SGCA: Obligation to pay entire interest charged on a loan upon default was an unenforceable penalty

Key takeaways: 

• This case involved a loan agreement that obliged the borrower to pay all the interest chargeable on the principal over the entire 15-year tenor of the loan immediately on the occurrence of a default. This obligation to pay all the interest chargeable on the principal immediately on default was ruled to be an unenforceable penalty. This was the case even though the agreement provided that the entire interest was deemed to have been earned and accrued on the date the principal was first drawn down. 
• The basis of the ruling was heavily premised on the ground that the requirement to pay the entire interest imposed the performance of the primary obligation in the case of breach. Accordingly, this was in breach of the purpose behind the penalty doctrine: which is to disallow clauses that act in terrorem to force compliance with a party’s primary obligations under the contract. 
• Careful drafting / legal advice is required particularly in the context of provisions which deem a particular amount of unaccrued interest due and payable upon acceleration – such “make whole” or similar clauses will need to be carefully worded. In our view, these types of clauses should still remain valid if they represent a genuine pre-estimate of loss; this may however depend not just on the wording of the clause but on the actual economics of the deal (e.g. whether the "make whole" is commercially reflective of the lender’s costs, including its opportunity costs and funding costs). 

Facts 

In Ethoz Capital Ltd v Im8ex Pe Ltd [2023] SGCA 3 (20 January 2023), the lender, Ethoz Capital Ltd (Lender), had entered into four facility agreements with Im8ex Pte Ltd (Borrower). While there were four facility agreements altogether, they were substantially each on the same terms except for the principal amount lent and will be discussed in this case note as a single agreement.

The facility agreement provided that a total of S$6.3 million was being lent. A flat rate of interest of 3.75% per annum on the entire amount for 15 years was charged. This meant that total interest charged was about S$3.5 million (Total Interest) or 56.25% of the principal amount. Clause 7 of the facility agreement provided that the Total Interest was deemed earned and accrued in full upon drawdown, and Clause 14 of the facility agreement provided that upon the occurrence of an Event of Default, the borrower would immediately repay the outstanding principal amount as well as the rest of the Total Interest not already paid. The facility agreement also set out a monthly schedule of instalment payments for the total amount of the principal and Total Interest to be made over 15 years. The Borrower defaulted on the loan in its first year, and the Lender then claimed for the outstanding principal and the Total Interest. 

The High Court ruled that the obligation to pay the Total Interest was a penalty (read "Tricky Issues in Ensuring Enforceable “Make Whole” Interest Obligations"). The Lender appealed. 

The acceleration obligation was a secondary obligation 

The Court of Appeal upheld the ruling that the obligation to pay the Total Interest was an unenforceable penalty. Among other things, it rejected the Lender’s argument that because Clause 7 of the facility agreement provided that the Total Interest was deemed earned and accrued in full upon drawdown, the obligation was a primary obligation and was therefore not a penalty. 

The Court of Appeal applied the penalty rule as set out in its decision in Denka Advantech Pte Ltd & Anor v Seraya Energy Pte Ltd & Anor (2020). In brief, that decision had affirmed that the penalty rule did not apply to primary but to secondary obligations. In considering whether an obligation is a primary or secondary obligation, the Court noted that it had set out the following non-exhaustive factors in Denka v Seraya: 

• The overall context in which the bargain in the clause was struck; 
• Any particular reasons for the inclusion of the clause; and 
• Whether the clause was contemplated to form part of the parties’ primary obligation to secure some independent commercial purpose or was only to secure the affected party’s compliance with his primary obligations. 

The Court considered Clause 7 and held that it had created an accrued debt and was a primary obligation. However, it noted that this was not the end of the matter; it stated that the acceleration of this primary obligation could attract the penalty rule. An accelerated obligation may change from a primary obligation to a secondary obligation depending on the nature and extent of the acceleration. 

More importantly, the Court rejected what it called the Acceleration Principle: that a contractual clause that merely accelerates the liability to pay an existing debt will be enforceable because it avoids the regulation of the penalty doctrine entirely. It noted that this was to ignore that a sum in the present has greater value than the same sum in the future due to inflation. A debtor who pays a sum in the present rather than in the future also loses the ability to use that sum of money in the duration of that interval of time between the present and the future. 

It then stated that as regards the payment of the Total Interest, the provisions on time of payment had to be seen as two separate obligations: an obligation to pay the Total Interest in instalments and an obligation to make the full payment of Total Interest. The obligation to pay the Total Interest in instalments was a primary obligation; the obligation to make the full payment of the Total Interest in one lump sum was a secondary obligation triggered on the breach of the contract. 

In this case, it was clear that the Borrower’s primary obligation was to pay the Total Interest in instalments as the facility agreement provided that, in consideration for the provision of the loan facilities, the Borrower would repay the principal and the interest in 180 equal instalments. Conversely, the obligation to pay the Total Interest in full only arose if there was a breach. 

