FIRST COMMERCIAL BANK AND OTHERS v. THE OWNERS AND/OR DEMISE CHARTERERS OF THE SHIP OR VESSEL "LIBERTY CONTAINER

HCAJ168, 169 & 175/2003

IN THE HIGH COURT OF THE

HONG KONG SPECIAL ADMINISTRATIVE REGION

COURT OF FIRST INSTANCE

ADMIRALTY ACTION NO.168 OF 2003

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Admiralty Action in rem against the ship “Mandarin Container” (Singapore Flag)

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AND

ADMIRALTY ACTION NO.169 OF 2003

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Admiralty Action in rem against the ship “Kingdom Container” (Singapore Flag)

BETWEEN

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AND

ADMIRALTY ACTION NO.175 OF 2003

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Admiralty Action in rem against the ship “Liberty Container” (Singapore Flag)

BETWEEN

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(HEARD TOGETHER)

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J U D G M E N T

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1. On 16 December 2003, the court entered default judgment in all three actions in favour of the plaintiffs’ mortgagees for the principal sums owing and the court also ordered that the plaintiffs “do recover interest on the principal at such rate for such period up to the judgment date as the court will subsequently determine”.  This hearing was therefore to resolve the difference between the parties as to very substantial matter of default interests to be awarded to the plaintiffs.

2. The main issue on interest is whether Clause 9.3 of the Facility Agreement providing for interest at additional 2% is a penalty.  There are also two additional minor issues arising out of interest.

Penalty or liquidated damages

3. Under Clause 9.1.1 of the Facility Agreement dated 19 December 1998 (“the Agreement”), interest is payable at the rate of 1.4% above three months LIBOR.  By Clause 9.3 of the Agreement, it was provided that in the event of non-payment, additional interest of 2% is payable.  Clause 9.3 provides :

“In respect of the relevant Loan, interest accrued thereon and all sums payable hereunder not repaid or not paid on the due date or dates hereunder, additional interest, which shall accrue from day to day, shall be payable (as well after as before judgment) on demand from the due date or dates for payment hereof until actual payment of such principal, interest or other sums (as the case may be) at the rate of two per centum (2%) over the applicable rate referred to in Clause 9.1.  The Borrower acknowledges that the additional interest payable as aforesaid represents a genuine pre-estimate of the loss and damage which the Banks will suffer arising from any failure by the Borrower to observe its payment obligations promptly.”

4. At or around the time of the Facility Agreement, three months LIBOR for Japanese Yen was 0.49141%.  The applicable interest rate, by adding 1.4% contractual margin to the three months LIBOR was therefore 1.89141%.  The default interest rate (if applicable in December 1998), when 2% additional rate is added to the applicable rate, would therefore be 3.89141%.

5. On 17 February 2003, the defendants failed to pay the instalment amount on that day.  By written notice in Chinese dated 15 April 2003 (page 185) and in English dated 16 April 2003 (page 184), the plaintiffs called the default and required the immediate payment of the entire loan and all other outstanding amounts.  On 17 February 2003, the three months LIBOR for Japanese Yen was 0.0625%, namely some 0.43% less than in December 1998 when the Facility Agreement was signed.  The case of the plaintiffs is that as from 17 February 2003, the defendants are liable to pay interest on the entire amount at the rate of 3.4625% (0.0625% + 1.4% + 2%).  The defendants’ case is that they are only liable to pay from 17 February 2003 interest at the applicable rate of 1.4625% (0.0625% + 1.4%).

6. The dispute between the parties is whether the defendants are liable to pay to the plaintiffs the default interest at the additional 2% for the period from default until date of judgment on 16 December 2003.  The contention of the defendants is that default interest at the additional rate of 2% is a penalty and that therefore it is not enforceable.

Legal principle on penalty

7. The modern history of the law on the non-enforceability of a penalty clause starts with Dunlop Pneumatic Tyre Co. Ltd v. New Garage and Motor Co. Ltd [1915] A.C. 79 where the well-known statement of Lord Dunedin appeared at pages 86-88 :

“2.   The essence of a penalty is a payment of money stipulated as in terrorem of the offending party; the essence of liquidated damages is a genuine covenanted pre-estimate of damage …

3.    The question whether a sum stipulated is penalty or liquidated damages is a question of construction to be decided upon the terms and inherent circumstances of each particular contract, judged of as at the time of the making of the contract, not at the time of the breach …

4.    To assist this task of construction various tests have been suggested, which if applicable to the case under consideration may prove helpful, or even conclusive.  Such are:

(a)   It will be held to be penalty if the sum stipulated for is extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved to have followed from the breach …

(b)   It will be held to be a penalty if the breach consists only in not paying a sum of money, and the sum stipulated is a sum greater than the sum which ought to have been paid.. This though one of the most ancient instances is truly a corollary to the last test …

(c)   There is a presumption (but no more) that it is a penalty when ‘a single lump sum is made payable by way of compensation, on the occurrence of one or more or all of several events, some of which may occasion serious and other but trifling damage’ ...

