's reliance on Interstar was in any event misplaced, as exemplified by the need to "cherry pick" passages from the judgment of the President in support of the plaintiff's argument. He submitted that the decision in Interstar does not provide support for the plaintiff's proposition at all. In my view, there is force in both submissions. 26In Interstar the Court of Appeal held that where a contract provides for a payment upon the happening of an event that is not a breach, and that the payment is not payable on breach, it cannot be penal in character, the payment simply forms part of the contractual consideration and the courts have no role in relieving parties of their contractual obligations however onerous they might be. However, once the essential element of breach as a condition of payment is introduced into the equation, the possibility that the clause under consideration operates as a penalty is available to be considered. 27At [116] Allsop P cited with approval the following passage from the judgment of Hely J in Ringrow Pty Ltd v Bp Australia Ltd [2003] FCA 1297, a passage which the President noted was adopted in the Full Court of the Federal Court and upon which no doubt was cast by the High Court in Ringrow Pty Ltd v BP Australia Pty Ltd [2005] HCA 71; 224 CLR 656: [97] The modern rule against penalties is a rule of law: AMEV-UDC Finance Ltd v Austin (1986) 162 CLR 170 at 191. The sphere of operation of the penalties doctrine is limited to payment of agreed sums or transfer of property upon a breach of contract: Rossiter Penalties & Forfeiture (1992) at p 66. A clause providing for a payment of an agreed sum on termination of a contract (in itself not an event of breach) is still within the reach of the penalties doctrine if one of the grounds on which the agreement may be terminated is breach: O'Dea v Allstates Leasing System (WA) Pty Ltd (1983) 152 CLR 359 at 367; Lanyon Equity and the Doctrine of Penalties (1996) 9 JCL 234 at 235. 28This is precisely the position that obtained in the present case. The Agreement provided expressly in Clause 18.1(c) for the plaintiff company to terminate the Agreement where the franchisee "voluntarily abandons the business or the franchise relationship", without having to comply with the notice provisions in Clause 18.2. Abandoning the business (or surrendering all transferring control of the business or failing to actively carry on the business) is also nominated in Clause 17.1(g) of the Agreement as an event of default entitling the franchisor to terminate. By its terms, Clause 19.5 is not confined in its operation to termination for breach. It also included other listed events specified in clause 18.1(a) - (i) including, for example, bankruptcy, insolvency or where the business is operated in a fraudulent manner or where it endangers public health or safety. However, the clause also operates in circumstances of breach and for that reason I am persuaded that it is still within reach of the penalties doctrine. 29I regard the Magistrate's reasoning to the conclusion that the defendant was in breach of the agreement and, accordingly, that breach was an element the plaintiff company relied upon when invoking reliance on Clause 19.5, as free from error. His Honour's appreciation and application of general principle in the paragraphs that follow are a further reflection of what I consider to be exemplary judicial reasoning: [9] In 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 v Allstates Leasing System (WA) Pty Ltd. 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. [10] I 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. [11] Consequently, 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 v Allstates Leasing System (WA) Pty Ltd, Wilson J observed that a clause of this nature would strongly support the defence to the claim ie 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. [12] Secondly, 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. 30I am not persuaded that error of the kind contended for by the plaintiff company in the first issue for determination has been made out. The principled approach to the question of construction adopted by the Magistrate is in my view both correct and in accordance with binding authority.

King of the Pack Pty Ltd v Luong

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