Cost and penalty

Legal Eagle tells us the law:

… the essence of a penalty is where it imposes a payment of money in terrorem of the offending party (i.e. intended to frighten or intimidate); whereas the essence of a true liquidated damages clause is that it represents a genuine agreed pre-estimate of losses which may result from the breach.

Okay – but the issue is, how do we know what the losses are? So in comments Jarrah says that the courts do this every day. Indeed the courts do something but I’m not convinced they assess ‘losses’.

Here is Ludwig von Mises describing how a judge (or impartial observer) might go about doing things (pg. 349-350):

Attempts to establish cost accounts on an “impartial” basis are doomed to failure. Calculating costs is a mental tool of action, the purposive design to make the best of the available means for an improvement of future conditions. It is necessarily volitional, not factual. In the hands of an indifferent umpire it changes its character entirely. The umpire does not look forward to the future. He looks backward to the dead past and to rigid rules which are useless for real life and action. He does not anticipate changes. He is unwittingly guided by the prepossession that the evenly rotating economy is the normal and most desirable state of human affairs. Profits do not fit into his scheme. He has a confused idea about a “fair” rate of profit or a “fair” return on capital invested. However, there are no such things.

Then there is this (pg 332):

In view of popular errors it is expedient to emphasize that catallactics deals with the real prices as they are paid in definite transactions and not with imaginary prices. The concept of final prices is merely a mental tool for the grasp of a particular problem, the emergence of entrepreneurial profit and loss. The concept of a “just” or “fair” price is devoid of any scientific meaning; it is a disguise for wishes, a striving for a state of affairs different from reality. Market prices are entirely determined by the value judgments of men as they really act.

If von Mises isn’t to your liking here is James Buchanan:

1. Most importantly, cost must be borne exclusively by the decision-maker; it is not possible for cost to be shifted to or imposed on others.
2. Cost is subjective; it exists in the mind of the decision-maker and nowhere else.
3. Cost is based on anticipations; it is necessarily a forward-looking or ex ante concept.
4. Cost can never be realized because of the fact of choice itself: that which is given up cannot be enjoyed.
5. Cost cannot be measured by someone other than the decision-maker because there is no way that subjective experience can be directly observed.
6. Finally, cost can be dated at the moment of decision or choice.

What courts do is cost-accounting but that is something very different to evaluating the costs that people face when making choices.

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55 Responses to Cost and penalty

  1. m0nty says:

    So I’m guessing this is Sinclair attempting to bolster the argument for retaining the sections of the RDA that Bolt got done on? Because hurt feelings are personal and subjective, you know, like capitalists’ profit margins. 🙂

  2. Sinc is attempting to influence the class action case against the banks regarding their fees and charges. The banks are arguing they are fees, the plaintiffs are arguing they are penalties.

  3. m0nty says:

    Sinc should stick with his excellent argument about the market taking care of the problem through competition.

  4. Nick Ferrett says:

    Sinclair, the law is pretty forgiving of attempted estimates and, I think, takes into account the factors you’ve identified. Hence the use of the word “genuine”. The estimate doesn’t have to be spot on, or even nearly right. You just have to get over the hurdle that the amount to be awarded is by way of punishment rather than compensation.

    Part of the preparedness to allow a fair bit of latitude is the recognition that whilst the loss cannot always be accurately assessed at the time the contract is drafted, there is a benefit to both parties (and to society in general as a result) in being able to deal with the matter efficiently by avoiding litigation to quantify damages.

    It is correct to say that in quantifying damages, courts engage in cost-accounting, but in working out whether a clause should be struck down as a penalty, courts engage in economic analysis.

  5. m0nty says:

    m0nty – ??? Confused.

    I’m referring to Sinclair’s appearance on PM.

    WILL OCKENDEN: Sinclair Davidson says competition between the banks is what will bring fees down.

    SINCLAIR DAVIDSON: They will charge what they can think they can get away with but if there’s push back from customers they will lower their prices. That more-or-less happens all the time. That’s what we’re seeing here and the competitive process will actually keep so-called excessive charges in check.