To get around the issue of whether the obligation to pay the Total Interest was a primary or secondary obligation, the Lender argued that Total Interest was also payable if the borrower gave a prepayment notice. However, the Court disagreed. It noted that the clause on prepayment only required payment on “interest computed thereon”, not “Total Interest”. It also held that there were no grounds to construe “interest computed thereon” as meaning “Total Interest” (see below on the Court’s reasoning behind its construction of the term). 

As it had determined that the obligation to make full and immediate payment of the Total Interest was a secondary obligation, it then considered whether this obligation offended the penalty rule. 

The obligation to pay Total Interest was an unenforceable penalty

On this, the Court emphasised that the test whether an obligation is an unenforceable penalty is whether it stipulates a payment of money in terrorem of a defaulting party. It emphasised that under the law, a party was always free to decide to breach a contract provided it was willing to pay the price (in terms of damages). Where the effect of a provision such as the requirement to pay the Total Interest was to effectively impose the performance of the primary obligation in the case of breach, this would indirectly force a party into compliance with their primary obligation. To allow this would be to undermine the purpose behind the penalty doctrine: which is to disallow clauses that act in terrorem to force compliance with a party’s primary obligations under the contract. 

In this case, the Court noted that the Borrower would be required to repay the principal plus the Total Interest even if all it did was fail to repay one instalment. The Total Interest to be paid in that instance was much larger than the single instalment sum defaulted on. The Court therefore held that the obligation to pay the Total Interest in full was an unenforceable penalty. 

Default Interest rate was also an unenforceable penalty

As the facility agreement also imposed a Default Interest rate of 0.065% per day, the Court also considered whether the Default Interest rate was a penalty. Parties accepted that the contractual interest rate on the loan was 6.444% per annum, and the Default Interest rate worked out to 26.08% per annum. The Court noted that this was four times the contractual interest rate and was clearly an extravagant increase. It therefore held that the obligation to pay the Default Interest rate was also an unenforceable penalty.

Borrower could exercise its equity of redemption to pay back the loan amount 

Finally, the Court held that the Borrower had an inherent right to exercise its equity of redemption by paying back the loan amount and interest due. Here, it held that the amount of interest to be paid should follow the amounts set out under the Schedule to the facility agreement for the number of months for which the loan had been running from when it was first made up to the redemption date ordered by the High Court in this case. The Borrower hence was given three months to exercise its equity of redemption by paying back the remainder of the principal and the amount of interest as determined by the Court. 

Additional points arising from the Court’s judgement 

The following additional points in the Court’s decision on penalty clauses are noteworthy: 

• The Lender sought to argue that the Borrower had failed to bring evidence to show that the amount of Total Interest and the amount of the Default Interest were penal in nature. The Court held that it was entirely sufficient for the Borrower and the court to simply rely on what was in front of them, namely, the provisions of the facility agreement. No additional evidence would be needed if this evidence was sufficient in itself. In this case, the amounts spoke for themselves and no additional evidence was needed. 
• In construing the prepayment clause, the Court had to construe the term “interest computed thereon”. There was nothing in the clause itself to tie that to the term “Total Interest”. The Court held that to construe the term “interest computed thereon” as referring to “Total Interest” would not be commercially sensible: the entire purpose of a prepayment is to allow a borrower to avoid the continuing obligation to pay interest on the remaining period. Such a purpose would be rendered nugatory if Total Interest had to be paid in full notwithstanding early payment. Furthermore, in this case, the prepayment clause also required the borrower to pay additional fees such as a prepayment fee and three months’ worth of interest if proper notice was not given. Taken as a whole, the borrower would be in a worse position if it sought to prepay if the phrase “interest computed thereon” meant “Total Interest”. This could not have been the commercial intent. Accordingly, therefore, the prepayment clause did not require the borrower to pay the Total Interest. 
• In prior cases dealing with the question of default interest, Singapore courts have considered the revenue lost from use of funds in considering whether the amount of default interest was a penalty. This was argued by the Lender. The Court of Appeal considered this briefly but stated that it was insufficient for the Lender to simply state that the Total Interest/Default Interest represented what it would have made from the funds lent. It had to bring evidence to show this. This it had not done. 
• The Lender had sought to argue that the amount of the Default Interest worked out to 1.95% per month which was much less than the interest rate prohibited in the Moneylenders Act 2008, which made it a criminal offence for a licensed moneylender to charge late interest exceeding 4% per month. The Court held that the amount specified in the Moneylenders Act 2008 was irrelevant: that was the maximum interest which if exceeded would attract criminal liability. It noted that criminal liability, by virtue of its severe consequences, will necessarily set higher standards. It was not a basis on which to determine whether an interest rate amounted to an unenforceable penalty or not.