Can a default interest clause be a penalty?

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In Sayde Developments Pty Ltd v Arab Bank of Australia Ltd [2016] NSWDC 76  the NSW District Court found that a default interest clause amounted to a penalty and awarded an amount of $248,939 to Sayde Developments Pty Ltd (Sayde) in respect of interest paid to the Arab Bank of Australia (the Bank). However, on appeal the NSW Court of Appeal overturned the District Court decision and found that the default interest clause was not a penalty.

Facts

  • Sayde entered into a “commercial loan facility” with the Bank for a loan of ultimately $7.05 million on a interest only basis;
  • The contract required Sayde to pay interest on a monthly basis and provided for default interest at a higher rate if Sayde was late or missed any of the monthly payments ;
  • During the course of the relationship Sayde paid an amount of $248,939 in default interest. After repayment of the facility Sayde sued the bank and argued that the default interest clause is a penalty and therefore unenforceable.
  • The District Court in NSW gave judgment in Sayde’s favour, but the decision was overturned on Appeal.

When is a provision a penalty?

Justice McDougall in the Court of Appeal provided the following summary of the applicable principles taken from the recent High Court decision of Paciocco v ANZ Banking Group Ltd [2016] HCA 28 in relation to current law in Australia when it come to penalties:

  • The often cited speech by Lord Dunedin in Dunlop concerning penalties are not “rules of law” but “distillations of principle”;
  • In essence a penalty is a collateral stipulation with the purpose to punish the offender and thereby compel performance;
  • One way of testing whether the relevant provision is penal, is to consider whether the specified sum is extravagant, out of all proportion to, or unconscionable in comparison with, the maximum amount of damage that might be anticipated to follow the breach;
  • Damage is not limited to damage recoverable on breach of the contract, but may extend to damage or losses caused by harm to other legitimate interests which the provision was designed to protect;
  • All the relevant issues should be considered as at the time of entering into the contract and not at the time of breach of the contract. The analysis should be made prospective, not retrospectively;
  •  Finally the mere disproportion between the stipulated amount and the possible damage is not sufficient to render the provision a penalty.  The extent of disproportion must be such that it is unconscionable for the lender to rely on the stipulation.
  • The onus of proof is always on the party who asserts the relevant stipulation is a penalty;
  • The presumption that a stipulation may be a penalty when a “single lump sum” is payable on the occurrence of one or more or all of various events is only “a weak one”.

Conclusion

The Court of Appeal found that the Court at first instance erred by accepting Sayde’s expert evidence that there was a significant distinction between “minor “ and “major defaults”, because there was no such distinction made at the time of entering into the contract.  The stipulated default interest rate of 2% was also not extravagant or unconscionable.

After the High Court decision of Paciocco it seems that it will be more difficult in future to convince our Courts that any stipulation for default interest in lending agreements should be unenforceable because it is a penalty.

For more information regarding default interest

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