DMC Category Rating: Developed

This case note is contributed by Crump & Co, the International Contributors to the website for Hong Kong

Facts
This was an application by the Plaintiff ship mortgagees for directions to determine whether they were entitled to an additional 2% interest pursuant to a term of a Facility Agreement for the period from the default on 17 February 2003 until the date of judgment on 16 December 2003, over and above interest at the rate of 1.4 % above three months LIBOR payable pursuant to another term of the Facility Agreement.

The applicable interest rate in 19 December 1998 when the Facility Agreement was concluded was 1.89141% (three months LIBOR for Japanese Yen was 0.49141%) and the default rate under (after adding the 2% interest) would have been 3.89141% in December 1998. The Defendants contended that the additional 2% interest was a penalty and was therefore unenforceable.

Judgment
The judge approached the issue by first considering the relevant authorities, starting with the case of Dunlop Pneumatic Tyre Co. Ltd v. New Garage and Motor Co. Ltd [1915] A.C. 79. He then reviewed the later cases, in particular, Robophone Facilities Ltd. v. Blank [1996] 1 WLR 1428 and Philips Hong Kong Ltd. v. Attorney General of Hong Kong [1993] 1 HKLR 269, quoting the following passage from the judgment of Lord Woolf in that case:

Except possibly in the case of situations where one of the parties to the contract is able to dominate the other as to choice of the terms of a contract, it will normally be insufficient to establish that a provision is objectionably penal to identify situations where the application of the provision could result in a larger sum being recovered by the injured party than his actual loss. Even in such situations, so long as the sum payable in the event of non–compliance with the contract is not extravagant, having regard to the range of losses that it could reasonably be anticipated it would have to cover at the time the contact was made, it can still be a genuine pre-estimate of the loss that would be suffered and so a perfectly valid liquidated damage provision…. the court has to be careful not to set too stringent a standard and bear in mind that what the parties have agreed should normally be upheld.  Any other approach will lead to undesirable uncertainty especially in commercial contracts."

Summarising his review, the judge concluded that the modern approach to penalty clauses is to look at whether, in respect of a commercial contract, the disputed provision can be said to be unconscionable or oppressive by reason of its being extravagant, exorbitant or excessive and that the court should be slow to find terms agreed by the parties to be in terrorem (a terrorizing threat) rather than a genuine agreement providing for fixed formula of loss. 

As regards default interest clauses in particular, the judge referred to the case of Lordsvale Finance v. Bank of Zambia [1996] Q.B. 752, in which Colman J. had held that an extra 1% for default interest was not a penalty. At page 763, he had said:

"Where, however, the loan agreement provides that the rate of interest will onlh increase prospectively from the time of default in payment, a rather different picture emerges. The additional amount payable is ex hypothesi, directly proportional to the period of time during which the default in payment continues. Moreover, the borrower in default is not the same credit risk as the prospective borrower with whom the loan agreement was first negotiated. Merely for the pre-existing rate of interest to continue to accrue on the outstanding amount of the debt would not reflect the fact that the borrower no longer has a clean record. Given that money is more expensive for a less good credit risk than for a good credit risk, there would in principle seem to be no reason to deduce that a small rateable increase in interest charged prospectively, upon default would have the dominant purpose of deterring default (and thereby a penalty).

In the light of the legal principles on penalty, the judge concluded that the sole question in the present case was whether, in relation to the particular commercial contract in the form of the Facility Agreement, it could be said that the clause providing for the 2% uplift interest upon default was "in terrorem" because it was "unconscionable, oppressive or extravagant" – an issue that had to be judged at the time of making, not breaking, the Agreement.

The judge then held that, in a large loan such as this one, in relation to the finance of a number of ships covering a long period of time, the range of possible losses consequent upon the non-payment would be "broad, extensive and difficult to visualise, identify or enumerate". In such circumstances, it would be sensible, he said, for the parties to agree beforehand on a formula for the interest rate regime covering the time when there was a default in payment. He continued:
"Having regard to what Lord Woolf said in the Philips case about contractual provisions not being in any way condemned merely by reason of showing the contractual damage exceeding a possible actual loss, it seems to me that in a case such as this with a large range of possible losses it is simply impossible to say that liquidated damages [under the Agreement] are totally out of proportion to the range of losses which might likely be incurred."

The court had to bear in mind, he continued, that the Agreement was a commercial contract where the parties on equal terms agreed on the stipulated liquidated damages and that the court should not be too ready to find a high "degree of disproportion" between the stipulated sum and the loss likely to be suffered. He added that his conclusion against the Defendants was reinforced by what he called the "alternative approach" adopted in the Lordsvale case above – namely, by considering whether the2% uplift represented a fair "rateable increase charged prospectively, which did not have the dominant purpose of deterring default. In his view, it was "reasonably clear" that the 2% uplift did have a proper commercial purpose. It was there, "not for deterrence but for the commercial reason of providing a different interest rate regime in respect of a borrower which had deteriorated into an inferior credit risk situation".

In addressing other arguments raised, the judge did not accept that an increase in interest rate upon default was prima facie (on first impression) penal, nor did the fact that the banks had security in the form of the mortgage of the vessels detract from the necessity of a higher rate uplift on default. "Banks," he said, "very often do have both security as well as a reasonable spread over LIBOR as well as uplift interest rate upon default. Security and default uplift are not mutually exclusive and their co-existence does not therefore suggest t hat default uplift is exorbitant or extravagant. Both are needed for the proper protection of the banks."

Judgment was accordingly given for the plaintiff banks, but the period for payment of the default interest did not begin on the date of the non-payment of the instalment due on 17 February 2003 but rather, on the date when the Bank submitted a written Notice in English to the Borrower demanding repayment of the entire loan on the occurrence of a default event. This took place on 16 April 2003. The default interest therefore applied only to the period from 16 April 2003 to the date of judgment in December 2003, and not from 17 February 2003. The Plaintiffs’ claim was limited accordingly.