  6. Sinclair Davidson says:

    LE / Nick – I suspect the sticking point to be the meaning of ‘excessive’.

    m0nty – wtf?

  7. Nick Ferrett says:

    In both fields, there is a lot of loose language. I think it comes down to this. You look first at whether the fee is being charged in response to a breach of contract (according to the judge in the ANZ case, a dishonour fee is not a response to a breach but a fee for considering whether or not to extend credit). If the fee is a response to a breach of contract, you then look at whether the parties have tried to arrive at some genuine approximation of damages, or instead simply to arrive at a punishment for non-performance. If it is the former, then whether or not the attempted approximation turns out to be accurate, it is fine. If it is the latter, it is not.

    I was going to say the word “excessive” is way too subjective to have a place in the analysis, but the fact is that it will. A court would, I think, take the post-facto excessiveness of an award into account in arriving at the view that the estimate could never have been genuine, as illogical as that would be.

  8. Jarrah says:

    I’m highly partial to the “costs are subjective” argument, because individuals are all different.

    However, to extrapolate that to the workings of a highly formalised, rational bureaucratic entity like a bank, without acknowledging that such an entity seeks to purge subjectivity from its cost-benefit analyses, is silly.

    Deciding the reasonable worth of a pianist’s finger, broken through someone’s negligence for which compensation is due, is difficult for courts. By comparison, deciding the reasonable cost of a very simple business transaction like a over-limit charge is straightforward.

  9. Driftforge says:

    This is stupid.

    The bank is charging exorbitantly more for delivering a lower level of service.

    For doing less.. they charge more.

  10. desipis says:

    What courts do is cost-accounting but that is something very different to evaluating the costs that people face when making choices.

    If the bank didn’t like the way the law of penalties determines the cost of the breach of contract, then they shouldn’t have structured their contract to invoke it in the first place. If they wanted a fee for service pricing model, then they should have written the contract create additional liability upon late payment and not included a legal obligation to pay on time.

  11. Pedro says:

    There was a reasonably recent Qld case where the LDs were struck out because the parties had clearly just made up a number. The High Ct was pretty clear though that quite a bit of lattitude would be allowed:

    “First, neither Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd[15] nor any other authority[16] supports the “proportionality” doctrine which the appellant advocated. The principles of law relating to penalties require only that the money stipulated to be paid on breach or the property stipulated to be transferred on breach will produce for the payee or transferee advantages significantly greater than the advantages which would flow from a genuine pre-estimate of damage. Among the different words which have been used to describe how extensive the difference must be before the transaction creates a penalty are the words employed by Mason and Wilson JJ in AMEV-UDC Finance Ltd v Austin[17] – a “degree of disproportion” sufficient to point to oppressiveness. But their Honours were not asserting any doctrine of the kind relied on by the appellant, which would rest on a disproportion between the innocent party’s commercial interests and the promise extracted to protect them. That type of idea underlies the law relating to contracts in restraint of trade, which recognises certain interests which it is legitimate for a covenantee to seek to protect by a covenant in restraint of the covenantor’s trade, so long as the covenant is not wider than is reasonably necessary to protect those interests[18]. Such an idea is not, however, part of the law relating to penalties. Mason and Wilson JJ initially made the point that an agreed sum should only be “characterized as a penalty if it is out of all proportion to damage likely to be suffered as a result of breach”[19]. Later their Honours referred to proportionality as follows[20]:
    “[E]quity and the common law have long maintained a supervisory jurisdiction, not to rewrite contracts imprudently made, but to relieve against provisions which are so unconscionable or oppressive that their nature is penal rather than compensatory. The test to be applied in drawing that distinction is one of degree and will depend on a number of circumstances, including (1) the degree of disproportion between the stipulated sum and the loss likely to be suffered by the plaintiff, a factor relevant to the oppressiveness of the term to the defendant, and (2) the nature of the relationship between the contracting parties, a factor relevant to the unconscionability of the plaintiff’s conduct in seeking to enforce the term. The courts should not, however, be too ready to find the requisite degree of disproportion lest they impinge on the parties’ freedom to settle for themselves the rights and liabilities following a breach of contract.” (emphasis added)
    Nothing in either passage supports the need to inquire into whether there is proportionality between the impugned provision and the legitimate commercial interests of the party relying on it.”

