Unfair contract terms and small business: have you checked your contracts?

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1 Unfair contract terms and small business: have you checked your contracts? Andrea Beatty and Gabor Papdi, KEYPOINT LAW There has been a major change in the law affecting those that enter into standard form contracts with small businesses. The unfair contract term protections applicable to standard form consumer contracts now also apply to standard form small business contracts (with some exceptions). This has been a sleeper change that is catching the business world unaware. Below we discuss a recent Federal Court case 1 and the impacts on banks that did not react fast enough to changes in the law regarding contracts with small businesses. The Australian Competition and Consumer Commission (ACCC) has taken a successful prosecution in the Federal Court of Australia for breach of unfair contract terms legislation. This legislation is not well known by many businesses and this case shows the practical impact of this sleeper legislation. If a term is found by a court to be unfair, it is void. This means that it has no effect and the contract is treated as if it had never contained that term. It cannot be relied on by any party to the contract. This has the potential to significantly impact contracts. Servcorp case On 13 July 2018, the Federal Court of Australia (Markovic J) made declarations that certain terms of serviced office supply contracts that two subsidiaries of Servcorp Ltd (collectively, Servcorp) entered into with counterparties were unfair and therefore void under section 23 of the Australian Consumer Law. 2 This meant that the terms in the Servcorp contracts were ineffective from the time that those contracts were renewed. The Federal Court ordered Servcorp to establish and implement a compliance program to ensure future compliance with the Australian Consumer Law protections against unfair terms. Servcorp was also ordered to pay the ACCC s costs, fixed in the amount of $150,000. The declarations and orders were made with the consent of the parties. This means that the ACCC and Servcorp agreed a result and asked the court to ratify it. The court s published decision contains a helpful overview of past jurisprudence on the issue of unfair contact terms (mainly in the context of consumer contracts 3 ) and Markovic J s reasons for agreeing with the parties settlement that the terms in question were unfair. Alleged unfair contract terms the facts Servcorp supplies serviced office space and virtual office services to clients in occupying office suites in various locations around Australia. it entered into contracts with various small business customers that contained the following terms (impugned terms): 4 (a) (b) (c) unless Servcorp or the customer terminates the contract at the end of the initial term, the contract is renewed for another full term at a price determined by the Servcorp entity (automatic renewal clause) Servcorp will not be held responsible for loss, theft or damage to the customer s goods in the offices, however that damage may be caused (damage liability limitation clause) the customer will not make any claim in tort, contract or otherwise against Servcorp s landlord under the relevant head lease (landlord protection clause) 1

2 (d) (e) (f) (g) (h) (i) (j) Servcorp may change the fees/rates charged for services under the contract at any time (unilateral price variation clause) a notice is taken to have been served on Servcorp only if it has been sent to Servcorp and the customer has received a confirmation of receipt from Servcorp (notices clause) the contract is terminated immediately if, in the absolute discretion of Servcorp, the customer is carrying on any activity that is illegal or in breach of the head lease (illegal activities clause) Servcorp may terminate the contract at any time by giving at least one month s written notice to the customer (termination clause) if the customer fails to demand the refund of their security deposit within 360 days after termination of the contract, the security deposit is forfeited to Servcorp (forfeiture clause) Servcorp is not liable for theft of the goods from the office, damage to the office or loss or damage to data due to failure of information technology systems provided by Servcorp during the term of the contract and the customer is required to indemnify Servcorp against any such liability (indemnity clause), and if the customer at any time during or within two years of the termination or expiry of the contract entices or persuades any other customer of Servcorp to leave Servcorp and move to a competitor, the customer is liable to pay a USD 15,000 penalty to Servcorp in addition to Servcorp reserving a right to demand further payment for damages (penalty clause). Each contract in question was entered into before the commencement of the Australian Consumer Law unfair contract terms provisions but renewed after that time and therefore subject to section 23 of the Australian Consumer Law. Section 23 of the Australian Consumer Law applies only to standard form contracts. A standard form contract is a contract prepared entirely by one party and presented to another on a take it or leave it basis with no effective opportunity to negotiate the terms of the contract. Servcorp did not dispute that the contracts were standard form contracts. Whilst the impugned terms were prepared entirely by a subsidiary of Servcorp, the following terms of the contracts were negotiated between Servcorp and each relevant customer: 5 location of the office space length of the contract term, and upfront price payable. The fact that the length, location of the office space and upfront price items that define the main subject matter of the contract and upfront price and so are not subject to section 23 of the Australian Consumer Law were negotiated between Servcorp and the customer did not affect the contracts characterisation as standard form contracts. 