Court confirms life easier for default interest clauses post-Paciocco

In brief

A recent New South Wales Court of Appeal case considered the application of the penalties doctrine to default interest rate provisions in loan agreements following the High Court's liberal approach to the doctrine in Paciocco v ANZ. Senior Finance Counsel Diccon Loxton, Lawyer Hamish McCormack, and Law Clerk Ryan Abotomey report on Arab Bank Australia Ltd v Sayde Developments Pty Ltd [2016] NSWCA 328.

A brief snapshot on the law of penalties (by way of introduction)

The doctrine of penalties is one way common law (and equity) courts interfere with freedom of contract, by declining to enforce provisions they deem to be a penalty. Put very broadly, a penalty is a provision whose purpose is to deter a party from breaching requirements by punishing that party, rather than compensating the innocent party for its loss.

The classic statement of what constitutes a penalty was by Lord Dunedin in Dunlop.¹ It operates in terrorem. It is not a genuine pre-estimate of loss. It is to be judged as at the time of contract. He then set out some tests, including that in a penalty 'The sum stipulated was extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved to have followed from the breach'.

The doctrine has been explored in three recent High Court cases:

• Ringrow,² which emphasised the requirement that to be a penalty the amount charged must be extravagant and unconscionable and 'out of all proportion';
• Andrews v ANZ,³ which held the doctrine was not limited to breaches of contract; and
• Paciocco v ANZ,⁴ which upheld late payment fees on credit cards, applying the genuine pre-estimate and extravagance tests not just against the narrow direct costs incurred by the bank, but against broader central costs, and the legitimate commercial interests of the bank. It said the tests in Dunlop were statements of principle not rules.

The Court in Ringrow and particularly Paciocco can be seen as preferring freedom of contract. While the Andrews decision caused some consternation in expanding the scope of the doctrine, overall the High Court has made it significantly harder for clauses to be ruled penalties. Many more clauses will survive scrutiny.

Background to the decision

A corporate customer had a commercial loan facility agreement with a bank for an interest only loan. Under the agreement, if the customer was late in making monthly payments, then for so long as the default continued, default interest would accrue at a higher default interest rate on the entire principal, not just on the overdue amounts. This applied whether or not the bank accelerated repayment of the loan, and irrespective of the amount or how long it had been in default. The default interest rate was an additional 2 per cent above the regular interest rate.

It should be noted that this approach was different from the old 'higher rate/lower rate' approach – long upheld by the courts (so far) – of providing that interest would accrue at a 'higher rate' (equivalent to the default interest rate) but reduce to a 'concessional' lower rate (equivalent to the normal rate) so long as there was no default (though the substantive result may be the same).

The customer failed to make several monthly repayments on time and consequently paid a significant amount of default interest to the bank. The customer sued the bank, arguing that the default interest rate was a penalty, and that the customer was entitled to be repaid the default interest it had paid to the bank.

Between the first instance and appellate decisions, the High Court handed down its decision in Paciocco.

First instance decision – the default interest clause an unenforceable penalty

The customer was successful in arguing that the default interest rate was a penalty, and the court ordered that the bank repay the default interest paid by the customer. The default interest rate was not a genuine pre-estimate of the cost to the bank of the customer's failure to make monthly repayments on the due date. The trial judge distinguished between major and minor defaults, and said that in the particular case there had only been a minor default of the commercial loan facility. As a result, the greatest loss for such a minor breach would only be the loss of the use of that month's interest payment for the time that it remained unpaid. Consequently, charging 2 per cent on the whole of the loan outstanding could not conceivably be a genuine pre-estimate of the cost to the bank for the minor breach, and was extravagant and unconscionable.

Court of Appeal decision – the default interest clause OK

On appeal, the court held that the default interest rate was not a penalty. It was not extravagant or out of all proportion. The court made a number of points.

