ACCELERATED PAYMENT AND THE PENALTY DOCTRINE
Does the acceleration of a “primary obligation” invariably falls outside the scope of the penalty doctrine? Or can it be a secondary obligation? This was addressed by the Court of Appeal in Ethoz Capital Ltd v Im8ex Pte Ltd and others [2023] SGCA 2.
Salient facts. In brief, Im8ex Pte Ltd (“Im8ex”) signed certain loan facilities (the “Facilities”) from Ethoz Capital Ltd (“Ethoz”). In these Facilities, there are certain provisions dealing with what happens if Im8ex defaults on payment. Key clauses include:
A term defining “Total Interest” as “the aggregate of all the interest payments” ([12]);
A Clause 7(B), providing that “… the Total Interest “shall be deemed earned and accrued in full upon the drawdown of the Advance”…” ([13]); and
A Clause 5(A), providing that “… in default of payment of any of the instalments in Schedule 3, Ethoz “may treat the whole of [the Facilities] or the balance thereof … together with interest thereon and all other sums due and owing under this Agreement as immediately due and payable without any demand.” ([14(b)]); and
A Clause 14, providing that “… an event of default will occur if Im8ex does not pay any of the “sum[s] payable under [the Facilities] when due” (as per Clause 14(A)(1)), and that this will entitle Ethoz to 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.”” ([14(c)]).
The argument on accelerated payment. For the purposes of this blog, we focus on Ethoz’s argument on appeal as summarized at [36]. The issue is simply this: is the payment of Total Interest upon Im8ex’s default an “accelerated primary obligation”, or is it a secondary obligation?
If it is a primary obligation, then the penalty doctrine does not apply. If it is a secondary obligation, then the penalty doctrine applies.
And if the penalty doctrine applies, the obligation may then be unenforceable if it falls foul of the penalty doctrine.
So, the Court of Appeal first dealt with what amounts to a primary or secondary obligation at [50] – [53]. In gist, after setting out certain factors, the Court of Appeal said that it is a question of substance over form.
But in general, a primary obligation would be the “essential purpose“ of a contract, while a secondary obligation would be one that is incidental to the primary obligation. Thus, a classic example of a secondary obligation would be an obligation to pay money upon breach of a contract, such as, e.g., liquidated damages provision.
Immediate payment of Total Interest a secondary obligation. The Court of Appeal then held that the immediate payment of Total Interest is a secondary obligation as it was not Im8ex’s primary obligation.
To summarise:
Im8ex’s primary obligation was to pay Total Interest in instalments ([55] – [56]).
There was nothing to suggest that Im8ex had to pay the Total Interest fully and immediately, other than in a case of default ([57]).
As for the issue of pre-payment, it was not commercially sensible to construe that Im8ex would have to pay both the advance and Total Interest if Im8ex made prepayment as this would render the purpose of prepayment to avoid continuing obligation to pay interest nugatory ([60]); and
For most loan agreements, the primary obligation of a borrower is to repay the loan sum and interest in instalments ([63]).
It is important to note that the Court of Appeal made clear that Clause 7(b) creates a debt ([37]): what is important is that despite this, on the facts of the case, the accelerated payment of the accrued debt fell within the scope of the penalty doctrine: i.e., it was a secondary obligation.
Genuine pre-estimate? The Court of Appeal then asked if the obligation to make full and immediate payment of Total Interest is an unenforceable penalty ([64]).
What is important to note is that the Court of Appeal held that the “… question is not whether a provision is not a genuine pre-estimate of loss; the question is whether that provision stipulates a payment of money in terrorem of a defaulting party …” ([79]).
In other words, the focus is not on whether the clause is a genuine pre-estimate: rather, the focus is on whether the provision is in terrorem.
The Court of Appeal then held that the clause was in terrorem:
Firstly, the Total Interest is a “single lump sum” payable upon the occurrence of one or more events, including some which may be relatively trifling ([80]); and
Secondly, if Im8ex defaults on the 10th payment, the sum which Im8ex had to pay would “clearly dwarf the defaulted payments” ([81]).
The way these findings are phrased should be familiar: they mirror the tests set out in the decision of Dunlop Pneumatic Tyre Co, Ltd v New Garage and Motor Col, Ltd [1915] AC 79, which have been helpfully summarised by the Court of Appeal at [67(a)] - [67(c)].
