Short-term loan facilities often come with horrendous rates of interest.
The WA Supreme Court recently examined a short-term loan with an interest rate of 9.75% per annum during the term of the loan, which increased to 53% per annum upon default.
The lender said its fee and interest rate structure during and after expiry of the loan was justified taking into account the high risks involved with the loan.
The borrower argued that the interest rate was void as a penalty.
The lender (Quantum) is a private financial institution that provides high-risk borrowers with short-term loans, typically not exceeding 6 months. The loans are generally secured by secondary or subsequent securities.
Quantum has a limited pool of funds available to it for loans and gave evidence that to remain profitable the rate of return it required across its portfolio was around 36%, taking into account the high risk of non-recovery because of the nature of its borrowers and security.
The borrower (Love Properties) was a special purpose project vehicle for property development. Quantum provided a short-term loan facility to Love Properties secured by second registered mortgages over properties owned by Love Properties and Mr Love. Mr Love also personally guaranteed repayment of the loan facility.
Under the loan facility a “higher rate” of interest (14.75% per annum) was payable during the agreed term of the loan facility (period A) unless Love Properties was not in default under the loan facility, in which case Quantum would accept payment of a “lower rate” of interest (9.75% per annum).
But if the loan facility was not repaid within the agreed term (initially 4 months), the interest rate jumped to 4.43% per month (53.16% per annum) until full repayment occurred (period B).
When Love Properties defaulted under the loan facility Quantum commenced proceedings.
On 2 June 2016 summary judgment was granted in favour of Quantum, and the defendants were ordered to pay $660,471.66 plus interest at a daily rate of $952.31 and costs.
The defendants appealed on the basis that the interest “uplift” provision (9.75% pa to 53.16% pa) in the loan facility deed was unenforceable as a penalty. They did not contend that the lower/ higher interest rate mechanism was unenforceable, as such a mechanism is well-recognised.
Quantum justified the higher rate of interest on the bases that:
- Mr Love’s credit report indicated a very high risk of default, numerous court writs and default judgments
- the defendants were in default with their existing lender when the loan facility was entered into
- the defendants’ repayment plan involved the subdivision and sale of a property that was already subject to litigation
Quantum also gave evidence that its annualised return during period A (52.68% pa when substantial establishment and other fees were added to interest) was approximately consistent with its annualised return during period B (53.16% pa comprising interest only).
The Court summarised relevant legal principles from recent High Court decisions (*):
- the question whether a sum stipulated is a penalty or liquidated damages (that is, a genuine pre‑estimate) is to be judged as at the time of the making of the contract
- the party seeking to be absolved of the liability imposed by the stipulation bears the onus of proving that the stipulation constitutes an unenforceable penalty
- the critical issue is whether the sum agreed was commensurate with the interest protected by the bargain
- the nature of the interest sought to be protected is relevant. The sum agreed may be intended to protect an interest that is different from, and greater than, an interest in compensation for loss caused directly by the breach. It may be intangible and unquantifiable. The essence of liquidated damages is a genuine pre‑estimate of damage. The reference to ‘damage’ as distinct from ‘damages’ is significant
- an interest may be of a business or financial nature
- a sum that is merely disproportionate to the loss suffered does not qualify as a penalty. The penalty must be ‘extravagant, exorbitant or unconscionable’ and ‘out of all proportion’ to the interest of the party which it is the purpose of the provision to protect
- the distinction between liquidated damages and a penalty, whilst useful, is not a limiting rule and does not mean that if no pre‑estimate is made at the time the contract was entered into, the sum agreed will be a penalty
- nor does it mean that a sum that reflects or attempts to reflect other types of loss or damage beyond those caused directly will be a penalty
- it may be that a reliable pre‑estimate is not possible or that damage caused by default is of such an uncertain nature that it cannot accurately be estimated or proved. In such a case a stipulated payment agreed by the parties may well be the true bargain and not a penalty
- where pre‑estimation of loss is difficult, precision may not be called for, bearing in mind the question is whether the stipulation is ‘out of all proportion’ to the interest said to be damaged by default
- the court will not lightly interfere with the bargain struck between the parties. The court requires good reason to attract judicial intervention to set aside the bargains upon which parties of full capacity have agreed. That is why the law on penalties is expressed as an exceptional rule and descriptors such as ‘extravagant’ and ‘out of all proportion’ are used in its application
- the ultimate question in determining whether a stipulation is a penalty, is whether it is intended only to punish the defaulting party. Framed another way – does the innocent party’s interest in the observance of the principal contractual obligation explain the agreed stipulation as having a purpose other than punishment
- the conventional application of the doctrine of penalties arises when a stipulated sum is made payable by upon breach. However, the rule as to penalties is not limited to cases arising out of breach of contract
- whether a clause is a penalty invites attention to the proper construction of that clause, and the contract as a whole, but it is not solely a matter of contractual construction. The court is not limited to considering the terms of the contract and any background factual matrix evidence that would be admissible for the purposes of contractual construction.
The Court dismissed the appeal, thereby upholding the summary judgment in Quantum’s favour, for the following reasons:
- the nature of the facility was high risk and in the short‑term money market. The period was expressed to be for the purpose of an exit strategy: the parties did not intend the facility to endure
- the parties were both experienced and commercially sophisticated. The proposal for high fees and interest was disclosed for some months before the letter of offer was executed
- Quantum had explained its manner of assessing risk, its targeted return, the restrictions under which it operates in terms of a finite pool of funds and the need for a certain level of return to remain profitable
- Quantum had an interest to protect, namely an interest in receiving repayment and on time. It had an interest in maintaining its targeted return and there was no reason that could not be achieved through both fees and interest. It also had an interest in pursuing opportunities to reinvest funds in the short‑term market and at high interest rates
- Quantum had explained why this particular loan had added risk which led it to seek a higher return than usual
- estimating such risk and the damage that might be caused by default is not straightforward. Whilst Quantum had made a genuine attempt to pre‑estimate loss and had developed a proprietary calculator to assist it in doing so, there was a limit as to the precision with which such a task can be undertaken. In such circumstances a stipulated payment regime on default was less likely to be a penalty
- the period A fees and interest give an indication of damage in the event of default. The annualised period B rate was only slightly more than the annualised blended (fees and interest) period A return of 52.68% per annum. The period B rate of 53.16% per annum could hardly be said to be exorbitant or extravagant in those circumstances.
Accordingly the Court held that Quantum had a strong case that the period B rates had the legitimate purpose of protecting Quantum’s interests, were not out of proportion to that interest and could not be said to only operate as a punishment. The defendants had no reasonable prospect of meeting their onus to establish otherwise. There was no real question to be tried.
This case is consistent with other superior Court decisions concerning alleged penalties in the short-term lending market.
For example in Yarra Capital Group Pty Ltd v Sklash  VSCA 109 the Victorian Court of Appeal held in respect of two 2 month loans that annualised default fees of up to 143% of the principal did not constitute penalties.
However in Bay Bon Investments Pty Ltd v Selvarajah  NSWSC 1251 the NSW Supreme Court held in respect of two 1 month loans that annualised default rates of up to 360% were unenforceable penalties, as there was no evidence that such rates could otherwise be obtained in the short-term lending market.
The case is Quantum Asset Management Pty Ltd v Love Properties (WA) Pty Ltd  WASC 167 (20 June 2017).
(*) the High Court decisions are Paciocco v Australia and New Zealand Banking Group Ltd  HCA 28 and Andrews v Australia and New Zealand Banking Group Ltd  HCA 30.