• The primary judge was incorrect in making a distinction between 'minor' and 'major' defaults. The loan agreement did not make any such distinction, nor did it treat late payments differently according to amount or duration, but gave the bank powers on any default, including to accelerate the loan. Whether a breach was minor or major could not be judged at the time of contract but only in retrospect, looking at the actual consequences. At the time the agreement was made, all that could be said was that default may have a number of consequences (which could include being required to monitor the loan, and decide whether to treat it as impaired and make provision for it).
• The presumption expressed in Dunlop that there is penalty if 'a single lump sum is made payable by way of compensation, on the occurrence of one or more or all of several events, some of which may occasion serious and others but trifling damage', is only a weak one.
• Costs of 'minor' defaults were not factored into the actual (non-default) interest rate.
• The costs of the default were not limited to opportunity costs. Costs of provisioning were real costs which could be foreseen at the time of the agreement.
• The actual amount of those provisions (which could normally be expected to exceed 5 per cent of the principal) gives some indication that the stipulated default rate of 2 per cent could not be regarded, even with the benefit of hindsight, as extravagant or unconscionable.
• An uplift in interest rate reflects the increased credit risk that a customer poses upon breach. Banks have a legitimate commercial interest in preventing increased credit risk, and default interest rates are a legitimate means of protecting this interest. Justice Macdougall quoted an English case,⁵ and Justice Keane's approval of the case in Paciocco. He said 'We have moved well beyond the days when judges lived in (real or pretended) ignorance of the facts of commercial life.' It should be noted that, unlike Paciocco, the court did not mention the need to set aside more regulatory capital for a higher risk (though Basel II was mentioned in cited expert evidence).
• The fact that the bank had other methods for satisfying the consequence of a default (including an indemnity) did not make the default interest rate a penalty. The doctrine of freedom of contract remains important. Commercial parties are free to agree on contractual terms as they see fit, and banks should not be compelled to rely on other contractual remedies where a default interest provision has been agreed upon.
• Following Paciocco the onus was on the customer to show there was a penalty. However, if the bank had pleaded that the default interest charge was a genuine pre-estimate of loss, that would be a separate issue on which the bank, the party asserting, would bear the onus of proof.
• The court did not need to decide whether punishment needed to be a sole or a dominant purpose, for there to be a penalty.

What it means for you – a wider range of acceptable default interest clauses, but how wide?

The doctrine of penalties has hung like a cloud over default interest provisions in loan documentation. Lawyers generally qualify their enforceability opinions in this respect.

There has been an increasing number of cases in which the courts have upheld relatively high default interest margins (within limits) for interest charged on overdue amounts. Even before Paciocco, this allowed growing confidence in relation to clauses like those seen in LMA and APLMA standard documents. Such clauses confine default interest to amounts which are due but unpaid, and usually apply default margins (often 2 per cent) well within the bounds upheld by the courts.

But that confidence has not in the past extended to provisions seen in some documents under which the interest rate on the entire principal steps up to a default interest rate on the occurrence of an 'event of default', which is normally widely defined to cover a list of events which include breaches of various kinds, insolvency, and various indicia of increased credit risk or reduction in the adequacy of the lender's recourse or security. This step-up applies whether or not the lender exercises its right to accelerate the loan and require immediate repayment of the entire principal.

The uncertainty as to such provisions related to their application in regard to events of default concerning breaches of the document and focused on the degree to which a borrower could suffer a very significant financial detriment whether the breach was major or insignificant. The High Court decision in Andrews may have extended that uncertainty in relation to events of default which were not strictly breaches.

This decision can be seen as alleviating that concern. It applied a commercial approach, it swept aside the distinction between major and minor breaches and it applied principles in Paciocco to look at the overall interests of the bank, and its general costs, and just not the specific operational costs arising from the breach, and to move from a formulaic application of the statements in Dunlop.

But the boundaries of the approach have not been tested. In particular:

• the court found a 2 per cent increase justified by the provisioning and credit risk considerations – a significantly higher rate may not find favour, and a court may be more inclined to find the amount which results from applying a higher rate to the principal to be extravagant for a breach which is not a payment breach;
• the interest rate uplift was limited to one type of breach, a failure to pay an instalment – the court's' attitude to a clause allowing uplift following breach of a range of other clauses, including say a delay in providing information, has not been tested – it may be harder to say the relative importance of breaches cannot be judged at the time of contract;
• it may not be as easy to point to a need for provisioning, impairment and credit risk reassessment for such other breaches; and
• though strictly the reasoning would apply to all types of party, and would apply equally to a retail or small business customer (as did Paciocco) the attitudes taken by the court in the case seemed to be influenced by the apparent sophistication of both parties. Perhaps questions of relevant sophistication and bargaining power may affect whether an impugned clause has the necessary unconscionability to be a penalty.

Of course, it is also important to remember that unfair contract terms legislation and statutory unconscionability still apply to facilities granted to individuals and small businesses by credit providers, and that the Australian Consumer Law and the National Credit Code should be considered when drafting credit contracts, when applicable.