(d)   It is no obstacle to the sum stipulated being a genuine pre-estimate of damage, that the consequence of the breach are such as to make precise pre-estimation almost an impossibility.  On the contrary, that is just the situation when it is probable that pre-estimated damage was the true bargain between the parties ...”

8. The “Dunlop approach” might be said to be the high water mark of modern Penalty jurisprudence as thereafter the limited application of the penalty jurisdiction (based on relief granted by the Courts of Equity) was emphasised by the courts.  Already in 1966, Lord Diplock in Robophone Facilities Ltd v. Blank [1966] 1 WLR 1428 at page 1447 said :

“… the Court would be doing an ill turn to those whom the rule about ‘penalty clauses’ is designed to protect if they were to apply it so as to make it impracticable for parties to agree at the time when they enter into a contract upon a fair and easily ascertainable sum to become payable by one party to another as compensation for the loss which the latter will sustain as a consequence of its breach.  It is good business sense that parties to a contract should know what will be the financial consequences to them of a breach on their part, for circumstances may arise when further performance of the contract may involve them in loss.  And the more difficult it is likely to be to prove and asses the loss which a party will suffer in the event of a breach, the greater the advantages to both parties of fixing by the terms of the contract itself an easily ascertainable sum to be paid in that event.  Not only does it enable the parties to know in advance what their position will be if a breach occurs and so avoid litigation at all, but if litigation cannot be avoided, it eliminates what may be the very heavy legal costs of proving the loss actually sustained which would have to be paid by the unsuccessful party.  The court should not be astute to descry a ‘penalty clause’ in every provision of a contact which stipulates a sum to be payable by one party to the other in the event of a breach by the former ...”

9. In Elsey v. Collins Insurance Agencies Ltd (1978) 83 DLR 15, Dickson J in the Supreme Court of Canada said that :

“It is now evident that the power to strike down a penalty clause is a blatant interference with freedom of contract and is designed for the sole purpose of providing relief against oppression for the party having to pay the stipulated sum.  It has no place where there is no oppression.”

10. The virtue of freedom of contract is again stressed by the High Court of Australia in AMEV-UDC Finance Ltd v. Austin (1986) 162 CLR 170 where at page 193-4, Mason J and Wilson J said this :

“… the courts should give the parties greater latitude to determine the terms of their contracts.  In the case of provisions for agreed compensation … that latitude is mutually beneficial to the parties … But equity and the common law have long maintained a supervisory jurisdiction, not to rewrite contracts imprudently made, but to relieve against provisions which are so unconscionable or oppressive that their nature is penal rather than compensatory.  The test to be applied in drawing that distinction is one of degree and will depend on a number of circumstances, including (1) the degree of disproportion between the stipulated sum and the loss likely to be suffered by the plaintiff, a factor relevant to the oppressiveness of the term to the defendant, and (2) the nature of the relationship between the contracting parties, a factor relevant to the unconscionability of the plaintiff’s conduct in seeking to enforce the term.  The court should not, however, be too ready to find the requisite degree of disproportion lest they impinge on the parties’ freedom to settle for themselves the rights and liabilities following a breach of contract. The doctrine of penalties answers, in situations of the present kind, an important aspect of the criticism often levelled against unqualified freedom of contract, namely the possible inequality of bargaining power.  In this way the courts strike a balance between the competing interests of freedom of contract and protection of the weak contracting parties…”

11. The Privy Council in the case of Philips Hong Kong Ltd v. Attorney General of Hong Kong [1993] 1 HKLR 269 provides the guiding principle on the modern approach to penalty clause in commercial contracts.  At pages 279 to 280, Lord Woolf said :

“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 use in argument of unlikely illustrations should therefore not a assist a party to defeat a provision as to liquidated damages…  A difficulty can arise where the range of possible loss is broad.  Where it should be obvious that, in relation to part of the range, the liquidated damages are totally out of proportion to certain of the losses which may be incurred, the failure to make special provision for those losses may result in the ‘liquidated damages’ not being recoverable …  However, 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.”

12. The modern emphasis on freedom of contract and limitation of unenforceable penalty clauses to cases of oppression is strongly supported in The Report on Penalty Clauses of The Scottish Law Commission Report (18 May 1999).  At paragraph 3.2 of the Report this was said :

“… The policy aim is to respect the parties’ freedom to contract for the payment of agreed sums, or for equivalent sanctions, in specified circumstances and to restrict judicial intervention to cases where the penalty is so excessive, or so exorbitant and unreasonable, that it would be unconscionable to permit it to be exacted.”

