Here the court considered whether an interest provision was void as a penalty. The issues before the court arose from a commercial mortgage backed securitisation transaction, but the court took the opportunity to restate the principles which apply when interpreting or implying terms where something is missing from the express drafting.  The decision provides some useful additional commentary on the penalty doctrine following the recent case of Cavendish Square Holdings v Makdessi. To read more about this decision, please click here.

The dispute arose from use of complex financial instruments.  In addition to 'Regular Notes' issued to investors, which paid interest at a floating rate of three month EURIBOR, plus a margin, there were 'Class X Notes'.  These latter instruments were designed to pay out to the holder the excess interest, if any, which was expected to arise in the hands of the issuer from the underlying commercial mortgage loans in the relevant interest period, over and above the amounts that the issuer was obliged to pay in respect of certain fees and costs and the amount of interest payable on the Regular Notes.

Issues arose concerning the amount payable under the Class X Notes, and in particular the definitions of Junior Rate and Senior Rate used in the intercreditor agreement. The claimants contended that the definitions required correction by inserting some additional drafting. A further issue was whether any outstanding Class X payments accrued interest at the Class X interest rate (which at times exceeded 5,000% per quarter). The judge found that no additional wording was required, and in doing so noted that he did not consider that the absence of the proposed additional wording was the result of an oversight or mistake. Furthermore, the wording did not precisely address the alleged problem. This meant there had been no historic underpayment of Class X interest.

In view of the judge's conclusion that there had been no underpayment, the issue as to whether any unpaid interest amounts themselves accrued interest at the Class X interest rate did not arise for determination, but at the parties' request Snowden J expressed an obiter view on the point.  After referring to Makdessi, the judge acknowledged that in the present case, it was common ground as between the parties that any interpretation of the relevant term which provided for interest at the Class X rate in the event of an underpayment of Class X interest could be regarded as a breach of a secondary obligation, thus engaging the penalty doctrine. The judge did not think this was necessarily correct, but was inclined to accept the penalty argument; the imposition of the Class X interest rates for breach in failing to make payment of a sum due would be regarded as exorbitant (if not extortionate).

Whether a clause was a penalty cannot depend upon the ability of the particular contract-breaker to pay the specified amount, or the source from which he has to pay. An innocent party cannot save a clause from being a penalty by claiming that the contract-breaker is so rich he will not notice the disproportion.

To read more, please click here.