Enforceability of abatement regimes

The payment regime for a service-payment PPP often allows the government to abate or reduce the service payment by pre-agreed amounts if the services are not provided to the desired standard. These abatements are typically passed through to the SPV's contractors and are critical in aligning the contractor's commercial interests with the outcomes that government is seeking to achieve and driving appropriate contractor behaviour.

For many years, there has been a risk that abatement regimes could be declared to be unenforceable on the basis that they offend the legal rule against contractual penalties. This rule renders unenforceable any provision in a contract that seeks to punish a party for non-observance of a contractual stipulation. The rationale for the rule is grounded in public policy - the law of contract has no role in punishing wrongdoing. Rather, the purpose of contract law is to satisfy the expectations of the party entitled to performance.

This risk - that abatement regimes could be declared unenforceable - increased following the Australian High Court's 2012 decision in Andrews v Australian and New Zealand Banking Group Ltd, which extended the application of the rule to situations that don't involve a breach of contract. Doing so removed the ability of contract drafters to avoid the rule by drafting abatement regimes in a manner that avoided abatement triggers being a breach of the contract. The Andrews decision caused much speculation amongst legal commentators that PPP payment regimes would be unenforceable, as abatement amounts are often set at levels designed to inflict sufficient financial pain on the contractor to motivate improved performance, rather than to compensate government for the loss it can be expected to suffer as a result of the abatement event.

Fortunately, the Australian High Court has since adopted similar thinking to that expressed by the UK Supreme Court in Cavendish Square Holding BV v Makdessi, which allows contractual provisions to legitimately protect a broader range of interests than mere recovery of compensation for loss caused by the event triggering the abatement.

In Paciocco v Australia and New Zealand Banking Group Ltd, the Australian High Court adopted a similar approach to that taken by the UK Supreme Court to the 'tests' articulated by Lord Dunedin in Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd, by finding that these tests have come to be applied more rigidly and literally than was originally intended.

In particular, much was said about the 'test' that a stipulated amount "will be held to be a penalty if the sum stipulated for is extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved to have followed from the breach." The High Court found this test had come to be applied too rigidly. The reasoning was not unanimous, but most of the judges in the majority essentially suggested that the relevant question is whether the abatement is out of all proportion to the legitimate interests of the government that the abatement is designed to protect.

In the case of a PPP contract, the government agency's legitimate interests might include:

•  additional costs incurred by government or users of the infrastructure as a result of the event triggering the abatement;

•  loss of or delay in realising benefits for the community;

•  lost productivity in the economy generally; and

•  damage to reputation of the government.

Where the government's interests in contractual performance are intangible and difficult to quantify, as is often the case with PPP contracts, it makes no sense to limit the amount of the abatement to the loss that the relevant government agency can expect to suffer as a result of the abatement event. Indeed, difficulty in proving and quantifying loss makes it more reasonable for the parties to agree beforehand what the figure for damages should be in order to avoid the problem.