Drafting alert – How to avoid penalty clauses in settlement agreements

The decision in Lachlan v HP Mercantile Pty Ltd [2015] NSWCA 130 provides a valuable reminder of the consequences which can flow from a breach of settlement agreement.

Where a creditor enters into a settlement agreement agreeing to compromise a debt owing but requiring the debtor to pay a greater sum if the debtor defaults, the default clause may constitute a penalty and be unenforceable. However, the Lachlan decision confirms the line of authority that the doctrine of penalties can be avoided in such a situation provided the agreement contains an acknowledgment by the debtor that the full amount of the debt is presently owing. The acknowledgement of the debt may be implied from the agreement, even where the acknowledgement is not contained in an operative provision of the agreement.

This decision also indicates that courts will be hesitant to exercise their discretion to vary or set aside consent orders based on an underlying agreement reached between parties.

Facts

The appellant, Dr Lachlan, entered into four loan agreements with a company that later assigned its rights to HP Mercantile Pty Ltd (HPM). Dr Lachlan issued legal proceedings seeking declaratory relief against HPM and HPM cross claimed to recover the debts owing under the loans.

The parties settled the proceedings by entering into a Deed of Release and Assignment (Deed) containing, amongst others, the following terms.

• Dr Lachlan would pay HPM a settlement sum of $300,000 by way of instalments (specified in the Deed) (clause 5);
• if Dr Lachlan defaulted in making instalment payments, and such default was not rectified following notice, HPM was entitled to enter judgment for the amount of $1,570,292.12 (which was defined in the Deed as the ‘Judgment Debt’) (clause 10).

The Court made orders by consent which incorporated the above clauses of the Deed and dismissed Dr Lachlan’s application (but not HPM’s cross-claim).

In addition, the Deed contained recitals which included the following:

• Recital N which made reference to HPM’s cross-claim as a claim for ‘recovery of the amounts owing under the Loans’; and
• Recital O which stated that Dr Lachlan ‘unconditionally affirms and confirms the debt obligations under the Loans… such that [Dr Lachlan’s] obligations to repay those debts are current and continuing obligations’.

Dr Lachlan defaulted in making the final instalment payment under the Deed and HPM applied for judgment for the Judgment Debt. Dr Lachlan sought an order for an extension of time to pay the last instalment under the Uniform Civil Procedure Rules (NSW).

At first instance

The NSW Supreme Court refused to grant Dr Lachlan an extension of time.  In reaching its decision, the Court considered the case of Paino v Hofbauer (1988) 13 NSWLR 193 (Paino) in which it was held that a court would only exercise its discretion to vary or set aside consent orders based on an underlying contract in ”exceptional” cases. In this case, given the failure to make the payment was Dr Lachlan’s own fault, the Court found there was no reason to vary the time for paying the installment.

Dr Lachlan also argued that clause 10 constituted a penalty and was therefore unenforceable. Dr Lachlan submitted that the Judgment Debt, for which HPM sought judgment, was not a ‘present debt’. The Court found that under the Deed, Lachlan had impliedly acknowledged that he was indebted to HPM for the amount owing under the loans as a ‘current and continuing obligation’, so clause 10 could not be a penalty.

Court of Appeal decision

Dr Lachlan appealed the decision on the grounds that the Trial Judge erred in:

• refusing to grant Dr Lachlan an extension of time in which to comply with the consent orders; and
• finding that clause 10 of the Deed was not a penalty.

The Court upheld the decision of the Trial Judge in relation to both grounds of appeal.

Refusal to grant a time extension

The Court held that the Trial Judge was correct in refusing to grant Dr Lachlan an extension of time.

In reaching its decision, the Court found that:

• the decision in Paino is good law and it is appropriate to require an ‘exceptional case’ to remove or vary a consent order based on contract, as this does not impermissibly fetter the Court’s discretion to make orders under the Uniform Civil Procedure Rules (NSW);
• sections 56-58 of the Civil Procedure Act (NSW) do not alter the manner in which a court may exercise its general discretion; and
• it was not unreasonable to refuse to grant an extension of time in circumstances where the failure to pay an instalment on time was the fault of Dr Lachlan and Dr Lachlan had an opportunity to rectify his default and failed to do so.

Clause 10 was not a penalty

Dr Lachlan submitted that the only present debt under the Deed was his obligation to pay HPM the sum of $300,000 because the Judgment Debt was merely an amount claimed by HPM.

The Court held that clause 10 of the Deed was not a penalty provision.

In particular, the Court found:

• there was no need for any express acknowledgment in the Deed that the Judgment Debt was presently owing; and
• the recitals in the Deed, recitals N and O in particular, contained an implicit admission by Dr Lachlan that the full amount outstanding under the loans was a presently owing debt and therefore could be construed as an acknowledgement that the Judgment Debt in clause 10 was a present debt, rather than a claim for a disputed amount.

On this basis Dr Lachlan was liable to pay HPM the judgment debt of $1,570,292.12 (less the amounts that had already been paid pursuant to the Deed).

Practical implications

Where a creditor has compromised repayment of a debt pursuant to a settlement agreement but wishes the total amount of the debt to be repayable should the debtor default, the agreement must contain an acknowledgment by the debtor (even if implicit) of the creditor’s present entitlement to the total amount of the debt. If there is no such acknowledgment, it is likely that a default clause requiring payment of the total debt will constitute a penalty clause and will be unenforceable because there is no ‘present debt’ but merely an amount claimed.

Further, recitals may be used to aid in construction of a provision of a deed (particularly where it is ambiguous), even though they are not part of the operative provisions. Therefore particular attention should be placed on the recitals when drafting a settlement deed to ensure they include relevant background facts.