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In the current inflationary market, lenders are changing the terms on which they are willing to lend money to both individuals and businesses.  For most borrowers, the key variable is interest rates.

Can an interest rate under a loan ever be so high that a court will refuse to enforce it?  Yes, if the interest rate is found to be a penalty.  However, courts in NSW are only willing to find that an interest rate charged under a loan is a penalty in limited circumstances.  Typically, courts will allow lenders to recover interest and other amounts owing on their loans.

What is a penalty?

A penalty is a contractual provision which is intended to ensure that a party performs a contract by severely punishing a breach of the contract.  When a contract provision is a penalty, the “punishment” is out of all proportion to the other party’s legitimate commercial interest and not a genuine pre-estimate of the other party’s loss.

For example, a contractual clause requiring a borrower to pay interest at a high rate will be a penalty if the interest charged is extravagant and unconscionable in comparison with the greatest loss that the lender could conceivably show it had suffered following the breach of contract (typically non-payment of the loan). The inclusion of such a provision can only be explained as a penalty for non-performance.  Courts do enforce such provisions.

Difficulties with penalties

The onus is on the borrower to demonstrate that an interest rate stipulated in a contract is a penalty. This is a very heavy onus to discharge given the high value placed by the law on the principles of freedom of contract.  There are multiple cases where loans with very high interest rates have been enforced by the courts: see Bhundia v Sommers (No 4) [2021] NSWSC 455 for an example where a loan with a default interest rate of 30% per annum, compounding monthly, was upheld by the Court.

To discharge the borrower’s onus, the borrower must show that the amount of interest sought to be recovered is not a genuine pre-estimate of their loss and bears no proportion to their legitimate commercial interests at the time the loan agreement was entered into.

Factors commonly taken into account by the Court to determine whether an interest rate under a loan is a penalty include:

  • the purpose of the loan;
  • what options were available to the borrower at the time the loan was entered into;
  • the amount of the loan;
  • how much the interest rate will accrue over the terms of the loan as against the principal advanced;
  • what the default rate of interest prescribed in the loan is as compared to the ordinary rate that will apply if the loan is performed;
  • the value of any security provided for the loan (if any); and
  • what loss will be incurred by the lender (beyond the return of the principal advanced) if the loan is not repaid on time and in full.

All of these issues will only be taken into account by the Court if they are addressed through admissible evidence given by an appliable lay or expert witness with appropriate supporting documentary evidence.

Penalties as a defence in litigation

Penalties often sound good in theory but are difficult to run as a viable defence. Courts do not lightly interfere with a bargain struck between the parties. A borrower needs a strong case to attract judicial intervention to set aside as a penalty the bargain that the parties have agreed.

Litigation is expensive. Careful consideration should be given to whether to run a penalty defence.  A distressed borrower with limited funds may be better off pursuing a formal insolvency process rather than running such a challenging defence.

If you need advice about a loan or whether a term of a contract is a penalty, please contact David Greenberg or Victoria Caldwell of Vincent Young’s Commercial and Insolvency Division.

This publication is for general information purposes only and does not constitute legal advice. You should seek legal advice regarding your particular circumstances.