The “No Penalty Rule”: Form over substance still survives – but with some room to chip away

Commercial N Pty Limited v Huang & Ors [2024] NSWSC 23

<>The decision in Commercial N Pty Limited v Huang & Ors [2024] NSWSC 23 has applied the anomalous adjunct of the doctrine of penalties sometimes known as the “No Penalty Rule”, which is based on the well-recognised distinction between provisions that incentivise prompt payment and provisions that instead increase the interest rate upon the failure of due payment. The former provisions are not a penalty but the latter can be held to be a penalty clause. In this decision, the higher interest rate (HIR) of 70.72% p.a. was the primary obligation and the lower interest rate (LIR) of 18.2% p.a. was the concessional rate payable whilst there was no default in the timely payment of interest.

Nonetheless, the court held that the capitalisation and monthly compounding of the HIR on a loan of $430,000 for 6 months was unconscionable under both s 21 of the ACL and s 12CB of the ASIC Act. The “sharp practice and unfairness” that constituted such unconscionability was demonstrated by comparing the calculation of the capitalised HIR at $2,789,342 in contrast with the simple interest calculation of the HIR at $882,417.

Justice Trish Henry decided that the terms providing for capitalised or compounded interest should be declared void or varied by removing them from the loan contract. Her Honour held that the HIR itself was neither unconscionable nor a contractual penalty provision. Instead, simple interest at the HIR was enforceable. Judgment should be given for the principal sum, together with simple interest at the rate of 70.72% per annum.

The express reservation to pay a higher rate of interest which is then reduced to a lower rate for punctual payment has historically been used to overcome the prospect of the default rate being treated as a penalty: Stoyanova v Equity-One Mortgage Fund Ltd [2016] VSC 414. There, Riordan J noted that despite the “No Penalty Rule” being an instance where form is preferred over substance, it could not be doubted that, since the turn of the nineteenth century, the rule has been referred to as firmly established in a number of authorities.

The question of whether the penalty doctrine is engaged at all is anterior to the  substantive inquiry of whether the provision is a penalty, ie: is the collateral stipulation properly characterised as penal and, if so, only then, what are the remedial consequences: Andrews v Australia and New Zealand Banking Group Ltd (2012) 247 CLR 205; [2012] HCA 30 at [15].  

The onus of proving that a stipulation amounts to a penalty lies with the party asserting it: Paciocco Australia and New Zealand Banking Group Ltd (2016) 258 CLR 525; [2016] HCA 28 at [167]; Arab Bank Australia Ltd v Sayde Developments Pty Ltd (2016) 93 NSWLR 231; [2016] NSWCA 328 at [75].

In Commercial N, Henry J held that the borrower’s liability to pay the HIR did not impose an additional or different contractual liability that arose upon the non-observance of the primary obligation to pay the HIR which was payable rather because the LIR had not been paid punctually: at [217]. Her Honour accepted that her construction “may appear to apply a matter of form over substance” and in reliance “on a distinction that has been the subject of debate”: at [218]. Although finely balanced, she did not consider, at [224], that it was open to infer that the HIR was out of all proportion, extravagant or unconscionably disproportionate or was purely punitive in character, having regard to the short-term nature of the loan, the fact that the plaintiff was a lender of last resort for the defendants; and the interest rates that applied in the various authorities to which she referred at [302].

In relation to her Honour’s finding that the capitalisation and monthly compounding on the HIR of 70.72% p.a. was “inherently oppressive and unconscionable”, Henry J noted that it could never be said that enforcement of the HIR with capitalisation was reasonably necessary for the protection of the lender’s legitimate interests as it was in the order of an effective annual rate of interest of about 417% per annum, which was “utterly crushing” and only increasing: at [305]. By comparison, the annualised simple interest rate was 70.72%.

Her Honour pointed out that the lender had taken no steps to highlight the effect of the capitalisation/compounding on the HIR, other than to refer to the lengthy set of interest provisions that included a formula attended by a degree of ambiguity; that the lender knew the borrowers’ ability to make the monthly repayments was limited and that they may need to sell their home; plus the inequality of the parties’ bargaining positions and their economic and personal circumstances – all of which meant that the lender’s conduct was irreconcilable with what is right and reasonable and involved a level of sharp practice and unfairness that was unconscionable withing the meaning of section 21 of the ACL and section 12CB of the ASIC Act: at [306].

The manner in which the penalty rule is applied is of such long standing that the consensus is that it can only be changed by the High Court or by Parliament: Kellas-Sharpe v PSAL Ltd [2013] 2 Qd R 233; [2012] QCA 371; Stoyanova at [37] – [38]; Oxygen Funding Solutions Pty Ltd v Dick-Telfar [2020] NSWSC 582 at [80] and Commercial Funds Pty Ltd v Fraval [2020] VCC 1787 at [128].

Finally, in any discussion of the applicability of the “No Penalty Rule” to credit contracts, the provisions of s 30 of the National Credit Code should be noted. According to the commentary in Beatty & Smith, Annotated National Credit Code (6th ed, 2020, Lexis Nexis Butterworths) at [30.05]: the purpose of s 30 of the NCC, which is Schedule 1 to the National Consumer Credit Protection Act 2009 (Cth), was to prohibit the common practice under which the debtors were required to pay a specified higher rate but received a discount for a lower rate of interest for timely payment.

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