6 Despite the above, the Federal Court did not disturb Servcorp s concession that the contracts were standard form contracts. A small business contract is defined in the Australian Consumer Law as a contract for the supply of good or services or the sale or grant of an interest in land where, at the time it was entered into: at least one party to it is a business that employs fewer than 20 persons, and the upfront price of the contract does not exceed $300,000 (or $1 million if the contract has a duration of more than 12 months). 7 It was not disputed by Servcorp that each contract in issue was a small business contract. 2

3 Why the impugned terms were unfair Section 24(1) of the Australian Consumer Law provides that a term is unfair if: (a) (b) (c) it would cause a significant imbalance in the parties rights and obligations arising under the contract it is not reasonably necessary to protect the legitimate interests of the party who would be advantaged by the term, and it would cause detriment to a party if it were to be applied or relied on. Each of the above criteria must be satisfied in order for a court to be able to declare a term to be unfair. Further, section 24(2) of the Australian Consumer Law provides that in considering whether a term is unfair under section 24(1), a court must take into account: (a) (b) the extent to which the terms is transparent, and the contract as a whole. Not reasonably necessary to protect a party s legitimate interests Servcorp did not dispute that the impugned terms were not reasonably necessary to protect its legitimate interests, thereby satisfying element (b) of unfairness. Significant imbalance in the parties rights and obligations Whether or not a term causes a significant imbalance in the parties rights and obligations under the contract requires consideration of the term together with the parties other rights and obligations under the contract. 8 A term will not cause a significant imbalance in rights if elsewhere in the contract a corresponding right is granted to the other party. Markovic J found that each of the impugned terms granted a right to Servcorp but did not create a corresponding right for the consumer (or impose an obligation on Servcorp) and so created a significant imbalance between the rights of Servcorp and the rights of the customers. Automatic renewal clause The automatic renewal clause caused a significant imbalance in the parties rights and obligations as it gave Servcorp the right to unilaterally vary the price payable under the contract for the renewed term, without imposing a corresponding obligation to notify the customer of any price increase prior to the expiry of the notice period (the customer could only terminate the contract within a small time period prior to the end of the term) during which they could terminate the contract. 9 In practice, this clause could result in the customer inadvertently missing the opportunity to terminate the contract and therefore remaining contracted to Servcorp for a full term at a higher price of which they were not made aware. Damage liability limitation clause The damage liability limitation clause caused a significant imbalance in the parties rights as it enabled Servcorp to escape liability in circumstances where it had caused the loss of, theft of or damage to goods held in the offices. Together with the indemnity clause (discussed below), it imposes further liabilities on the customer and limits their right to sue Servcorp. No corresponding right or benefit is given to the customer in return. 10 The landlord protection clause similarly caused a significant imbalance in rights as it restricted the customer s right to sue to enforce their rights without imposing a reciprocal restriction on Servcorp or the landlord. 11 Unilateral price variation clause The unilateral price variation clause allowed Servcorp to unilaterally vary the price payable for services under the contract without any need to notify the customer. It granted Servcorp an absolute discretion in setting prices, seemingly unrestricted by an obligation to act fairly or 3