    and

    “Thirdly, consideration of the purpose of the law of penalties shows why this must be so. The law of contract normally upholds the freedom of parties, with no relevant disability, to agree upon the terms of their future relationships. As Mason and Wilson JJ observed in AMEV-UDC Finance Ltd v Austin[22]:
    “[T]here is much to be said for the view that the courts should return to … allowing parties to a contract greater latitude in determining what their rights and liabilities will be, so that an agreed sum is only characterized as a penalty if it is out of all proportion to damage likely to be suffered as a result of breach[23].”

    Exceptions from that freedom of contract require good reason to attract judicial intervention to set aside the bargains upon which parties of full capacity have agreed. That is why the law on penalties is, and is expressed to be, an exception from the general rule. It is why it is expressed in exceptional language. It explains why the propounded penalty must be judged “extravagant and unconscionable in amount”. It is not enough that it should be lacking in proportion. It must be “out of all proportion”. It would therefore be a reversal of longstanding authority to substitute a test expressed in terms of mere disproportionality.”

  12. Sleetmute says:

    If the plaintiffs win, I wonder what it would mean for airlines, hotels, theatres, sports venues, etc.

  13. Nick Ferrett says:

    The ones who must be really crapping themselves are the mobile phone carriers. Their penalties for early termination are the clearest case of a penalty in those sort of mass contracts I think.

  14. Cato the Elder says:

    I doubt it, NF. Early termination payout on a telco “plan” is in a different arena. They are certainly used as leverage and to secure “loyalty”; but they aren’t “clearly” penalties.

    What the telcos ask for is that the consumer pay out the balance of the contract, so that the telco gets the same cash payment and is put in the same position as if the contract had been performed. They lose the customer and any additional charges; but they get payment early – pretty much a wash.

    The obvious argument is that they consumer doesn’t get the service – but the consumer does get the handset. As an example, a straight purchase of an iPhone 4 from Apple is about $800. Yet you can get one on a “plan” from Telstra for an extra $21/month over 2 years = $504, a “saving” of $296. Consumers who sign up for this sort of plan know up front that it’s a “package” and they will have to pay out the balance if they depart early.

    Whether or not there should be a discount for the early payment is another issue; but with most contracts having a 2 year term the discount wouldn’t be much.

    There’s a clear argument that it’s a reasonable pre-estimate of loss and provides certainty for both sides, so it’s not in the the same league as a bank charging $30 for a transaction that really only takes $2 to process.

  15. . says:

    The ones who must be really crapping themselves are the mobile phone carriers. Their penalties for early termination are the clearest case of a penalty in those sort of mass contracts I think.

    My first ever mobile phone was a piece of shit Motorola pre paid through Telstra.

    Inside the box the documentation told me since I opened the box I was subject to the terms and conditions I was now reading, enclosed IN the box.

    No shit.

  16. JC says:

    …..so it’s not in the the same league as a bank charging $30 for a transaction that really only takes $2 to process.

    Yoy mean like an OD fee. With OD’s banls carry risk they may lose out in that the customer doesn’t replenish his account. There isn’t just the processing cost you have to take into account if you’re operating a bank.

  17. . says:

    Stuff like that justifies a bit of swearing in a formal letter of complaint, I believe.

  18. Andrew Reynolds says:

    JC,
    You are right there – but that risk is not worth anything near $28.
    I have seen the costings for two major banks.

  19. JC says:

    Inside the box the documentation told me since I opened the box I was subject to the terms and conditions I was now reading, enclosed IN the box.

    No shit.

    If you wanted to exit, Dot, you could make that as a valid claim against the Telco.

