Protecting your interests or punishing their breach? The penalty doctrine in contract
Loan contracts, mortgage contracts and finance facility agreements are often complicated documents that seek to juggle the competing interests of lender and borrower.
Discussion of finance agreements invariably leads to consideration of one of the most important factors when drafting mortgage contracts or loan facilities – the penalty doctrine. The recent New South Wales Supreme Court Case of Bellas v Powers [2023] NSWSC 1198 (Bellas) provides a useful example of when a contractual stipulation to pay a higher interest rate following an event of default will be treated as an unfair punishment for breaking the contract, and therefore be void and unenforceable as a penalty.
Background
The plaintiffs in these proceedings were Theo Bellas and Artos Espresso Pty Ltd (Artos). They were parties to a loan facility agreement dated 2 September 2021 (the Agreement) in which Artos was the Borrower and Mr Bellas was guarantor. The defendants, Tommy Wayne Powers and Rosemary Ann Powers, were the lenders (Lenders).
The parties entered into a short-term loan agreement whereby the plaintiffs could draw down from a $3 million facility and repayment of any amount drawn down plus interest would be repayable 2 months later.
The facts and the provision in dispute
The plaintiffs drew down $3 million. Two months later, they were in default by failing to repay the $3 million within 60 days of 1 September 2021.
Clause 5 provided for the calculation and payment of interest in the following terms:
5.1 Interest period
The Borrower shall pay to the Financier interest at the Standard Rate on the Termination Date provided that if no Event of Default has occurred or remains subsisting, then the Financier shall accept the payment of interest for the Term calculated at the Discounted Rate. Any difference between interest charged at the Standard Rate pursuant to clause 7.1 and the Interest Paid In Advance will be added to the Money Owing.
The Standard Rate was 9.75% per 30 days and the discounted rate was 1.75% per 30 days.
Accordingly, the Lenders were claiming a total debt of $7,803,142.59 which comprised the principal amount loaned plus interest accumulating at the Standard Rate from 1 September 2021 to 19 July 2023, less a repayment on 22 March 2022 of $2,948,211.14 from the proceeds of sale of a property owned by Mr Bellas, on which there was a registered mortgage securing the loan.
Given their obvious aversion to paying the Lenders $7.8 million, the plaintiffs approached the court seeking orders that the imposition of the Standard Rate was penal and unenforceable.
What is a penalty?
The Court said in Bellas that a contractual provision will be penal if “the provision for the payment of a sum of money on default is out of all proportion to the interests of the party which it is the purpose of the provision to protect.”[1]
The Court also observed that the question of whether a sum stipulated is a penalty, as opposed to liquidated damages, is a question of construction to be decided upon the terms and inherent circumstances of the contract, judged at the time of entering into the contract […] and a sum will be a penalty if it is extravagant and unconscionable in comparison to the greatest loss that could have followed, and if the sum stipulated is greater than the sum that ought to have been paid.[2]
The Lenders’ arguments
The Lenders submitted that the penalty doctrine had no application because the Standard and Discount Rate were both available alternatives during the term of the Agreement, and the real primary obligation under the Agreement was the payment of the Standard Rate, with the Discounted Rate being a secondary obligation that replaced the Standard Rate if they made payment on time.
The Lenders further submitted that the rate of 9.75% per 30 days was not extravagant, and that given the short-term nature of the loan, any argument regarding the annuitisation of the Standard Rate was an unfair exaggeration of the true burden faced by the Borrower and the Guarantor.
The Court’s decision
The court rejected the Lenders’ submissions and held that the terms of the Agreement which imposed the Standard Rate were a penalty. The Court reached this conclusion for the following reasons:
- the only interest suggested by the Lenders that needed to be protected was their interest as lenders to earn the greatest amount of interest on their loan funds that was sustainable in the market in which they operated;
- there was no evidence that suggested that their Standard Rate was reasonable in the short-term loans market, especially when secured by a mortgage over real property. In fact, the Court found that the Discounted Rate was more consistent with the market rate for short term secured loans of that amount; and
- the court considered the extreme disparity between the two interest rates. The Standard Rate would increase the Lenders’ recovery of funds far beyond their position had there been no event of default. It found that the increase in the interest rate by a factor of over 4 was exorbitant.
Key takeaways
The Penalty Doctrine balances the competing interests of upholding the principles of freedom and certainty of contract (particularly in commercial settings) and protecting parties from penal terms. For both lenders, who want to ensure all provisions of their standard form contracts are enforceable, and borrowers, who want certainty on what their liability may be when entering a loan contract, it is important to have certainty surrounding any potential penalty clauses.
This case provides a useful reminder of some of the factors the court will take into account when deciding when a clause will be penalty. Loans which are secured by real property and therefore involve less risk for a lender are treated differently than unsecured loans, where the court will often allow a higher interest rate due to the increased risk faced by a lender.
It is always necessary for lenders to consider any disparity between the standard interest rate payable or the interest rate payable after an event of default, as well as the proportionality and reasonableness of any increased interest rate payable after an event of default.
Queries
If you have any questions about this article, please get in touch with a key contact or any member of our Litigation & Dispute Resolution team.
Disclaimer
This information and the contents of this publication, current as at the date of publication, is general in nature to offer assistance to Cornwalls’ clients, prospective clients and stakeholders, and is for reference purposes only. It does not constitute legal or financial advice. If you are concerned about any topic covered, we recommend that you seek your own specific legal and financial advice before taking any action.
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[1] Paciocco v Australia and New Zealand Banking Group Ltd (2016) 90 ALJR 835 at [29].
[2] Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd [1915] AC 79, [86]-[87]