4 reasonably. Although the contracts entitled the customer to terminate the contract on one month s written notice in response to a change in prices by Servcorp, the unilateral price variation clause was held in the context of the contract as a whole to cause a significant imbalance in the parties rights and obligations as it operated to leave the customer having to pay higher service charges without any opportunity to negotiate the price or receive any corresponding benefit. 12 Notices clause The notices clause provided that a notice required to be given by the customer was taken to have been served on Servcorp only when it has been sent and the customer has received a confirmation reply from Servcorp. On the other hand, the contract provided that a notice required to be given by Servcorp was taken to have been served on the customer if it was ed, delivered to the customer s office or posted to the customer s last known address (in which case it would be taken to have been served on the second working day after posting). This causes a significant imbalance in the parties rights and obligations as it is within Servcorp s power to determine whether and when a notice has been validly served on it. Servcorp could affect the timing of service of a notice by delaying giving a confirmation response to the customer. In practice, this means that Servcorp could determine whether or not the customer had exercised a termination right within the timeframe required by the customer. 13 Illegal activities clause The illegal activities clause in practice enabled Servcorp to summarily terminate the contract in circumstances where the customer s breach was not a material breach, the customer was not notified of or otherwise aware of the breach, the customer was not given an opportunity to remedy the breach or the customer had already remedied the breach. The absolute discretion element allows Servcorp to determine whether or not its right to summarily terminate has arisen. Further, Markovic J held that the illegal activities clause lacked transparency as to the nature and extent of the obligations under the clause, as it referred to laws and requirements required by the head lease, so that if the customer had not sought details of the relevant laws and requirements, it would not have been aware of them. 14 The illegal activities clause was therefore held to cause a significant imbalance in the parties rights and obligations under the contract. Termination clause The termination clause permits Servcorp to terminate the contract without cause or reason, and without compensating the customer for any loss, simply by giving at least one month s written notice. On the other hand, the contract granted the customer only very limited rights of termination. Therefore, it caused a significant imbalance in the parties rights and obligations under the contract. 15 It was noted that the termination clause is of the type contemplated by section 25(b) of the Australian Consumer Law, but that section 25 does not operate to deem particular terms to be unfair or to create any presumption of unfairness. 16 Forfeiture clause The forfeiture clause caused a significant imbalance in the parties rights and obligations under the contract as it allowed Servcorp to unilaterally acquire the customer s property, without granting any benefit to the customer or imposing any right (e.g. to notify the customer in advance of forfeiture) on Servcorp. The entire burden of obligations relating to the security deposit was borne by the customer; to pay a security deposit and to take steps to secure its repayment within 360 days of termination or expiry of the contract. 17 Indemnity clause The indemnity clause caused a significant imbalance in the parties rights and obligations under the contract for substantially the same reason as the damage liability limitation clause discussed above. It shifted substantially all of the risk of loss to the customer, creating an effective unlimited indemnity in favour of Servcorp, even when the loss is caused by Servcorp s conduct, without correspondingly limiting the customer s liability to Servcorp for its own conduct. 18 The only carve- 4

5 outs from the indemnity were losses caused by the gross negligence or wilful misconduct of Servcorp. Penalty clause The penalty clause imposed a substantial penalty on a customer if it persuaded any other customer to leave Servcorp in favour of a competitor or if it persuaded an affiliate of another customer to receive services from a competitor. The USD 15,000 penalty applied regardless of whether Servcorp suffered any loss or damage, and the clause permitted Servcorp to seek damages for actual damage that it may have suffered. As Servcorp has 24 office locations throughout Australia, it would be difficult for a customer to know if an entity is a customer of Servcorp at another location, or an affiliate of another customer of Servcorp. It therefore lacks transparency and was held to cause a substantial imbalance in the rights and obligations of the parties. 19 Detriment In this case, detriment appeared to flow naturally from the significant imbalance in the rights and obligations under the contract that the impugned terms caused. The detriment arises from the fact that the rights granted to Servcorp and obligations imposed on the customer would, if enforced by Servcorp, impose additional costs on the customer and require them to bear substantially more of the risks inherent in the contract. The compliance program In addition to declarations that the impugned terms are unfair and therefore void, the Federal Court ordered that Servcorp establish and implement a program for the purpose of ensuring compliance with the unfair contract terms provisions of the Australian Consumer Law. The terms and content of the program are to be agreed between Servcorp and the ACCC, though Servcorp will be responsible meeting the costs of the program. Servcorp was also ordered to procure that its subsidiary who drafts the base terms of the contracts, including any relevant employees and agents, participate in an administer the compliance program. 