    People should simply do what I do, when it isn’t a bank. IF you get with with some sort of penalty, simply ignore the letter and throw in in the rubbish. Don’t even bother responding until the call and if they do, tell them it just isn’t going to happen.

  20. . says:

    Like I said JC, the “resident lawyers” don’t take solvency seriously.

  21. JC says:

    JC,
    You are right there – but that risk is not worth anything near $28.
    I have seen the costings for two major banks.

    There’s also cost of capital, Andrew. In other words OD becomes a regular business for banks on which they have to expend employee time and resources. The banks then begin to treat this like any other profit center because it really does legitimately become a business.

    If people want to see the impact of forcing banks to reduce fees, then look no further than what’s going on in the US with the impact of Dodd Frank and the various regulations that were introduced to fuck the banking system over there as punishment for the GFC by Congress.

    The banks were told to lower their paycheck loan fees by a material sum. The banks did their calcs on profitability impact and decided to exit the business as risk reward was no longer skewed their way.

    The law was supposed to help the very poor who don’t have bank accounts. Sounded good on paper at the time, right? Now they are forced to go to shadow finance firms and outright loan sharks in order to get their pay cashed.

    Another example… The US banks were regulated into materially lowering their E-payments fees as the geniuses that conceived Dodd Frank thought that the banks were making far too much money without really undergoing any serious study. They believed that in lowering these fees the consumer would get the the saving. They were wrong. The retailers are by and large pocketing the difference.

    Leave markets lone and stop whining.

  22. . says:

    WILL OCKENDEN: Sinclair Davidson says competition between the banks is what will bring fees down.

    Absolutely true monty.

    The question is if the court would allow banks to charge a fee that merely covers the risk of solvency vs something which discourages a risk factor of insolvency (as they currently do now).

    I accept though the current prices might exceed both of those and actually be past zero marginal returns. If you’re a day late, should you pay the whole fee or not?

  23. Gab says:

    Who will now decide how much the banks will charge for their services and costs now? And how will they work out the right amount to charge?

  24. Gab says:

    “how much the banks will should charge”

  25. JC says:

    …..because they’ve got the contractual power to do so and the market is not acting in a competitive fashion (partly because of information asymmetry).

    See, this where the problem creeps up on you and hits us straight in the face with a good dose of reality.

    Banks a regulated, highly so. The four pillars strategy is but one example.

    You end up with raising the barriers to entry bar for new players and in the end it always leads to more and more regulation becoming a tangled mess. Net result… everyone is pissed off.

    Do not regulate the banks anywhere near as highly as we do. Accept that some are going to fail and none are too big. Make certain that the playing field for new entrants wanting to participate in the market place is wide open and leave shit alone. The fees would take care of themselves in the end.

  26. Andrew Reynolds says:

    JC,
    I think that’s a touch OTT. Again – I know how much these things actually cost the banks, based on their ABC (activity based costing) analysis. These numbers are always fully loaded, including systems costs (the processing power needed and the cost of the actual computers doing it), analysis time and effort, capital loading, credit costs, everything.
    I can assure you, it is nowhere even remotely near the fees charged.
    I agree that we should let the markets work, but markets work on information and freedom. At the moment, we have a regulated oligopoly for the supply of banking services. Personally, I would be happy if that regulatory status was removed so that the market was allowed to work.
    ATM the market is not being allowed to work, again, through that regulation. Let’s either (or both) work to reduce these fees through information and disclosure and/or through deregulating the banking market.
    The first I see as a near-term realistic goal. The second will take longer.

  27. . says:

    I have a rough idea of how to become a retail ADI in Aus, calling your firm a “bank” requires more assets etc, but is there anything in particular which would stop entry from new firms?

  28. papachango says:

    But I don’t believe one party should always be allowed to stipulate what their losses are. It’s true that they know best, but it’s also true that they know that they can get away with asking for more than their losses (particularly where there’s a disparity of power between contracting parties, where there’s no opportunity to negotiate, where there’s an effective monopoly and/or where there’s information asymmetry).

