Thinking | 10 June 2021
Interest rates and penalties – the importance of proportionality
By Nick Slack and Arin Harman
A decision of the Supreme Court of New South Wales in Bhundia v Sommers (No 4)  NSWSC 455 (Bhundia) considered the applicability of the rule against penalties in the context of an unsecured loan from an overseas lender on short notice. We provide a rundown of the case and its implications for lenders and borrowers generally.
In this case, Justice Adamson held that there was insufficient evidence to conclude that the 30% per annum default interest rate payable under the Loan Agreement (as defined below) was a penalty.
- Sundip Bhundia (Lender), based in Switzerland, loaned US$500,000 to an Australian company, Propertybay Holdings Pty Ltd (Borrower), under a loan agreement dated 30 December 2018 (Loan Agreement).
- The Loan Agreement was entered into between the Lender, Borrower, Timothy Sommers and Sean Neylon (both based in Australia) (together, the Defendants), who were the directors of the Borrower and shareholders of 50% of the issued shares in the Borrower. The Loan Agreement was entered into:
- on short notice; and
- without the Lender obtaining security.
- Each Defendant provided the Lender with a personal guarantee in connection with the Borrower’s obligations.
- On 3 January 2019, the parties executed a variation agreement increasing the loan amount to US$630,000 with a fixed interest amount of at least US$189,000 (the total amount repayable being at least US$819,000).
- The Lender was permitted to make the principal and any interest immediately due and payable where a default subsisted. Such amounts were to accrue interest at the rate of 30% per annum.
- The Lender demanded that the Borrower repay all amounts owing under the Loan Agreement (as varied) pursuant to a notice of default dated 1 February 2019, with further letters of demand served on the Borrower on 26 February 2019 and 18 March 2019.
- Despite this, no amounts were repaid to the Lender, the Borrower was wound up on 22 July 2019, and a statement of claim was filed on 23 July 2019 by the Lender against the Defendants claiming US$925,076.38 (Debt) under the guarantee.
- At issue was whether the calculation of the Debt, which included interest accruing at the default rate, was a penalty.
Justice Adamson held that the interest provision was not a penalty. In particular, she held that the Defendants did not discharge their onus of proving that the interest rate was ‘out of all proportion’ to a genuine pre-estimate of the Lender’s damages (at ) given the time pressure, nature, and risk of the advance.
The key takeaways are that:
- genuine pre-estimate: where an interest rate is a genuine pre-estimate of damages, or not out of all proportion to the legitimate commercial interests of a lender, a Court is unlikely to intervene and rule the applicable provision a penalty. In this case, given that the loan was requested on short notice from an overseas lender and that the facility was unsecured, the high interest rate was not ‘out of all proportion’ to this pre-estimate or the Lender’s legitimate commercial interests; and
- onus: the onus is firmly on a party claiming a provision is penal to prove that the provisions are penal.
Justice Adamson also summarised the key legal principles underpinning penalties, being:
- penalty: whether a term is penal is determined by reference to ‘whether the payment of the sum was extravagant, unconscionable or out of all proportion to the legitimate commercial interests of the party which the provision is intended to protect’ (at ) (citing Paciocco v Australia & New Zealand Banking Group Ltd (2016) 258 CLR 525);
- counterfactual: a comparison is to be made between the position of the defaulting party with and without the provision (citing Ringrow Pty Ltd v BP Australia (2005) 224 CLR 656);
- jurisdiction: equity will intervene even where there is no breach of contract (citing Andrews v Australia & New Zealand Banking Group Ltd (2012) 247 CLR 205); and
- in terrorem: while there may come a point at which an interest rate ‘operates in terrorem and as punishment for default rather than compensation for the lender being kept out of its money’ (at , quoting Justice White in Bay Bon Investments Pty Ltd v Selvarajah  NSWSC 1251), this requires the disparity to be so high that the rate itself was exorbitant and out of all proportion to the Lender’s interests.
If you would like help with any aspect of a loan transaction, please contact Nick Slack who can assist you navigating these legal principles and loan transactions more broadly.
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