20 The order for the compliance program was made under section 23 of the Federal Court of Australia Act 1976 (Cth), which empowers the Federal Court to, in relation to matters in which it has jurisdiction make orders of such kinds as the Court thinks appropriate. Comments about the decision The decision in this case is both uncontroversial and unremarkable. 21 It applies the principles in past decisions concerning Part 2-3 of the Australian Consumer Law, notably Chrisco and Australian Competition and Consumer Commission v JJ Richards & Sons Pty Ltd. 22 At [15]-[22], Markovic J 23 provides a helpful summary of general principles derived from past decisions under Part 2-3 as well as similar Victorian and United Kingdom legislation. A number of the impugned terms in this case were materially the same as terms found to be unfair in JJ Richards. This decision illustrates and reinforces the concept of substantial imbalance in the rights and obligations of the parties under the contract one of the three elements of unfairness. 24 At its core, entering into a contract involves incurring obligations and/or granting rights in return for some form of consideration. A party may give an undivided consideration (e.g. the provision of a service) in return for a number of discrete and severable rights and obligations (e.g. an obligation to pay and an obligation to take certain actions one person s obligation is another person s right). However, for the purpose of assessing unfairness under the Australian Consumer Law, it is necessary to look at rights and obligations individually and ask whether the other party is also given the benefit of a substantial corresponding right or obligation, or something else substantial in exchange for bearing the burden of the term. This must be ascertained from the parties rights and obligations under the contract as a whole. It should not be possible to conclude from one term alone that it causes a substantial imbalance in the parties rights and obligations arising under the contract. 5

6 Note, however, that it does not follow that just because a term causes a significant imbalance in the parties rights and obligations under the contract, it will be unfair. Whilst this case shows that detriment readily flows from a significant imbalance in rights and obligations, a term will not be unfair if it protects a legitimate interest of the party advantaged by it. Though this decision was made under the Australian Consumer Law, it is equally applicable to unfair contract terms in contracts subject to the identical unfair contract terms regime in the Australian Securities and Investments Commission Act 2001 (Cth). 25 A number of the impugned terms in the Servcorp contracts can be readily translated to contracts for financial products and services such as automatic renewals, near-unlimited indemnities, unilateral price changes, unilateral termination rights, forfeitures and penalties. Where financial services are provided over a long period of time, such as credit, financial advice and asset management, it is necessary to ensure that contractual terms included to give the provider certainty as to income or flexibility to respond to future changes in circumstances do not exceed what is necessary to protect their legitimate commercial interests. Of perhaps more interest in this case was the basis on which the compliance program was ordered. In JJ Richards, the compliance program was ordered as a mandatory injunction under section 233 of the Australian Consumer Law. Section 232 empowers a court to grant an injunction in such terms as the considers appropriate if the court is satisfied that a person has or is proposing to engage in conduct that contravenes a relevant provision of the Australian Consumer Law. The compliance program ordered JJ Richards represents an expansive application of the statutory injunction power, being directed at minimising the risk of future contracts containing unfair terms, rather than merely preventing reliance on the terms that were declared to be unfair (which is the conduct enlivening the section 232 power 26 ). However, this ultimately did not matter in JJ Richards because the injunction was made by consent and so allowed by section 233 regardless of whether or not the court was satisfied that the elements in section 232 had been met. Nevertheless, by relying on section 23 of the Federal Court of Australia Act, Markovic J provided a more conceptually satisfactory basis for ordering Servcorp to establish and implement a compliance program directed towards preventing the inclusion of undeclared unfair contract terms in future contracts. This may be important where the regulator seeks similar orders in a contested case without the consent of the respondent. Conclusion Servcorp adds to the growing body of jurisprudence concerning the unfair contract terms regime in Part 2-3 of the Australian Consumer Law and provides a helpful demonstration of how to apply the concept of unfairness to contractual terms. As the impugned terms are terms that readily can and do appear in contracts for the provision of financial products or services, it is relevant to providers of financial services in case the Australian Securities and Investments Commission (ASIC) starts enforcing the corresponding provisions of the ASIC Act with similar vigour to the ACCC. It also sets out a conceptually satisfactory basis on which a court may order a respondent to establish and implement a broad compliance program. Banks small business loan contract terms While the ACCC has been vigorously enforcing the unfair contract terms provisions in the Australian Consumer Law through court proceedings, ASIC has been working with the Australian Small Business and Family Enterprise Ombudsman (ASBFEO) in conducting a review, writing a report and raising concerns with the major (i.e. big four) banks about potentially unfair contract terms in their small business loan contracts. 