The recent WA Supreme Court case of Argonaut Equity Partners Pty Ltd v Moran  WASC 24 provides a useful reminder to borrowers and lenders of the importance of careful drafting of default interest clauses.
- In 2014, Mr Moran entered into a loan agreement (Loan) to borrow approximately $6 million (Principal) from a group of private lenders represented by Argonaut Equity Partners Pty Ltd (Argonaut).
- Originally intended to be a short term loan, the Loan was extended twice by two extension letters (Extension Letters).
- The Loan carried a default interest rate of 5% per month capitalised (Default Interest).
- Mr Moran defaulted in December 2016 and Argonaut later exercised its right to sell the secured shares.
- Despite realising $12 million from the sale of the shares, Argonaut claimed that Mr Moran still owed the Principal, accrued interest and Default Interest.
The primary issue for the Court was whether the Default Interest imposed on Mr Moran amounted to a penalty and therefore unenforceable by Argonaut.
Mr Moran's argument:
- The interest of 5% per month capitalised was not a "genuine pre-estimate" of the loss the lenders' would suffer from a default of the Loan; and
- the Default Interest was not part of the primary obligation as set out in the Loan;
and was therefore a penalty and unenforceable.
- Despite being described as a "Default Rate", the Default Interest was not a collateral obligation imposed to punish Mr Moran for failing to meet the primary obligation under the Loan; it was part of the primary obligation and did not fall under the penalty doctrine.
The Doctrine of Penalties
Originally established by Lord Dunedin in Dunlop,1 the doctrine of penalties states that if an obligation to pay a sum of money is found to be a penalty, it will be unenforceable. A penalty:
- punishes for non-performance of an obligation rather than compensates for a party's actual loss suffered as a result of that non-performance.2
- unlike liquidated damages, is not a genuine pre-estimate of the loss that the enforcing party would suffer as a result of non-performance.3
- is "extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved to have followed from the breach".4
However, just because a sum payable under an agreement prima facie appears exceptionally high does not automatically mean it is a penalty and unenforceable.
In the case of Argonaut, the Court reminded the parties that "Whether a sum or rate stipulated is a penalty is a question of construction 'to be decided upon the terms and inherent circumstances of each particular contract, judged of as at the time of the making of the contract, not as at the time of the breach'".5
For Mr Moran, it was not determinative that the clause was titled "Default Rate". The focus was on the operation of the clause rather than how it was described by the parties. The Extension Letters extended the time for which the Principal and accrued interest was due and payable. Under the Extension Letters, the Default Interest was payable from the date of the first Extension Letter to the date on which Mr Moran paid off his debt. The Extension Letters were each a new and separate agreement. By agreeing to the terms of the Extension Letters Mr Moran agreed to pay the Default Interest as a primary obligation separate from his other obligations.
The Court held that the Default Interest in this case was not a penalty and as a result, Argonaut was entitled to the outstanding Principal, the unpaid but accrued interest and the Default Interest.
This case serves as a useful reminder to both borrowers and lenders to take care when drafting and negotiating default interest clauses. Whether a sum is considered a penalty will depend on the circumstances of the case. It is recommended that all parties to lending agreements, particularly private lending agreements, seek independent legal advice not only at the time of entering into the agreement but also at any time where the agreement is to be altered or extended.
1 Dunlop Pneumatic Tyre Company v New Garage and Motor Company Limited (1914) AC 79 (Dunlop). See also Ringrow Pty Ltd v BP Australia Pty Ltd (2005) 224 CLR 656, Andrews v ANZ Banking Group Ltd  HCA 30 and Paciocco v Australia and New Zealand Banking Group Limited  HCA 28.
2 Legione v Hateley (1983) 152 CLR 406 at 446.
3 Dunlop at 86-87.
4 Dunlop at 87.
5 Argonaut at 144 citing Dunlop at 86 – 87.
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