Can the deprivation of accrued contractual rights amount to a penalty?

A recent decision of the NSWCA of Kay v Playup Australia Pty Ltd [2020] NSWCA 33 considered whether the deprivation of accrued contractual rights can amount to a penalty for the purpose of the doctrine of penalties.

Kay agreed to sell his shares in a company to Playup for $1.6 million. Under the terms of the Share Sale and Purchase Agreement (the SSPA), $1 million was to be paid on exchange and a deferred payment of $600,000 was to be paid in monthly instalments shortly following the exchange (the Deferred Payment). Kay gave Playup numerous warranties under the SSPA, including a restraint on engaging in competing businesses and assurances as to the company’s financial situation. Relevantly, clause 4.3(b) of the SSPA provided that, if any instalment of the Deferred Payment was not paid within seven days of its respective due date, the entire balance of the Deferred Payment would be payable immediately, and the warranties and restraints provided under the SSPA would be rendered void.

Neither Kay nor Playup performed their respective obligations under the SSPA in the time and manner envisaged by the terms of the SSPA. Kay, having completed the majority, but not all, of his obligations under the SSPA, issued a demand to Playup for the balance of the Deferred Payment pursuant to clause 4.3(b) of the SSPA. Playup satisfied the demand by making payment of the balance of the Deferred Payment. Playup then commenced proceedings seeking a declaration that the relevant warranties and restraints were not void. Playup argued, amongst other things, that clause 4.3(b) of the SSPA was void and unenforceable as a penalty.

In the first instance, the NSWSC held that clause 4.3(b) was not a penalty, but that it could only be enforced where Kay had also performed his completion obligations under the SSPA. The decision was appealed.

On appeal, the NSWSCA held that clause 4.3(b) of the SSPA was a penalty, at least insofar as it operated to avoid the warranties and restraints provided in the SSPA. In making such a finding, Brereton JA held:

•    The predominate purpose of clause 4.3(b) was to ensure timely payment of each instalment of the Deferred Payment. However, it achieved this purpose by imposing an additional detriment in the event of default – not only acceleration of the Deferred Payment, but also a deprivation of the benefit of the relevant warranties and restraints.
•   The deprivation of the warranties was a severe consequence which amounted to a substantial ‘undercutting’ of the subject matter of the share sale, which can amount to a penalty for the purpose of the doctrine of penalties.
•   The penal nature of the clause was evident through its indiscriminate operation. Specifically, the deprivation of the benefit of the relevant restraints and warranties occurred regardless of whether there was a total failure to pay the Deferred Payment, or simply a delay of one day in paying the last instalment. While that consequence might not be disproportionate in the former case, it would be plainly disproportionate in the latter.
•   While, in the context of a negotiated agreement between properly advised parties of comparable bargaining power, there is a strong initial presumption that the parties themselves are the best judges of what is legitimate in a provision dealing with the consequences of breach, a provision that is otherwise penal in character does not cease to be so simply because it was negotiated.

The full decision can be found here.