    Understand your reasoning, but in the real commercial world, parties voluntarily enter into contracts and should make and assessment of risks and potential liabilities etc. There might be occasions where there’s a power imbalance and one party might put in excessive LDs, but a proper commercial view of a contract is that you need the other party’s goods and services, so sending them broke is counterproductive.

    You could use the same logic to argue that a powerful buyer or seller might set excessively low (if they’re the buyer) or high (if they’re the seller) fees for the goods or services. Do you advocate that the courts should intervene to determine whether general contract pricing is ‘reasonable’? I’ve had issues with suppliers who win the contract with a low price, then claim they’re making a loss. It never gioes to court – we either renegotiate, using the other market bids as a guide or terminate the agreement and award to another supplier.

    As it happens the common law has a similar view to mine.

    Yes but it’s easy enough to get around – see my post in the other thread about service level agreements.

  29. Pedro says:

    Umm, judging from the terms of my NAB accounts, the market is working to drive down those fees.

  30. Andrew Reynolds says:

    dot,
    The application process is long and very expensive, with no guarantee at all.
    Once there, you also have differential capital treatment between the big banks (the four plus Macquarie).
    The comparative advantage this gives the big four is pretty big.

  31. . says:

    The application process is long and very expensive, with no guarantee at all.

    So if you get knocked back, can you take it to the Federal Court or AAT?

  32. johanna says:

    It is ludicrous to talk about bank charges in Australia in the same breath as free market competition. Not only is banking regulated to the nth, it is supported (as seen during the GFC) by government.

    While I admire our host’s dedication to his principles, in the real world banks will not give up their protected status without a life and death struggle. Therefore, they have to cop the other side of the two-edged sword – pro-consumer regulation.

    It doesn’t matter so much with large and medium sized businesses, but small businesses and individuals can’t just choose another pizza shop. In practice, they are locked in.

    WRT mobile phone contract break fees, the government did intervene. The issue was that the break fees were the same whether you were one month into the contract or one month out of finishing the contract. Uncannily, all the companies had the same provision. I can’t recall the mechanism, but the government intervened to ensure that break fees reflected the length of the unexpired contract. Like banking, telecommunications is heavily regulated. Swings and roundabouts, guys.

  33. Penndragon says:

    Well done Sinclair, you have everyone burried in debates on detail. Other than that, your contribution shows why accountants and not economists are best equipped to work out suitable compensation.

    The bottom line is that if you want to punish people who breach contracts persuade the State to make it a crime. Commerce and markets do not work well if those involved are focussed on getting even and punishing each other rather than trading, making a profit and getting on with their lives.

  34. . says:

    Well done Sinclair, you have everyone burried in debates on detail. Other than that, your contribution shows why accountants and not economists are best equipped to work out suitable compensation.

    This is pretty insulting to accountants, and your comment is more appropriately aimed at lowly skilled bookkeepers.

    The bottom line is that if you want to punish people who breach contracts persuade the State to make it a crime

    There is no need for that. At best, the anti banking crowd have shown they overcharge, not that such charges shouldn’t exist.

  35. Penndragon says:

    “This is pretty insulting to accountants, and your comment is more appropriately aimed at lowly skilled bookkeepers.”

    I have worked with accountants in complex cases where losses have to be determined. It can require considerable skill, experience and judgement and a great deal of work.

    When I wrote this I thought I was paying them a compliment and was having trouble remembering when I last did! I apologise to any accountant who thinks an insult was in any way contemplated, let alone intended.

  36. . says:

    You don’t even consider that banks should price solvency or deterrence of non payment is justified as a regulated protected industry or as a free market, quasi public institution.

    I hope court cases are not decided by “judgment” of analysts. I want the courts to give commercial orders on analytical calculation, not mere opinion or guesses.

  37. Penndragon says:

    “You don’t even consider that banks should price solvency or deterrence of non payment is justified …”

    Solvency risk is a reasonable input to determining a fee but “deterrence” is back to crime and punishment again. Leave crime, punishment, deterence, revenge and such like out of commerce because it does not belong there.

