Charging default interest – contractual obligation or a penalty?
Lenders should proceed with caution and obtain specific legal advice for facilities which impose default interest for a failure to make prompt payment
The recent New South Wales District Court decision of Sayde Developments Pty Limited v Arab Bank Australia Limited provides a timely reminder of the importance of careful drafting for lenders who seek to charge their clients default interest on late payments.
Sayde Developments Pty Limited (Sayde) was a land development company, who had entered into three commercial loan facilities with Arab Bank Australia (Bank).
In the event of a default by Sayde, such as missing a monthly interest repayment, Sayde was charged 'penalty' interest of an additional two per cent per annum from and including the day repayment is due, excluding the day it is paid in full. The penalty interest was to be applied prospectively, from the date of the default, and not retrospectively.
In total, Sayde was charged $248,938.98 in penalty interest payments over the life of the loans.
Law of penalties - unconscionability
The court recognised the traditional approach to determining whether a sum charged will be a penalty, quoting Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co, which held the sum will be a penalty and therefore unlawful:
'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.'
In such cases, an examination is required to determine whether the greatest conceivable consequential loss was so disproportionate to the penalty imposed, as to amount to oppressiveness. If so, the imposition would be regarded as a penalty and therefore unlawful.
In this case, Sayde was charged penalty interest for a minor default being late payment of interest between one and 90 days and on a major default, being late payment exceeding 90 days.
The Bank conceded the greatest loss that could follow from a failure to pay by the due date was associated with a 'major default', but it did not necessarily follow that minor defaults imposed only minor losses to the Bank.
However, in this case the Bank failed to produce evidence of the actual costs involved in managing a minor default.
The Bank attempted to claim the costs of protocols to manage minor defaults by way of the involvement of relationship managers and internal reporting. However, the court found these were the 'costs of doing business as a bank', as it was required to do by the regulatory authority, and those costs would have been incurred regardless of any default.
Incentive vs penalty
The court agreed the law recognises a distinction between a clause which provides an incentive for prompt payment and a clause where the applicable rate of interest is increased upon failing to make a prompt payment.
It further recognised that provisions which operate prospectively when the increased interest rate applied only to outstanding payable amounts post the event of default is seen not as a punishment for default, if they constitute a genuine pre-estimate of compensation to the bank for late payment.
Ultimately the court considered the imposition of the penalty rate for a minor default was not a genuine pre-estimate of the loss which would be incurred by the Bank and awarded Sayde $352,302.00, plus costs.
Loan facilities and securities which apply a higher rate of interest, discounted upon the client making prompt payment will not generally be considered a penalty.
Lenders should proceed with caution and obtain specific legal advice for facilities which impose default interest for a failure to make prompt payment, against the traditional regime of charging higher rates of interest during each interest-period and then applying a discount to the lower rate, if the interest payment is received on or before the due date.
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