Short-term lending is a risky business. Typically, those seeking funds from short-term lenders do so because of pressing circumstances under which they see higher interest rates as a better option than no funds at all. However, above and beyond the risk of default and an inability to recover the full amount owed, is the significant legal risk of falling foul of the laws relating to penalties and unconscionable conduct under the Australian Securities and Investments Commission Act 2001 (Cth) (‘the ASIC Act’). We explain these concepts below and provide our tips on how to avoid breaches.

The Law on Penalties

The common law took a stand against the enforcement of penalties a long time ago. This is because parties were imposing consequences for breach of contract that went far beyond providing compensation for the actual loss suffered. Accordingly, English courts decided that they would not enforce penalty clauses contained in contracts.

But what is a penalty? In a general sense, a penalty is any consequence of a breach or default which enables the aggrieved party to recover far more than its loss. It’s important to remember that when it comes to the resolution of common law disputes (like a breach of contract), the law only offers remedies. The function of a remedy in medicine is to cure an illness. So too in law, the role of remedies is to right the wrong that has occurred. If a party has breached a contract, what’s relevant is the true loss the innocent party suffered relative to what it would have gained had the contract been fulfilled. For this reason, Australian courts will not enforce any contractual clause which constitutes a penalty.

In Australia, parties are free to contract with each other on terms they accept (subject to consumer protection and unfair trading laws). This means that the law will not interfere if you are prepared to pay an exorbitant price for goods or services and do so fully informed. In fact, if the other party needs to enforce the terms of the contract, the courts will assist them to do so.

The law on penalties is, therefore, an exception to the freedom of parties to contract on terms that they see fit. What this means is that parties have to be very careful when drafting default clauses. 

The primary question short-term lenders must ask is, ‘what loss will I suffer if the borrower defaults?’ This can usually be answered by reference to the interest that may be charged to the lender by the party from which it has obtained its funds. There may also be administrative and enforcement costs associated with a default by the borrower, but these can (and perhaps should) be dealt with in a separate indemnity clause, rather than in the default clause.

The consequences of a default by the borrower under the loan agreement should bear some relation to the loss the lender suffers. The court will only uphold this provision if its function is to compensate the lender for its loss, rather than to punish or intimidate the borrower.

Common Law Exception

There is, however, a common law quirk that is worth mentioning. In Kellas-Sharpe v PSAL Ltd [2013] 2 Qd R 233 (‘PSAL’), the Queensland Court of Appeal affirmed the principle that loan agreements that are structured so as to reward timely repayments are not to be regarded as penalties. 

In that case, the sum of $1.1m was lent for two months on the following terms: 

“The standard rate of 7.50% per month, but while the Borrower is not in default under the Facility, the Lender will accept interest at the concessional rate of 4.00% per month.” 

The practical effect of this clause was that upon default, the interest rate would increase from 4% per month to 7.5% per month. However, the clause operated so as to provide a reduction in the interest payable – if paid on time. The Court then upheld that it could not be regarded as a penalty clause. Other states and territories are also likely to uphold the decision.

A Word on Unconscionable Conduct

It is often the case that the legal meaning of terms and phrases is different to their usual meaning. However, when it comes to ‘unconscionable conduct’, the courts have adopted a definition that relies on its common usage. 

Unconscionable conduct is any conduct in trade or commerce (under the Australian Consumer Law) or in the course of the supply/acquisition of financial services (under the ASIC Act) which is morally wrong. Such conduct is judged in light of all the relevant circumstances. 

In PSAL, the trial judge held that the lender’s actions in continuing to capitalise the interest owing on a monthly basis after the loan remained unpaid for over 12 months were unconscionable. This was despite the fact that the borrowers had requested the lender not repossess the mortgaged property while they sought to refinance the loan.

The effect of the monthly capitalisation of interest was that the borrowers were unable to refinance the loan. The lender also continued to charge the borrower for its costs and expenses related to the default as per its contractual entitlement. This was cumulatively held to be an exercise of contractual power that went beyond the lender’s legitimate interests.

Interestingly, this was so even though none of the individual terms of the loan agreement were held to constitute penalties. This goes to show that lenders must carefully consider how they exercise their powers under a loan agreement and mortgage, even if the specific terms are themselves enforceable.

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Whether you are a borrower or a lender, our specialist banking and finance lawyers can assist you – get in touch on 1300 544 755. 

Noam Greenberger

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