  38. . says:

    Solvency risk is a reasonable input to determining a fee but “deterrence” is back to crime and punishment again

    You are aware that banks charge preferential rates depending on borrower quality, aren’t you?

  39. Penndragon says:

    Yes, they price according to commercial risk. There is nothing wrong with that in a free market, it is part of the competitive process.

  40. pete m says:

    If the banks are worried about the loss of capital they shouldn’t allow the account to go into OD in the first place.

    They have charged fees and penalties far in excess of actual cost and risk. Even the Reserve Bank had to step in on ATM fees and say enough.

  41. . says:

    Penalty fees do much the same thing, they are a disincentive for poor payment performance.

    So what you’re telling me is that it is inefficient and morally wrong if a borrower has a choice between high upfront rates and a penalty fee with a lower upfront rate (but the same implicit rate)?

    You’re encouraging the indiscriminate punishment of good borrowers with a poorly perceived credit risk who are trying to improve their credit rating and otherwise can get a good cheaply or take more profits home.

  42. Penndragon says:

    I am pointing out that I and the law want fees set according to normal commercial principles and not to be used to inflict a punishment or to gauge customers using an alleged infraction as justification.

    If banks set fees so that cross subsidisation occurs then that is either a chosen policy or bad price setting.

  43. . says:

    Clearly penalty fees are the norm, they are used in a variety of goods and services.

    You are not making sense to me.

    “normal commercial principles”

    “cross subsidisation is bad”

    The way to avoid this is to be able to price with the highest degree of discrimination possible to the lender and borrower. Eliminating penalty fees stops this.

    Tell me how they can do so otherwise.

  44. Penndragon says:

    Penalty fees are only common because the amounts are small and it is uneconomic to fight back. I have sweated over contracts where penalties are an issue and where larger sums are involved penalties are avoided like the plague.

    A joint venture agreement has to stike a balance between removing a failed party quickly and easily and avoiding confiscating their assets. The rule against penalties prevents the latter and makes sure the retiring venturer is not, in effect, robbed of assets. If the provisions amounted to a penalty the provisions would be unenforceable. This is the commercial norm and has been for hundreds of years. These fees are an aberration and amount to confiscating assets for breach of contract.

    Risks are determined early and locked in and adjusted with credit limits. Penalty fees are too little too late and if anything increase risk if loaded on to a customer in financial difficulty. Risk discrimination is not procured by $40 penalty fees. This is pure banker’s spin.

  45. Penndragon says:

    I suppose I can praise the banks because I have spent significant professional hours concerned by and avoiding the risk that the law relating to penlties presents in agreements. But every now and then, just as the frustration builds my bank hits me with a penalty and I am reminded to be patient and tollerant of this valuable principle and wish banks were more law abiding.

  46. cohenite says:

    Try liquidating “damages” in a pre-nup.

  47. Penndragon says:

    Look on the bright side Cohenite: if the banks win, it may be much easier, you may be able to insert whatever you want. You may be able to have a whole new section on penalties for breach. Perhaps fine partners for adultery, forgeting birthdays or anniversaries, or insulting mothers in law. The list could be endless!

  48. cohenite says:

    The list could be endless!

    And will be! Kama Sutra forever!

  49. Penndragon says:

    Just remember, you may have to call them fees or charges for exceeding agreed limits. Just so long as they do not have to be proportionate to the harm done.

  50. . says:

    Risks are determined early and locked in and adjusted with credit limits. Penalty fees are too little too late and if anything increase risk if loaded on to a customer in financial difficulty. Risk discrimination is not procured by $40 penalty fees. This is pure banker’s spin.

    This is just opinion and not what bankers think.

    Credit limits are not an example of incentivisation.

    You haven’t answered the question.

  51. Penndragon says:

    “This is just opinion and not what bankers think.”

    If you know what bankers think, then perhaps you are connected with one. Banks have their own lawyers, ask one. Incentivisation may be a move in the right direction if is not another name for seeking to punish customers.

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