Default Interest and Capitalising Interest: Drafting Pitfalls For Lenders

Originally published in the Australian Banking and Finance Law Bulletin – Volume 40 (March 2024) at pages 4 to 7.

Lenders must be extremely careful in how they draft clauses providing for: (a) the charging of interest using the “higher and lower rate” drafting technique; and (b) the “capitalising” of interest: that is, adding interest to the principal loan amount so that the capitalised interest itself attracts interest. This article considers the lessons to be learned from two recent cases which demonstrate what can happen to lenders when their drafting goes wrong.

The “higher and lower rate” drafting technique

Broadly, a clause in a loan contract is at risk of being void as a penalty if the clause is “a collateral stipulation, the (or a predominant) purpose of which is to punish the borrower for breach, and thus to compel performance”.^[1] However, there is a distinction between clauses in loan and security agreements “which incentivise prompt payment” as distinct from clauses “which increase the rate of interest upon failure to make prompt payment, where the latter may be held to be a penalty clause and the former are not.”^[2] This technique depends on stipulating a “Higher Interest Rate” which is said to be the standard rate applicable under the loan. At the same time, a mechanism is created under the contract to the effect that, where there is no default by the borrower, the borrower is permitted to pay a concessional “Lower Interest Rate”.^[3] Judges have noted that this technique may appear to be a matter of form over substance and relies on a distinction that has been subject to debate.^[4] However, “[w]hile trial judges and intermediate courts have railed against the consequences of this distinction, which is to immunise the result of a drafting device from scrutiny on the basis of equitable principles relating to penalties and unconscionability, it has been said, time and time again, that the principle is too well established to be disturbed other than at the highest level, by the High Court or by Parliament.”^[5]

The risks of “belt and braces” drafting

In Bellas v Powers^[6] (Bellas) a private lender had included complex (and partially inconsistent) drafting in its loan terms. These complexities mainly arose because, as is common in loans of the type considered in Bellas, the loan terms provided for:

• interest for the term of the loan to be paid upfront out of the proceeds of the loan;
• interest to be capitalised monthly; and
• the rate of interest to be expressed in respect of a period of 30 days, not per annum (no doubt for “optical” reasons) – here the standard rate was expressed as being 9.75% per 30 days and the discounted rate was specified as being 1.75% per 30 days – instead of 118.6% per annum and 21.3% per annum respectively (the per annum rates as calculated by the trial judge).^[7]

In Bellas, the Court found as follows.

• Despite inconsistency with another loan term, the operative loan term provided for the standard rate (i.e. the higher rate) to apply only in respect of periods when an event of default was subsisting.^[8] This was the relevant “collateral stipulation” for the purposes of the doctrine against penalties, to operate upon the failure of the primary stipulation that no event of default must occur during the period in which there was money owing.^[9]
• Of the sixteen events of default specified in the loan terms, only two involved breaches of the loan terms.^[10] However, the “collateral stipulation” for the purposes of the doctrine against penalties, was engaged if any event of default occurred, whether or not that occurrence constituted a breach of contract by the borrower.^[11]
• The loan terms which imposed the standard rate (i.e. the higher rate) on the borrower by means of a collateral stipulation (upon failure of the primary stipulation) constituted a penalty. This was on the basis of the exorbitance of the difference between the lower rate (1.75% per 30 days) and the higher rate (9.75% per 30 days), each compounding monthly.^[12]
• The lender did not identify a meaningful interest on its part which justified the inclusion of the impugned provision. The only interest suggested by the lender was to “earn the greatest amount of interest on [its] loan funds that was sustainable in the market in which [it] operated, which was the market for relatively high risk short-term loans on the security of a mortgage over real property.”^[13] The Court noted that the fact that the loan was secured by first registered mortgages over two properties significantly diminished the ultimate risk borne by the lender. The Court was prepared to infer that the discounted rate, being a rate agreed between the parties at arm’s length, was consistent with there being a market for the provision of bridging finance for short periods at rates up to that amount.^[14]

Compounding the problem

In Commercial N Pty Limited v Huang & Ors^[15] (Huang) borrowers borrowed the principal sum of $430,000 from a private lender for a term of 26 weeks on the security of real property. The borrowers were required to make monthly interest payments over the term, with a lower interest rate of 0.35% per week and a higher interest rate of 1.36% per week. The borrowers defaulted on their interest payments and failed to repay the principal sum. The private lender sought judgement against the borrowers and orders for possession and sale of the real property mortgaged as security for the loan. In their defence, the borrowers accepted that the principal sum of $430,000 needed to be repaid, but alleged that the interest claimed by the private lender (alleged by the borrowers to be 70.72% per annum, compounding monthly) was excessive and amounted to a penalty. There were other matters and parties involved in the dispute, but they are not relevant for present purposes.

Construing the interest rate formula

One issue examined by the Court was one of construction. The formula for calculating the amount of interest at the higher interest rate was expressed as being the HIR (the higher interest rate) divided by 365 and multiplied by N (i.e. the number of days for the relevant interest period). The question was whether the weekly interest rate of 1.36% should be used for the HIR integer in the above formula or whether that rate should be converted into an annual rate of 70.72% for the purposes of the above formula. The lender contended that HIR in the above formula should be read as 70.72% “in order to avoid an absurd outcome contrary to commercial common sense”.^[16] The Court accepted that an absurdity would arise if the weekly interest rate was plugged into the above formula. The Court also accepted the lender’s submission that the purpose of the division by 365 in the formula was to produce a daily amount of interest and it was commercially implausible that the amount to be divided by 365 would be based on a weekly rate of interest.^[17]

Did the interest rate regime constitute a penalty?