27 In its review of the major banks small business loan contract terms, ASIC found the following terms that it considered to be unfair: (a) entire agreement clauses that exclude liability for precontractual representations made by the bank or its agents 6

7 (b) (c) (d) (e) broad indemnity clauses that require customers to bear losses caused by the conduct of the bank, its employees, its agents or persons appointed by it (e.g. receivers who are appointed by the bank but notionally the agent of the customer) non-monetary default clauses, particularly material adverse change clauses that create events of default in circumstances outside the customer s control financial indicator covenants that create events of default for failure to meet certain financial ratios (e.g. loan to value ratio), and unilateral variation clauses allowing the bank to vary the terms of the contract without the agreement of the customer. In Report 565, ASIC states that the major banks have agreed to remove or reduce the scope of the above terms, in response to ASIC s concerns that they may be unfair. The major banks will also advise their small business customers of the changes via a number of channels readers may have noticed newspaper advertisements by banks setting out changes to their small business loan contract terms. Some of the abovementioned terms, such as broad indemnities and unilateral variation clauses, are substantially the same as terms found in JJ Richards and Servcorp to be unfair. Others, such as the entire agreement clauses, are unfair for the same reasons as the terms in Servcorp: they grant a substantial benefit to the bank without creating any corresponding right or obligation in favour of the customer and so cause a s they cause detriment to the customer by restricting their rights, imposing costs and/or imposing additional risks on them, and they are not reasonably necessary to protect the bank s legitimate interests. With respect to others, such as non-monetary default clauses and financial indicator covenants, ASIC and ASBFEO s opinion that the terms are unfair are less legally certain. Whilst such terms may, on the reasoning in Servcorp and predecessor cases under the Australian Consumer Law, cause a significant imbalance in the parties rights and obligations under the contract and operate to the detriment of the customer, it is not certain that they are not reasonably necessary to protect the banks legitimate interests. Non-monetary default clauses and financial indicator covenants are material to the level of credit risk that the bank is exposed to, and its corresponding regulatory capital requirements. It may therefore be the case that non-monetary default clauses and financial indicator covenants can continue to paly a role in small business lending, but with modified effect so that they do not result in acceleration of the loan and immediate repayment in all cases. This is a major legal change to small business lending. Author contact details: Andrea Beatty Consulting Principal Keypoint Law Level 25, Aurora Place 88 Phillip Street Sydney NSW 2000, Australia Phone: Direct: Mobile: andrea.beatty@keypointlaw.com.au Gabor Papdi Lawyer Keypoint Law Level 25, Aurora Place 7

8 88 Phillip Street Sydney NSW 2000, Australia Phone: Mobile: gabor.papdi@keypointlaw.com.au 1 Australian Competition and Consumer Commission v Servcorp Ltd [2018] FCA 1044 ( Servcorp ). 2 Schedule 2 to the Competition and Consumer Act 2010 (Cth). 3 The extension of the protections to small business contracts commenced in November 2016, so the only notable decision in a small business context is Australian Competition and Consumer Commission v JJ Richards & Sons Pty Ltd [2017] FCA 1224, which we refer to later in this article. 4 Servcorp [2018] FCA 1044, [33]. 5 Ibid [31]. 6 Ibid [37]. 7 Australian Consumer Law s 23 (4). 8 Servcorp [2018] FCA 1044, [20], citing Australian Competition and Consumer Commission v Chrisco Hampers Australia Ltd (2015) 239 FCR 33, [51] ( Chrisco ). 9 Servcorp [2018] FCA 1044, [39]-[40]. 10 Ibid [41]-[42]. 11 Ibid [43]. 12 Ibid [44]-[45]. 13 Ibid [46]. 14 Ibid [49]. 15 Ibid [51]. 16 Ibid [16], citing Chrisco (2015) 239 FCR 33, [44]. 17 Ibid [52]. 18 Ibid [53]-[54]. 19 Ibid [56]. 20 Ibid [59], [64]. 21 The author means that as a compliment Markovic J. 22 [2017] FCA 1224 ( JJ Richards ). 23 Citing Australian Competition and Consumer Commission v CLA Trading Pty Ltd [2016] FCA 377, [54]. 24 Australian Consumer Law s 24(1)(a). 25 See Australian Securities and Investments Commission Act 2001 (Cth) Pt 2 Div 2 Subdiv BA ( ASIC Act ). 26 Australian Consumer Law s 232(3). 27 ASIC, Report 565: Unfair contract terms and small business loans (2018) ( Report 565 ). 8