Extravagant? Out of proportion? It’s likely to be a penalty. NSW Supreme Court reiterates principles delineating between enforceable payments upon default and penalties.

Bellas v Powers [2023] NSWSC 1198 serves as a reminder that clauses purporting to make fees payable upon default need to be carefully considered to ensure they do not fall foul of the principles set out in the Penalties Doctrine.

In this matter, a borrower defaulted under a private Facility Agreement, resulting in the borrower being liable for a higher standard rate equivalent to 118.6% per annum, being 550% of the lower discounted rate of 21.3% per annum. If this interest was not paid by the borrower, the standard rate was capitalised monthly, allowing interest to accrue at an effective rate of approximately 200% per annum over the first year, and at a rate greater than 600% in the second year, increasing exponentially. The borrower sought a declaration from the Court that the clauses imposing the higher rate were void and unenforceable as a penalty. In finding that the higher rate did amount to a penalty, the Court reiterated several principles of the Penalties Doctrine, including:

1. the Penalties Doctrine is enlivened where a stipulated sum becomes payable on breach of contract where that sum is out of all proportion to the interests protected by the clause that was breached;
2. a sum payable upon a party’s default must be a genuine pre-estimate of loss, and must not be extravagant to, or out of all proportion with, the maximum amount of damage that might flow from the default;
3. the Penalties Doctrine can also be enlivened in circumstances where the contract requires payment upon an event of default that does not amount to a breach of contract; and
4. there is a (weak) presumption in favour of a penalty existing where a lump sum is made payable by way of compensation on the occurrence of one or more or several events, some of which may cause serious loss, but others causing trivial or no loss at all.

The Court usefully noted that whilst the onus of proof is initially on the plaintiff to prove a provision is a penalty, it will often then fall on the defendant to lead evidence that the sum payable is commensurate with its loss, especially in rebutting the presumption referred to at (4) above.

In this matter, the Court found that the financiers failed to demonstrate that the higher interest rate incorporated a genuine pre-estimate of the loss following from the borrower’s default, given that the obligation to pay the higher rate was triggered by any event of default, regardless of the event having no or only trivial consequences. Further, the financiers’ evidence failed to establish that the various events of default raised the credit risk of the borrower to the extent necessary to justify the imposition of the higher rate to protect the financiers’ interests as lenders.

Accordingly, to reduce the likelihood of a provision demanding payment upon default being rendered void and unenforceable as a penalty, parties seeking to include such a provision should carefully consider the following:

1. What is the loss you are trying to protect against by including this provision?
2. Can you demonstrate that this provision only protects against loss that is commensurate with the harm you might suffer in the event of default?
3. Is this provision triggered by events of default that may cause trivial or no loss?
4. Can you otherwise point to evidence that justifies the requirement to pay the provision’s sum on the occurrence of each or multiple event(s) of default?
5. Does the provision predominately provide security for the performance of some other contractual obligation, as opposed to genuinely protecting against loss you might suffer?

The full decision can be found here.