One issue that often comes up in a dispute concerning a loan agreement is whether certain fees, such as termination fees, or establishment fees, have to be paid at settlement. Depending on the circumstances, such a fee may be a penalty, and therefore cannot be enforced by the lender against the borrower.
What is a penalty?
There is nothing wrong with a loan agreement, or any contract, specifying a sum that is payable upon a specific event occurring, such as a breach of the contract. These clauses are commonly described as “liquidated damages” clauses.
The test of when a liquidated damages clause becomes a penalty, and therefore unenforceable, was settled by the High Court of Australia in Paciocco v Australian and New Zealand Banking Group (2016) 258 CLR 525. In essence, a clause will be a penalty if it requires one party to pay the other an amount that is “extravagant” or “unconscionable” and out of all proportion to the legitimate interests of the party receiving the sum. That is, the amount specified by the contract must be a “genuine pre-estimate” of the loss that the party will suffer.
When it comes to determining whether a clause is unenforceable as a penalty the usual rules limiting the admissibility of evidence about surrounding circumstances, arising out of Codelfa Construction v State Rail Authority (NSW) (1982) 149 CLR 525, do not apply. The Court is free to go beyond the actual words of the clause to determine whether, objectively, the clause is a penalty. It does not matter how the parties describe the clause, what matters is its effect in substance.
The question then arises – can fees in a loan agreement, such as termination or establishment fees, be penalties?
Loan agreements in the spotlight
This issue was recently considered by the Victorian Court of Appeal in Melbourne Linh Son Buddhist Society v Gippsreal Ltd  VSCA 161. In this case, the Buddhist Society intended to borrow a sum of $1,775,000. The loan agreement contained a “loan establishment fee” of 1.5%, which amounted to $26,625.
The parties subsequently agreed to reduce the borrowed amount to $500,000, however the loan establishment fee was not reduced to reflect the lower amount, meaning that it amounted to 5.3% of the amended facility. The lender’s deed of offer did not continue to settlement as the Buddhist Society failed to settle the loan on time. The lender withdrew its offer of finance, terminated the loan, and claimed liquidated damages, which included the establishment fee.
The Court of Appeal ultimately held that the lender was not entitled to withdraw the offer of finance and claim liquidated damages, but in any event they considered whether the loan establishment fee was a penalty.
It was submitted to the Court of Appeal that the figure of 1.5% of the initial loan facility was:
“in the circumstances, a random, wildly disproportionate and excessive figure.”
The plurality of Kyrou JA and Cameron AJA, forming the majority of the Court of Appeal, found that the clause was, in the circumstances, a penalty as the figure
“bears no relation to any possible damage to or interest of the respondent arising from the putative breach of the Deed of Offer by the applicant and it is not commensurate with any legitimate commercial interest of the respondent which is sought to be protected by that deed in the event of its breach.”
On the issue as to why the establish fee remained constant after the change in the facility amount, the Court found that the amount remained unchanged not because of any calculation of loss, but rather because of the additional administrative work the lender had to perform due to the changes in the proposed loan.
The Court noted that this administrative work was done prior to the breach, and accordingly could not possibly be a pre-estimate of loss as a result of the breach. The Court also found that there was no way to quantify the costs of the additional administrative work as there was no item by item correlation between the fee and the work performed. Therefore, it was an “irresistible inference” that the fee was retained in order to punish the borrower for the inconvenience caused by the changes.
The borrower also sought to justify the figure on the basis of the level of risk associated with the loan. The Court rejected this and stated that while risk might be relevant for setting the lender’s “price” for the transaction, it does not go to quantifying the loss of a breach.
Finally, the Court also found that the fact that the amount was fixed and agreed between the parties had no bearing on the question of whether the amount is a penalty. It is the Court’s role, not the borrower’s, to determine whether an amount is a penalty.
Take home message
It is clear that various fees included in loan agreements may well be unenforceable as they are, at law, a penalty. Courts will look at all of the surrounding circumstances to determine what the purpose of the clause is. If the fee is proportionate and for the purposes of recovering a loss, then it will likely be enforceable. However, if the purpose of the clause is simply to punish a party for a breach, and there is no way of quantifying the amount calculated, then it is likely the clause is a penalty.
Regardless, if a borrower intends to resist such fees in a loan agreement, it is essential to seek timely legal advice. Simply refusing to settle the loan in time, including any fees, may result in a breach of the contract which may result in damages to the lender.