What is more interesting is the reasoning set out at [86] – [88], which we duplicate below:
“86 The “essence” of a penalty is that it is a contractual stipulation that acts in terrorem over the offending party such that the threat of the penalty forces compliance with that party’s primary obligations under the contract. The latter part of that is key: a penalty forces compliance with the contract breaker’s primary obligation. As we noted above at [65], this is objectionable because parties should be free to breach their contracts as long as they pay the price.
87 But what if the price stipulated in the contract is, in essence, the full performance of the primary obligation that the defaulting party breached in the first place? This would indirectly force a party into compliance with their primary obligation. Thus, by fixing the “minimum payment” such that it amounts to the entire or substantial performance of the parties’ primary obligation, the relevant clause would undermine the purpose behind the penalty doctrine. Hence, in our view, it must be considered a penalty.
88 Turning back to the case before us, by requiring the full and immediate payment of the Total Interest, Clauses 5(A) and 14(B)(2) were essentially forcing Im8ex to comply with its primary obligation under the Facilities (the full payment of Total Interest in instalments). This is yet another reason for concluding that the full and immediate payment of the Total Interest is a penalty.”
(our emphasis added)
So, if a clause is drafted to ensure that the other party would be “forced into compliance” with the other party’s primary obligation, this clause would be a penalty.
This is because, as set out in [65] – [66], parties are free to “change their mind and break their contractual undertakings if they so wish, albeit at a price”.
What is therefore objectionable about an unenforceable penalty is that it is a clause that interferes with parties’ freedom to break their contractual undertaking.
Genuine pre-estimate. And to round off our observations, we highlight [98] - [99], as set out below:
“98 It thus falls on Ethoz to show that the Default Interest rate is a genuine pre-estimate of its loss. In doing so, it first cites a single paragraph in an affidavit that one of its representatives had filed in the matter:
[Im8ex’s] assertion that Clause 15 of [the Facilities] is a penalty clause is equally unmeritorious especially since it is devoid of any factual basis. The default interest at a rate of 0.0650% per day is [Ethoz’s] genuine estimate of [its] loss, taking into account [its] business considerations (including the loss of the use of funds).
99 Clearly, this is not a sufficient explanation. Having stated that the Default Interest rate is a genuine estimate of loss stemming from, inter alia, the loss of the use of funds, Ethoz could have gone on to show calculations substantiating this assertion. Indeed, as it is Ethoz’s own “business considerations” that are cited, such figures would be especially within its knowledge, and thus they would bear the burden of adducing evidence on the matter: s 108 of the Evidence Act 1893 (2020 Rev Ed). That it did not, suggests to us that the above paragraph is simply an assertion devoid of any evidential basis.“
In the context of liquidated damages, what this means is that if, e.g., the Contractor manages to raise a prima facie case that the rate of liquidated damages provision too high and hence prima facie an unenforceable penalty, the focus will shift to the Employer to justify the rate of liquidated damages.
And these two passages tell us that it is not enough for the Employer to simply assert that the rate is a genuine pre-estimate. The Court would expect, e.g., calculations to explain why it is a genuine pre-estimate and adduce evidence to support the same.
Observations. The Court of Appeal started off the judgment by cautioning parties engaging in “clever drafting”, i.e., drafting to obscure the true nature of a provision by attempting to obfuscate its substance as a secondary obligation.
While this may seem to be not relevant to the construction industry, the emphasis here on what amounts to a clause that is in terrorem is important.
After all, the penalty doctrine is not limited to just liquidated damages provision: any provision that is a secondary obligation can be subject to the penalty doctrine, and it all depends on the facts of the case and the contract in question as to whether the secondary obligation in question may be struck down.
So, if a clause attempts to “force” you into complying with your obligations under another clause, pause and ask: is that clause a secondary obligation, and is it liable to be struck down as a penalty?
This publication is not intended to be, nor should it be taken as, legal advice; it is not a substitute for specific legal advice for specific circumstances. You should not take, nor refrain from taking, actions based on this publication. Chancery Law Corporation is not responsible for, and does not accept any responsibility for, any loss or damage that may arise from any reliance based on this publication.