Default interest found not to be a penalty

What you need to know

• The New South Wales Court of Appeal has held that default interest payable under a commercial loan facility was not in that case a penalty: Arab Bank Australia Ltd v Sayde Developments Pty Ltd [2016] NSWCA 328.
• The default rate, payable when monthly payments were late, was 2% above the ordinary rate.
• The Court held that in view of the cost to the Bank of making provisions against impaired loans, the default interest could not be regarded as extravagant or unconscionable.
• Sackville AJA observed that the costs associated with penalty litigation add to the overall costs of borrowing and suggested that there may be a case for statutory law reform in this area.

The commercial loan facility

The borrower borrowed about $7 million under a commercial loan facility during the period 2008 to 2013, when the facility was repaid in full. The facility was an interest only facility and the terms of the facility required the borrower to pay interest monthly. Interest was charged on the principal of the loan at the rate specified in various letters of offer (offering, renewing and renegotiating the facility from time to time) and was also charged at a higher or default rate if, among other things, the monthly payments were not made on time. The default rate was 2% above the ordinary rate stipulated in the various letters of offer.

Over the course of the loan the borrower paid almost $249,000 in default interest. After repaying the loan, the borrower sued the Bank to recover the default interest, claiming it was a penalty. The District Court found that the default interest was a penalty, but this finding was overturned on appeal to the New South Wales Court of Appeal.

The Court applies the High Court's decision in Paciocco v ANZ

McDougall J, with Gleeson JA agreeing, applied the principles recently outlined by the High Court in Paciocco v Australia and New Zealand Banking Group Ltd [2016] HCA 28; (2016) 90 ALJR 835 (see "What is a penalty?" below).

In particular, McDougall J considered whether the default interest provisions were extravagant or out of all proportion to, or unconscionable in comparison with, the maximum amount of damage that might be anticipated to follow from the breach. His Honour emphasised the importance of assessing the likely consequences of default at the time the contract was made and not at the time of breach.

Provisioning costs are real costs

In this case, it was clear that if the borrower was late in making repayments, the Bank would be required under certain banking regulations to monitor the loan with a view to deciding whether it should be classed as "impaired". If so, the Bank would need to consider and, if appropriate, make provision in its financial statements for the possible loss.

McDougall J found that the costs of these provisions are real. The provisions are made either against current profits, in which case they reduce current profits and the likely dividends to shareholders, or against capital, in which case they reduce the total amount of shareholders' funds available.

Even though evidence of costs actually incurred necessarily looks at the matter at and after the time of breach, Gageler J in Paciocco noted that "evidence of the later occurrence of an event can be probative of the earlier probability of that event occurring". Here the evidence showed that the provisions against impaired loans averaged 5.45% of the total amount in default.

The precise quantum of these provisions could not be foreseen. Nonetheless, the actual amount of the provisions gave some indication that the stipulated default rate of 2% could not be regarded as extravagant or unconscionable. Viewing the matter prospectively, default might well lead to the need to make provision against bad or doubtful loans.

The fact that the Bank had other contractual means of satisfaction of the consequences of any default was not relevant: "why should the Bank be compelled to work through its range of contractual remedies, rather than rely upon the agreed contractual consequence of a default in payment"?

Should the law be reformed?

Sackville AJA agreed with the orders proposed by McDougall J, commenting that the present case is a very good example of a contractual arrangement that should not attract the penalty doctrine.

His Honour added that "the transaction costs associated with the penalty doctrine add to the overall costs of borrowing" and "there is at least an arguable case for re-evaluating the penalty doctrine". However, as the courts are ill-equipped to consider this policy issue, Sackville AJA considered that statutory law reform might hold more promise.