In what will be further good news for lenders, the NSW Court of Appeal has recently held that the application of a 2% default interest margin under a loan contract is not a penalty.
In overturning the decision of the District Court below, the Court of Appeal has followed and applied the principles recently established by the High Court in this area.
In October 2008, the Bank provided a commercial loan to a property developer, Sayde Developments Pty Ltd, for AU$6,825,000.00 to purchase land at Liverpool for development.
The facility was extended and renegotiated a number of times, until it was repaid in full in 2013.
At numerous stages during the facility, the Borrower was late in making monthly repayments.
It was a term of the facility that on default the Bank could charge higher interest on the full loan balance, being a margin of an additional 2%.
During the period from October 2008 to August 2013, the Borrower paid the Bank a total of AU$248,939.00 as default interest.
Once the facility had been repaid, the Borrower sued the Bank claiming that the default interest it had paid was a penalty and therefore ought to be paid back by the Bank.
Initially, the District Court gave judgment in favour of the Borrower and found that the higher interest rate of 2% was a penalty.
The Bank appealed.
Minor v Major Defaults
In reaching its judgment, the District Court had drawn a distinction between:
- ’minor’ defaults, where repayments were overdue for less than 90 days; and
- ’major’ defaults, where repayments were overdue for more than 90 days.
All of the Borrower’s defaults had been in the nature of ’minor’ defaults.
The Court of Appeal was critical of the District Court having drawn this distinction.
It found the distinction was irrelevant and erroneous, and diverted analysis to the wrong point in time—namely after the breach occurred, rather than at the time of entering the contract.
The Court of Appeal observed that any default by the Borrower could have a number of consequences. For example:
- the Bank may decide not to take action, other than imposing the default interest charge;
- the Bank may issue notices of default, where consequences of the default not being rectified may include having the whole facility amount become due and payable;
- if the Bank did not take any action it would nonetheless be required to monitor the loan, with a view to deciding whether it should be classed as ’impaired’ for the purposes of the APRA’s Prudential Standard APS 220; and
- if it had been established that the facility was ’impaired’ in accordance with APS 220 the Bank would then need to consider and, if appropriate, make provision in its financial statements for the possible loss.
The Court accepted that APS 220 applied in this regard and that this may require the Bank to take certain actions in respect of any payment default, including raising provisions.
The fact that an individual default might not require a provision to be raised was irrelevant. This was something that could only be known after the default occurred, and not at the time of entering into the loan agreement. This was a crucial factor in the case and for the law of penalties.
Default Interest rate provisions binding on Borrower
On appeal the Borrower argued that there were other provisions in the loan contract available to the Bank to recover costs associated with the Borrower’s default, which obviated the Bank's requirement to charge default interest, including:
- the ability to charge ’arrears letter’ fees;
- the right to reprice the loan; and
- the power to require additional security.
In response the Court of Appeal considered the loan contract in this case was made between commercial parties who, it may be assumed, were capable of understanding and protecting their respective interests.
The parties chose to provide for a default interest regime, and chose to make the Bank's various rights on default discretionary. The parties did not stipulate for any requirement that the Bank have recourse to other rights before the default interest rate could be applied.
Default rate not extravagant or unconscionable
The Bank’s evidence identified, among other costs incurred by the Bank, the cost of provisions against impaired loans to be approximately 5.45% of the total amount in default.
The Court of Appeal noted that the Borrower's expert evidence itself supported the proposition that provisioning costs were real costs that could be attributed to payment defaults.
In this context, the Court of Appeal found that the Bank's default interest rate charge of 2% was not extravagant or unconscionable.
This is a good decision for all lenders.
It upholds a lender's entitlement to charge a higher or default interest rate when a Borrower defaults in payment, irrespective of the significance of the monetary default.
The rate of 2% in question in the case was consistent with a range of other judgments in various jurisdictions in Australia and overseas, which accept the ability of lenders to charge a reasonable margin to take account of the increased risks and costs associated with defaults.
The judgment sends a strong message that borrowers, particularly in commercial lending transactions, will be bound by the contractual arrangement.
The Court noted that it is not clear whether the result will be to increase or decrease the extent to which the penalty doctrine is invoked.
However, lenders can take comfort from the fact that a 2% higher interest rate will not be a penalty having regard to the costs and possible consequences of managing default loans in similar circumstances to those present in the Arab Bank case.