Since Dunlop, the courts have focused on reviewing potential penalty clauses in context when determining whether a clause provides for a disproportionate payment or whether the payment is actually compensatory. Relevant factors likely to be considered include the parties relationship at the time of the contract, the origin and discussions relating to the clause, each party’s bargaining position, and the degree of imbalance between the amount payable and the loss likely to be suffered by the non-defaulting party.
Though the law of penalties acts as a restraint on the principle of freedom of contract and limits the parties' freedom to settle for themselves the rights and liabilities following a breach of contract, courts have considered it necessary to make ‘penalty clauses’ unenforceable to avoid giving effect to contractual provisions which produce unconscionable results. It is however, a balancing act.
This balancing act was demonstrated in the High Court decision in Paciocco v Australia and New Zealand Banking Group Ltd  HCA 28. Here the court, in upholding the validity of the clause, re-confirmed the importance of the values of commercial certainty and freedom of contract and that the idea that the courts will not ‘lightly invalidate a contractual provision for an agreed payment on the ground that it has the character of a punishment.’
The question of whether a compulsory transfer clause in a shareholders’ agreement amounted to a penalty was examined in In the matter of Pioneer Energy Holdings Pty Ltd  NSWSC 1134 (Pioneer). Here a compulsory transfer clause gave the non-defaulting party the option to acquire all the defaulting party’s shares for $1. The defaulting party paid $13 million for the shares.
In Pioneer, the defaulting party successfully argued that the transfer of its shares for just $1 was ‘extravagant and unconscionable in amount by comparison with the greatest loss that could conceivably be proved to have followed from the breach.’
In deciding whether the clause was a penalty, Bergin CJ considered CRA Limited v NZ Goldfields Investments & Anor  VR 870 (NZ Goldfields) in which a defaulting party was required to transfer its joint venture interest at fair market value less 5%. In this case there was a ‘good commercial reason for the 5% discount’ and the clause stood.
In Pioneer, rather than calculating the default price payable by reference to a discount to the fair market value or taking into consideration when the default occurred, the transfer of all shares was for a ‘lump sum’ of $1. Bergin CJ held that the loss of the whole of the amount invested in the joint venture was out of all proportion to the actual loss and that this amounted to a punishment unenforceable as a penalty.
The point at which a compulsory transfer clause is at risk of being set aside as a penalty will depend on the specific facts and circumstances present at the time the contract is entered into, in addition to the specific contractual terms.
Potentially, in Pioneer, if the clause had been drafted as a small discount to fair market value (as was the case in NZ Goldfields) or the price payable was a lump sum amount that increased to reflect the development stage of the joint venture, the court may have not considered the clause a penalty. What is clear is that nominal transfer prices or aggressive discounts to fair market value that have no bearing to the loss likely to be actually suffered as a result of the breach leading to the compulsory transfer right are at significant risk of constituting a penalty and being determined unenforceable.
If you would like any assistance or advice in relation to your shareholders’ agreements, please feel free to contact the Corporate team here at McCabe Curwood.