Singapore Court of Appeal Sends Acceleration of Interest Payment Clause To The Penalty Box
Commercial contracts commonly include clauses providing for liquidated damages, accelerated repayment or late payment interest in the event one party breaches the contract.
It is trite that such clauses are not enforceable as of right. The Singapore Courts have consistently affirmed the test set out in the seminal decision of Dunlop Pneumatic Tyre Co, Ltd v New Garage and Motor Co, Ltd  AC 79 ("Dunlop") that a contractual clause will be considered a "penalty clause" (and therefore unenforceable) if it was found to be designed to deter a breach of contract rather than to provide for genuine compensation for the party.
Despite landmark decisions in the UK and Australia1 casting some uncertainty over Dunlop's "genuine pre-estimate of loss" test, the Singapore Court of Appeal affirmed the continued application of the test in Dunlop.2
The recent decision in Ethoz Capital Ltd v Im8ex Pte Ltd and others  SGCA 3 ("Ethoz Capital") is the latest case affirming the test in Dunlop, where the Court of Appeal interestingly found an accelerated repayment clause to be a penalty clause and thus unenforceable.
Relevant Background Facts
Ethoz Capital Ltd (“Ethoz”) lent $6.3 million to Im8ex Pte Ltd (“Im8ex”) under several loan facilities which were secured by mortgages over several different properties (“Properties”).
The parties subsequently renewed these loan facilities under a new set of 4 loan facilities (the "Facilities"). Pursuant to the Facilities, the amount advanced to Im8ex was $6.3 million (the "Advance") and was similarly secured by mortgages over the Properties.
The Facilities included several important clauses which were essentially:-
- The Advance was extended at an interest rate of 3.75% p.a. to be paid equally over 180 monthly instalment payments.
- An amount termed “Total Interest” (which was the aggregate of all the interest payments) was “deemed earned and accrued in full upon the drawdown of the Advance”, and if Im8ex defaults on payment, it will pay interest (“Default Interest”) on the Advance and Total Interest at a rate of 0.065% per day (“the Default Interest Rate”).
- If Im8ex failed to pay any sum when due, Ethoz could declare that “all amounts due and owing under [the Facilities], including the Advance and the Total Interest and any default interests … be immediately due and payable.”
When Im8ex defaulted on payment, Ethoz applied for vacant possession of the Properties, payment of the Advance, the Total Interest and the Default Interest. Im8ex's case was, amongst other things, that the payment of Total Interest and Default Interest constituted unenforceable penalties.
The Court of Appeal's Decision
The Court of Appeal held that the accelerated payment clauses in the Facilities were unenforceable as penalty clauses.
The Court reiterated the well-established position that secondary contractual obligations are unenforceable if they are penal in nature, rather than compensatory.
Two distinct inquiries were identified in determining whether a contractual provision would be deemed to be a penalty clause: (a) whether the contractual provision creates a secondary obligation triggered by a breach of contract (the “threshold issue” referred to in Denka)3, and (b) whether it requires the defaulting party to pay an amount of money that seeks to intimidate or frighten the defaulting party to comply withtheir primary obligations.
With respect to the "threshold issue", that the Court of Appeal acknowledged the reality that distinguishing between the two types of obligations is "not always clear", and that some parties may try to 'mask' secondary obligations as primary obligations through "clever drafting".
The Court of Appeal held that Singapore courts would adopt a "substance over form approach – in line with the contextual approach to contractual interpretation", and the court must "analyse the whole contract, not just the impugned clauses in isolation." This involves a non-exhaustive list of factors including:
- “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 obligations to secure some independent commercial purpose, or was only to secure the affected party’s compliance with his primary obligations”.
Applying this approach, the CA held that it was clear that the "immediate and full payment of the Total Interest is a secondary obligation that is only triggered upon breach; it is not Im8ex’s primary obligation under the Facilities."
The Court of Appeal then considered the second inquiry and held that the immediate and full payment of Total Interest was a penalty. On the plain text of the Facilities, the increase between the regular interest rate and the Default Interest rate was an "extravagant increase" which Ethoz could not justify.
The Court of Appeal decisively held that the test in Singapore to be applied in determining whether a provision is an unenforceable penalty is that of Dunlop: "any clause that essentially forces compliance with the primary obligations of a contract – thus interfering with the parties’ freedom to break their contractual undertakings – will be held to be an unenforceable penalty".
Ethoz Capital is the first reported decision in Singapore where the acceleration of interest payments upon breach amounted to a secondary obligation that was subject to the penalty rule. Such clauses are a mainstay in contracts such as loan or settlement agreements, where parties agree for a total sum to be paid over various instalments. In the event of default of payment for any instalment, the accelerated payment clause enables the non-defaulting party to immediately claim for the total outstanding sum instead of waiting for each instalment to fall due.
It may be tempting for lenders to provide for draconian remedies especially where there is a high risk of default by the borrowers. Such an approach should be tempered in light of the decision in Ethoz Capitol.
To avoid potential complications in attempting to enforce any accelerated payment clause, lenders should be aware of the following factors:
- What is the borrower liable to pay under the accelerated payment clause?There are likely to be little to no complications enforcing the clause, if the borrower is only liable for the entire principal sum after defaulting on a single instalment. On the other hand, the same cannot be said if the borrower is made to also pay interest on the principal sum which has not even accrued. Alternatively, an exorbitant and crushing interest rate may also raise concerns with a Singapore court.
- What is the lender's loss in the event of default? Lenders need to take a realistic and pragmatic estimation of the potential loss suffered if the borrower defaults on payment obligations. Where there is a genuine belief that the "premium" paid by the borrower over and above the principal sum reflects the potential loss, the basis, factors and calculations behind this belief should be included in the contract.
- Can the parties agree beforehand that the accelerated payment mechanism is not a penalty clause? In light of the decision in Ethoz Capitol, the Singapore courts will look robustly at the substance of a contract rather than the labels ascribed by the parties. The mere fact that parties agree to a clause generally providing that they have agreed that a payment mechanism is not a penalty clause or that the mechanism is a primary obligation is very unlikely to be exempt from the Court's scrutiny.
- Which system of law should govern the contract? Given the differing approaches adopted by Singapore, UK and Australia on the enforceability of penalty clauses, it would be prudent for lenders to seek legal advice to determine which approach is the most suitable for a particular contract.
1Cavendish Square Holding BV v Makdessi  AC 1172 ("Cavendish") held that the test for when a penalty clause is unenforceable is whether the impugned provision constitutes a secondary obligation that imposes a detriment on the contract-breaker that is out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation; and Andrews & Ors v Australia and New Zealand Banking Group Limited  247 CLR 205 ("Andrews") took a more expansive approach, holding that the rule against penalties should not be limited only to clauses that took effect upon a breach of contract. There is no single test for when the clause is unenforceable, but would consider factors such as whether the sum or remedy stipulated is (1) exorbitant or unconscionable or (2) out of all proportion to the interests of the party which it is the purpose of the provision to protect; or (3) whether the stipulated is properly characterised as having no purpose other than to punish.
2Denka Advantech Pte Ltd v Seraya Energy Pte Ltd  1 SLR 631 ("Denka")
3Denka Advantech Pte Ltd and another v Seraya Energy Pte Ltd and another and other appeals  1 SLR 631 ("Denka"), where the issue was whether a liquidated damages clause was in fact a penalty clause