What do debt fund managers need to know about penalties?

By Emma Donaghue and Kate Dart

There has been a recent uptick in the number of debt funds coming to the market. Non-bank lenders and debt fund managers are often aware of the risk posed by setting high default charges under a loan agreement. However, a recent decision of the New South Wales Supreme Court serves as a timely reminder, particularly for those new in the market, that default charges must be a genuine pre-estimate of the lender’s loss incurred in respect of a breach or default. If not, the default charges may be deemed a penalty and unenforceable.

Facts

In Bellas v Powers, a lender (Tommy and Rosemary Powers as trustee for the Paecu No 1 Trust) provided a $3 million loan to a borrower for a term of two months with an option to extend by agreement between the lender and the borrower. The loan was secured by a first ranking mortgage granted by Theo Bellas (guarantor) over two of his properties (security properties).

On the drawdown of the loan, the lender retained $105,000 as an advance payment of interest. Interest under the loan agreement was to be calculated either at the ‘discounted rate’ of 1.75 per cent per 30 days (21.30 per cent per annum) or the ‘standard rate’ of 9.75 per cent per 30 days (118.6 per cent per annum). Interest was payable at the end of the loan term and, in the absence of any occurrence of an event of default, was to be calculated at the discounted rate. The standard rate was to apply during the period where a default subsisted.

In addition to default interest, Credit Connect (manager) was entitled to be paid a default management fee of $360 per hour for services to the lender to manage and rectify any borrower event of default. The borrower and Mr Bellas also indemnified the lender for any loss the lender incurred in connection with a default.

The borrower did not repay the loan by its due date and, over a term of approximately 10 months, the lender claimed an aggregate amount of interest, fees and costs of $7,751.353 had accrued.

Snapshot of the decision

The essential question for the court was whether the standard rate under the loan agreement was a penalty, and, if so, were the terms which impose that interest obligation void and unenforceable.

Under the law of penalties, if a contractual term imposes a financial expense on a breaching party which is greater than the loss of the innocent party, the financial expense is deemed a ‘penalty’ and unenforceable. However, if the financial expense is (at the time of making the contract) a genuine pre-estimate of the innocent party’s loss in respect of the breach or default, the penalties doctrine will not apply.

The court said the standard rate would only apply to periods when a default was continuing. As a result, the subsistence of a default after the repayment date for the loan would not have the effect that the standard rate was retrospectively applied to periods when there was no default.

The court did not consider the occurrence of any particular event of default under the loan agreement sufficiently increased the risk profile of the borrower or guarantor to warrant the increase in the interest rate from the discounted rate to the standard rate. This was due in part to the fact the loan was secured by a first ranking mortgage.

The lender argued that the annualisation of the standard rate unfairly exaggerated the burden of the standard rate given the short-term nature of the loan. The court was not persuaded by this argument. It said the terms of the indemnity and the obligation of the borrower to pay the default management fee entitled the lender to be compensated for any loss resulting from an event of default and this right was separate to the lender’s entitlement to receive default interest. If it was established that short-term borrowers were available in the market to borrow at the standard rate, this may have justified the imposition of the standard rate. However, the court found no evidence to support this finding.

The court ultimately held the standard rate constituted a penalty and the clauses in the loan agreement imposing the standard rate were void and unenforceable.

Key takeaway

This case serves as an important reminder that default charges are not a stick to be used to punish a borrower or compel performance.

Reach out to Emma Donaghue or a member of the HW Funds team if you need more information about the law of penalties and what debt fund managers need to know.