Is a default interest rate a penalty?

In 2016, two important decisions were delivered which considered whether amounts charged in connection with the provision of finance were penalties. Late credit card payments were the focus of Paciocco v Australia and New Zealand Banking Group Ltd[1] (Paciocco). The article deals with the later decision of the New South Wales Court of Appeal in Arab Bank Australia Ltd v Sayde Developments Pty Ltd[2] (Sayde Developments). In that case, the court considered whether the imposition of a 2% “default interest rate” could amount to a penalty. For the reasons explored below, it was found not to be.

The decision in Sayde Developments clarified, albeit in a general sense, the legal position in relation to default interest rates. Importantly, it also illustrated the impact of the High Court’s observations in Paciocco, particularly those which eschewed the narrow view of the interests that may be legitimately protected by a stipulation in a contract for payment in an agreed amount. As explained below, this wider view should be expected to, except in the clearest cases, make the task of determining whether the provision sought to be impugned is extravagant or unconscionable in comparison with the damage likely to be suffered by the bank considerably more difficult.

Recent treatment of the penalties rule

In essence, a penalty operates as a punishment for non-performance of the terms of a contract. It does so by imposing an additional or different liability that is extravagant and unconscionable in comparison to the loss flowing from the breach.

The penalties rule has been considered in three (relatively) recent decisions of the High Court. In Ringrow Pty Ltd v BP Australia Pty Ltd; Ultimate Fuel Pty Ltd v BP Australia Pty Ltd; Nader-One Pty Ltd v BP Australia Pty Ltd,[3] the court confirmed that Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd[4] (and particularly Lord Dunedin’s speech) articulated the principles relevant to determining whether a provision of a contract was a penalty. Lord Dunedin’s remarks remain the touchstone of Australian courts’ analysis of the law of penalties.

In Andrews v Australia and New Zealand Banking Group Ltd,[5] the High Court confirmed equity’s jurisdiction in relation to penalties, and that relief was available in circumstances that extended beyond where a breach had occurred. This was regarded by some commentators as a “radical departure from the law as it had been commonly understood”.[6] The availability of relief in the absence of breach represents the major point of difference between the law in Australia and the United Kingdom, having recently been rejected by the Supreme Court of the United Kingdom in Cavendish Square Holding BV v Makdessi; ParkingEye Ltd v Beavis.[7]

The third decision of the High Court, Paciocco, confirmed (among other things) that one method of testing whether a provision of a contract is a penalty is to examine whether the stipulated amount is not merely disproportionate to the damage that might be expected to flow from the breach, but so out of proportion so as to be extravagant or unconscionable. Importantly, the relevant “damage” for the purposes of the analysis extends beyond that which is recoverable for breach of contract, and may include damage caused as a result of the impairment of other legitimate commercial interests intended to be protected. In particular, Keane J explored[8] the “multi-faceted” interest a bank has in the timely payment of its customers’ debts.

One such interest identified by Keane J was the maintenance or enhancement of the reward (a legitimate interest of the bank) for the assumption of the risk inherent in making a facility available to the customer. Second was the freedom, obtained by the timely repayment, to more profitably pursue the making of loans, unconstrained by the effect of defaulting customers on revenues. In Keane J’s opinion, this was not limited to the lost opportunity of re-investing the funds paid late, rather extend to a reduction in the cost of all of the bank’s facilities, and such lower costs would likely generate more business. These observations were particularly relevant to the discussion in Sayde Developments.

The facts in Sayde Developments

Arab Bank Australia Ltd (the Bank) and Sayde Developments Pty Ltd (Sayde) entered into a $6.825 million commercial loan facility, later increased to $7.05 million. The facility was “interest only” with interest payable monthly. The facility agreement provided that if those payments were not made on time, the applicable interest rate (the default rate) was increased by 2%. In the period of about 5 years concluding with the repayment of the loan in full, Sayde paid a total of $248,939 in default interest. Following repayment of the facility, Sayde sued the Bank for this amount.

The judge at first instance found the default interest to be a penalty and ordered that it be repaid. His Honour did so following receipt of expert evidence as to the likely costs that the Bank might be expected to incur in the event of default. This evidence established that the costs incurred by the Bank in respect of payments made greater than 90 days past due were likely to exceed those incurred where payment was made within that 90 day period. Such defaults were characterised by the primary judge (in reliance on Sayde’s expert) as “major” and “minor” respectively.

His Honour found that Sayde’s breaches were minor in that they involved payments made within 90 days past their due date. His Honour considered that the loss suffered as a result of those breaches resulted in, at their highest, the Bank’s loss of the use of the monthly interest payment, and the application of a further 2% on the whole of the amount owing could not conceivably amount to a genuine pre-estimate of the Bank’s loss. Conversely, the primary judge found that 2% would not have amounted to a penalty in respect of major breaches.

The Court of Appeal’s major criticism of that approach was that the consequences of the breach were examined as at, and after, the time of the default. The appropriate time to consider these matters was at the time of the contract. Moreover, the characterisation of breaches as major or minor was irrelevant and diverted the primary judge’s analysis to the wrong point in time.

The court referred to a number of consequences that may have been foreseen to have arisen in the event of a default. These included the possibility that costs would be incurred monitoring the loan with a view to determining whether it would be classed as “impaired” for the purposes of the Australian Prudential Regulation Authority Standard APS 220. The cost of the making of provisions against impaired loans was also identified. The court ultimately concluded that, while the precise costs of the provisions could not be foreseen, enough was known to conclude that the stipulated default rate of 2% could not be regarded as extravagant or unconscionable.

As Keane J did in Paciocco, the court made reference to the need to acknowledge the economic reality that the credit risk associated with the defaulting customer is greater. The court adopted Keane J’s observations in Paciocco[9] to the effect that the common law had now accepted the cost to the bank’s revenue associated with the greater financial risks assumed by the bank by reason of late payments by customers.

Conclusion

While there will naturally be a point at which a default rate becomes penal, it may be concluded from the decision in Sayde Developments that default rates are not penal per se, and a default rate in the vicinity of 2% is unlikely to be considered a penalty. As the decisions in Sayde Developments and Paciocco demonstrate, ascertaining the point at which a default rate becomes penal will be a difficult and costly exercise for litigants. It will require, as a first step, attempting via expert evidence to quantify the value of the full range of the bank’s interests protected by the provision sought to be impugned. In Sayde Developments (and Paciocco) the parties’ expert evidence did not adequately address these matters.

The value of a bank’s interest in (for example) the maintenance or enhancement of the reward for the assumption of the risk involved in making a facility available to the customer will be difficult to quantify with any precision. The same can be said for a bank’s interest in the increased profits that might be expected to flow from maintaining a loan book free from defaulting customers.

Even once a meaningful estimate of the value of the bank’s legitimate interests is arrived at, ascertaining whether the relevant provision is a penalty will involve the making of a value judgment as to whether a stipulated payment not just exceeds this amount, but is out of all proportion with it so as to be exorbitant or unconscionable. As a result, the outcome of penalties cases (especially involving bank fees and charges) will remain difficult to predict.