In this case, the Mortgage Details Schedule in the lender’s loan and security documentation provided that the “Specified Interest Regime” was Interest Regime B. The provision in relation to interest (clause 5.12) relevantly provided that:

If the Specified Interest Regime applicable to this Mortgage is Interest Regime B:

1. The Debtor shall pay Interest to the Lender in arrears on the Date for the Payment of Interest until the Outstanding Interest is paid in full;
2. and, the Debtor fails to pay Interest on the Date for the Payment of Interest, then:
   1. the Debtor shall be liable to pay Interest on the Outstanding Interest at the Higher Interest Rate compounding monthly on the Date for the Payment of Interest until the Outstanding Interest is paid in full; and
   2. The interest on the Outstanding Interest compounded on the basis specified in paragraph (i) above shall become part of the Secured Money as soon as it compounds.

The borrowers submitted that the above clause contained a contractual penalty provision – clause 5.12(b)(i) – because that sub-clause operated on a default (i.e. the failure to pay interest) and in that event provided for interest to be payable at the higher interest rate. The defendants alleged that the increase from the lower interest rate effected by the higher interest rate – by a factor of almost 400% – was extravagant, excessive and out of all proportion.^[18] The lender did not address clause 5.12. Instead, its submissions focused on clauses 5.3 and 5.5, which generally adopted the “higher and lower rate” drafting technique outlined above.^[19]

The Court found that clause 5.12(b)(i) was not a penalty. This was on the basis that:^[20]

“the liability to pay interest at the Higher Interest Rate compounding monthly in [that clause] does not impose an addition or different contractual liability that arises upon the non-observance of the primary contractual liability to pay the Higher Interest Amount, but rather is payable because the reduced rate has not been paid punctually. Further, and while noting that the terms on which interest is payable under clause 5.12(b)(i) is worded differently from the formula in clause 5.5, there are no calculations before the Court to suggest that the application of the interest provisions under clause 5.12(b) gives rise to a different outcome or higher amount than would be payable if applying the formula under clause 5.5 to ascertain the Higher Interest Amount.”

In reaching this conclusion, the Court accepted that its approach may appear to apply a matter of form over substance and relies on a distinction (i.e. the “higher and lower” drafting technique) that has been the subject of debate.^[21]

Capitalisation of interest

The Court found that the capitalisation and monthly compounding on the higher interest rate of 70.72% per annum (which the borrowers could expect to pay on default) on a loan of $430,000 for 6 months was inherently oppressive and unconscionable.^[22] As a result, the provisions for capitalisation and compounding of interest were declared to be void under section 243 of Australian Consumer Law and/or section 12GM of the Australian Securities and Investments Commission Act 2001 (Cth) (ASIC Act). The Court was influenced by the massive disparity between the approach involving the capitalisation and compounding of interest (leading to a total amount outstanding of $3,219,342.52 as of 17 August 2022) versus an approach involving simple interest without capitalisation and compounding (leading to a total amount outstanding of $1,312,417.62 as of 17 August 2022).^[23]

Unfair contract terms

From 12 November 2015, the unfair contract terms regime under the Australian Consumer Law as well as the ASIC Act was extended to cover standard form small business contracts. This had the effect that lenders were regulated under the unfair contract terms regime in respect of small business loans of up to $1 million – i.e. if the aggregate of the principal amount plus loan establishment fees was at or below this threshold – where those loans were provided under standard form contracts to small businesses (as defined in the ASIC Act) with effect from 12 November 2016.

From 9 November 2023, the unfair contract terms legislation as it applied to small business loans was changed so that the relevant application threshold is below $5 million – up from $1 million – thereby bringing more contracts which are entered into after that date into the regulatory net. Additionally, the definition of “small business” in the ASIC Act has been expanded too.

The unfair contract term regime does not apply to a term of a contract to the extent, but only to the extent, that the term sets the upfront price payable under the contract.^[24] The “upfront price” payable under a contract is defined as the consideration that: (a) is provided, or is to be provided, for the supply under the contract; and (b) is disclosed at or before the time the contract is entered into; but does not include any other consideration that is contingent on the occurrence or non-occurrence of a particular event.^[25] It would appear that a properly drafted “higher and lower rate” interest clause is capable of being outside the unfair contract term regime on the basis that it sets the upfront price payable under the contract. However, the same analysis would not apply to clauses providing for the capitalisation and compounding of interest as those clauses would appear to be contingent on the non-occurrence of a particular event, i.e. the payment of interest in the ordinary course by the borrower.

Conclusions

In summary, the following conclusions can be drawn from Bellas and Huang.

• For now, the “higher and lower rate” drafting technique for interest rates in loan contracts remains alive and well, pending a full review and determination of this issue by the High Court of Australia on appeal from an intermediate court in an appropriate case.
• In the meantime, courts are likely to give the interest rate clauses in loan contracts careful scrutiny. It will take very little for a court to discern that – due to ambiguous drafting – there exists a primary stipulation and a collateral stipulation, thereby making it possible for a borrower to invoke the doctrine against penalties. This means that “higher and lower rate” interest clauses need to be drafted very carefully to withstand judicial scrutiny.
• Clauses concerning the capitalisation and compounding of interest need to be reviewed carefully to assess their substantive effect, in light of the conclusions reached in Huang. Those clauses should be made more transparent so that a borrower is clearly on notice of the practical impact that an interest capitalisation clause could have on them.
• The above points apply to any loan contract, regardless of the aggregate amount of the principal and establishment fees (i.e. they could exceed $5 million). Where the aggregate amount of the principal and establishment fees is below $5 million, however, lenders should also be conscious of the impact that the unfair contract term regime may have, particularly in the context of the terms relating to the capitalisation and compounding of interest.