Does early termination catch the penal worm?.

1 November 2017 | Reading time: 2 minutes

Most of us have tried to worm our way out of a phone contract in pursuit of the latest iPhone – only to find ourselves paying off an expensive 24-month fixed contract.

Contracts for services (such as those related to building a house or providing internet access) often include provisions for early termination fees (ETFs). These usually require the customer to pay out the remainder of the contract, or even a fixed amount, should they terminate the contract prematurely. But are ETFs legal or are they a voidable penalty?

What is an early termination fee?

ETFs are invoked when a party brings a contract to an end prior to the contracted end date. They are commonly either:

  • a fixed sum; or
  • a sum which decreases as you approach the contract end date (like a phone contract).

What’s a legal ETF then?

Under contract law, an ETF will not be valid if it can be characterised as a ‘penalty’.

To be valid, an ETF must be a ‘genuine pre-estimate of the loss the service provider suffered’ because of the early termination. A genuine pre-estimate may be calculated by taking into account a number of variables, such as:

  • the supplier’s lost net profit (eg the unpaid amount under the relevant contract less costs that would have been incurred in supplying the service); or
  • the supplier’s wasted costs (eg costs and resources ‘tied up’ in relation to the contract).

If a clause requires a party who breaches the contract (by terminating early) to pay a sum which is ‘extravagant and unconscionable’ compared to the greatest conceivable loss, this will be a penalty.

Don’t forget the consumer law.

One must also be conscious of the Australian Consumer Law and its wider implications with respect to ETFs.

Under the Australian Consumer Law, an ETF may be considered an ‘unfair term’[1] and thus void if it does not bear a reasonable relationship to the likely loss suffered by the service provider because of early termination.

What’s the High Court got to say?

In Andrews v ANZ[2] the High Court determined that a clause will be construed as a penalty if:

  • it imposes a detriment on the breaching party to the benefit of the aggrieved party; or
  • the ETF acts as security for performance of the contract.[3]

In Pacciocco v ANZ,[4] the High Court determined that charging late repayment fees to credit card holders were not penalties, as they were designed to protect ANZ from financial losses flowing from late payments.

So… what if my ETF is a penalty?

If your ETF is a ‘penalty’, it will be enforced only to the extent that it provides genuine compensation to the aggrieved party.[5] Including an ETF which varies depending on how early the contract is terminated may allow suppliers to justify that the ETF is a ‘genuine pre-estimate of loss’ and therefore enforceable.

Any business wanting to recoup their losses from early termination must be wary that their ETFs may be punitive. Consequently, if you have any doubt chat to one of our early birds to avoid the penal worm.

[1]Australian Consumer Law, s 24(1).
[2][2012] HCA 30.
[3]Ibid [10].
[4][2016] HCA 28.
[5][2012] HCA 30 [10].