Overview

The New South Wales Court of Appeal in Arab Bank Australia v Sayde Developments Pty Ltd [2016] NSWCA 328 held that a 2% default interest rate was not a penalty in the context of a facility agreement. The Court said the amount claimed as default interest was justified as a genuine pre-estimate of loss. The costs taken into account were real and foreseeable at the time the contracts were entered into. In determining that the default interest rate was not a penalty the Court adopted the commercial approach taken in the recent High Court decision in Paciocco v Australia and New Zealand Banking Group Ltd [2016] HCA 28 which affirmed ANZ’s right to charge late payment fees in relation to credit card transactions. In upholding the default interest clause by reference to evidence as to the bank’s costs arising on default, the latest decision has provided greater certainty for lenders and utility companies seeking to charge default interest.

Background

Sayde entered into an interest only commercial loan facility agreement with ABA. The relevant provision provided for interest to be payable at a default rate of 2% on the whole amount if monthly interest payments were not made on time. The 2% on top of the normal interest rate was to be paid regardless of the amount or length of breach. Sayde paid a substantial amount of money as default interest ($248,939) over the term of the loan. Having repaid the whole loan, Sayde then commenced proceedings claiming that the total amount of default interest paid was a penalty. The District court held that the default interest was indeed a penalty and the bank appealed to the NSW Court of Appeal.

Issues

In resolving this issue, the Appeal Court identified the following issues:

  • Was the amount paid as default interest out of all proportion compared to the greatest conceivable loss suffered by the bank because of the delayed payment so as to amount to a penalty?
  • Did the primary judge err by considering circumstances that arose only upon and after default?
  • Did the primary judge err by relying on a distinction drawn by Sayde’s expert between ‘major’ and ‘minor’ defaults?

What did the court say?

  • The Appeal Court held that the default interest provision was not a penalty in the sense of aiming to punish the borrower. This was because the stipulated default rate of 2% could not be regarded as extravagant or unconscionable. It was not out of all proportion compared to the maximum conceivable loss.
  • The primary judge was incorrect in determining that the clause was penal by accepting a distinction between minor defaults (the borrower had argued that the breach was minor and as a consequence the default interest clause was penal) and major defaults (in which case the evidence was that the clause was not penal) and in considering the question upon and after the date of breach, not when the parties entered into the facility agreement.
  • However, evidence of the actual costs incurred by the bank on default can be of assistance in determining whether the clause was penal as at the date of contract formation.
  • The bank incurred provisioning costs against impaired loans from the period of 2008-2014 averaged to 5.45% of the total amount in default. These costs were real and made either against current profits (in which case they reduced current profits, and the likely dividends to shareholders) or against capital (in which case they reduced the total amount of shareholders’ funds available).
  • Where there is evidence, the characterisation of a clause as penal should be assessed by reference to that evidence.
  • On a borrower’s default, banks do not need to work their way through the contractual remedies available. They may rely on the agreed contractual consequences of a default in payment.

How does this affect you?

  • Provisions that aim to recover legitimate business costs that are not out of all proportion to the interest that it is intended to protect will not be a penalty.
  • The courts will take a commercial approach in assessing similar default interest clauses. The costs that may be considered include both direct and indirect costs. These include, but are not limited to:
    1. capital adequacy costs;
    2. regulatory costs (compliance with Australian Prudential Standards, Basel II);
    3. recovery costs;
    4. provisioning costs;
    5. reserve costs; and
    6. head office and labour costs.
  • Freedom of contract ensures that organisations need not rely on contractual remedies. Terms agreed upon by commercial parties will be given effect. This provides lenders and service providers more commercial certainty in the law.
  • Default interest provisions as agreed between the parties will apply even though a bank may have other ways to recover the costs, unless the amount claimed is out of all proportion.
  • Commercial contracts involving parties with equal bargaining powers who are well advised are unlikely to attract the penalties doctrine.
  • The language used by the court suggests the sophistication and commercial savviness of the parties will be taken into account. This may have some influence in future decisions, if the bargaining powers are unequal.

However, although not argued in the instant case, it is important to note that in certain circumstances the unfair contract terms provisions in the ASIC Act may apply to loans provided by a bank and any default interest clauses in those loans.

Expert evidence

The person asserting that a clause is penal carries the onus of proof in establishing the claim. Importantly, much depends on the expert evidence presented to the court and the court’s acceptance or rejection of that evidence. In this case, the claimant failed to discharge this onus as seen in the table below.

Evidence John Fairley (Sayde’s expert) Bruce Auty (Bank’s expert) Court's view

Main costs of default include:

• Capital adequacy costs;

• Provisioning and reserve costs; and

• Head office and labour costs.

Agreed Agreed Agreed
Is there a distinction between minor and major defaults? Yes No - Irrelevant No, that distinction finds no basis in the contractual documents
Should the cost of defaulting loans be measured against the whole book or just the defaulting book? Considered that the cost should be measured against the whole book Considered that this distinction was not relevant Not expressly addressed but implicitly rejected
Is there a practical distinction between loans less than 90 days past due and loans more than 90 days past due? Yes – categorised into major and minor Did not accept that this was a relevant categorisation Not a relevant categorisation
Do banks factor in risk of default into price of loans? Yes – Fairley contended that “minor” defaults were incorporated into the interest rate Yes – but did not accept that “minor” defaults were incorporated. In his view, even for a “minor” default, costs would vary considerably depending on the circumstances. Court implicitly accepted the bank’s expert evidence
Did the bank factor into the interest rate additional costs incurred as a result of a minor breach? Yes No No