Default interest clauses: An explainer

What are default interest clauses?

Default interest clauses are terms in loan contracts that require the payment of a higher interest rate if the borrower defaults on their obligations under the loan agreement.

For example, in the case of Arab Bank Australia v Sayde Developments Pty Ltd (2016) 93 NSWLR 231 (Sayde), the loan agreement provided that if the borrower did not meet their minimum monthly repayment obligations, they would have to pay a further 2% interest on top of the regular interest rate on the loan.

Lenders can use these default interest clauses as a sort of deterrent, using the threat of the penalty of increased debt to encourage borrowers to comply with their obligations.

Why are they problematic?

However, this understanding of default interest clauses as a deterrent penalty has prevented their enforcement in the past.

English courts, such as the one in Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd [1915] AC 79, define penalty provisions as terms that focus on on using the threat and fear of a penalty. Accordingly, the clause does not aim to recover the potential losses that might arise out of a breach, but rather imposes an extravagant penalty.

Australian courts have elaborated on this principle in cases such as:

• Ringrow Pty Ltd v BP Australia Pty Ltd (2005) 224 CLR 656 (Ringrow)
• Andrews v Australia and New Zealand Banking Group Ltd (2012) 247 CLR 205 (Andrews)
• Paciocco v Australia and New Zealand Banking Group Ltd (2016) 258 CLR 525 (Paciocco)
• Sayde

Ringrow emphasised that the issue of penalties was not one of “mere disproportionality.” A penalty clause is not merely disproportionate, but “out of all proportion” in its extravagance. Likewise, Andrews emphasised the deterrent aspect of penalties. They are punishments that go beyond any calculable money compensation. Clauses are not penalties if there is no calculable compensation. Furthermore, Paciocco extended the scope of the “out of all proportion” requirement. Paciocco decided that a term is a penalty only if it is out of proportion with the interests that the lender is trying to protect. These interests can extend beyond direct compensation to other increased costs such as operational costs.

In summary, default interest clauses will be penalties where they are punishments that extravagantly go beyond the lender’s legitimate interests. Where a borrower proves that a term is a penalty, courts will refuse to enforce the clause. This, of course, includes default interest clauses.

When are they enforceable?

Accordingly, a default interest clause is enforceable if it is not a penalty, but instead bears a reasonable connection with the lender’s interests. Evidently, from the explanation above, merely drafting that a clause “is not a penalty” is not enough. Courts will consider the effect of the clause in light of the entire agreement at the date the contract was made.

For example, the default interest clause that raised the interest by 2% in Sayde was not a penalty as:

• it was not intended to punish
• 2% was not out of proportion with the interests of the lender

What should I do?

It should be clear that whether you intend on including a default interest clause or fighting a default interest clause, care is needed. As with most contractual disputes, outcomes depend heavily on each individual contract and situation. As always, consulting a contract lawyer earlier in the process can improve your chances of success.

Originally published by Lawpath