Then at paragraph 3.8 this was said :

“… we have come down in favour of the term ‘manifestly excessive’ which is used in the Council of Europe’s recommendation on this subject.  It helps to give the impression that the court should not examine agreed sanctions too closely.  The excessive nature of the penalty should be immediately obvious to anyone considering it.  It should be manifest and not a matter of nice calculation.  Unless the specified penalty is manifestly excessive, it should be enforceable.”

13. The above review of the legal jurisprudence on penalty suggests 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 rather than genuine agreement providing for fixed formula of loss. 

14. Two authorities involving “default interest” penalty clauses were also cited to this Court. In the first case of Lordsvale Finance v. Bank of Zambia [1996] Q.B. 752, it was held by Colman J that an extra 1% for default interest was not a penalty.  In the second case of Hong Leong Finance Ltd v. Tan Gin Huay [1999] 2 SLR 153, the Singapore Court of Appeal held that an extra 11.25% (from 6.75% for the third year onwards increased to 18% after default) is an extravagant increase being in terrorem of the borrower.

15. The Lordsvale judgment is of particular interest because the penalty clause was analysed in the context of firstly, this type of standard provision regularly seen in modern commercial loan agreements and secondly in the light of the various international authorities bearing on this type of uplift interest rate upon default.  At page 763, Colman J said :

“Where, however, the loan agreement provides that the rate of interest will only 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.  That is not because there is in any real sense a genuine pre-estimate of loss, but because there is a good commercial reason for deducing that deterrence of breach is not the dominant contractual purpose of the term.”

Application of legal principle on penalty

16. The sole question in the light of the legal authorities previously considered, is whether in relation to the particular commercial contract in the form of the Facility Agreements, it can be said that Clause 9.3 providing for the 2% uplift interest upon non-payment can be said to be in terrorem because it is unconscionable, oppressive or extravagant. 

17. It is of course well established that the question of whether Clause 9.3 is a penalty is to be judged at the time of the making of the Facility Agreements namely in December 1998 and not in February or April 2003.

18. The applicable interest rate in December 1998 was 1.89141% and the default interest rate under Clause 9.3 (after adding the 2%) would be 3.89141% in December 1998.  It was however unknown at the time of the Facility Agreement what might be the future applicable rate or what therefore might be the future default interest rate.  Japanese Yen interest rate in December 1998 was of course low but that interest rate could go up just as it could go down (which was what happened).  A loss in the strength of the Japanese currency over the long period of the loan could easily therefore bring the interest rate for Japanese Yen substantially up.  The movement of the Japanese Yen three months LIBOR was therefore within the range of many possibilities which would affect the possible losses to be suffered by the plaintiffs. 

19. In a large loan, such as this, in relation to the finance of a number of ships covering a long period of time, the range of possible losses consequent upon non-payment by the defendant of its contractual obligations would be broad, extensive and difficult to visualise, identify or enumerate.  It is therefore sensible for the parties to agree beforehand on an agreed formula for interest rate regime covering the time when there was default in payment.  Having regard to what Lord Woolf said in the Philips case about contractual provision 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 Clause 9.3 are totally out of proportion to the range of losses which might likely be incurred.

20. This court must bear in mind that this is a commercial contract where the parties on equal terms agreed on the stipulated liquidated damages and as was said in the AMEV case, the court should not be too ready to find high “degree of disproportion” between the stipulated sum and the loss likely to be suffered.

21. But in any event, I am clearly of the view that there was no such unacceptable “degree of disproportion”.  Having regard to the circumstances of this loan, the 2% uplift is clearly in my view not extravagant or exorbitant or excessive.  There can be no suggestion that this is a provision made in circumstances of oppression or unconscionability requiring the court to exercise its supervisory role to grant relief.

22. My conclusion above against the defendants is further reinforced by what I might call the alternative approach adopted in the Lordsvale case by considering whether the 2% uplift represents a fair “rateable increase charged prospectively” which does not have the dominant purpose of deterring default.  In my view, it is reasonably clear that the 2% uplift in the Facility Agreement does have a proper commercial purpose.  It is 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.  The rate increase of 2% although higher than the 1% increase in the Lordsvale case is really quite modest compared to the 11.25% increase condemned in the Hong Leong case.

23. In reaching my conclusion in favour of the validity of Clause 9.3, I have not overlooked the many points made by Mr Kat for the defendants.  His point for example about this loan being secured as compared to the Lordsvale loan not being secured does not assist him.  Floating security is often difficult to enforce and the loss of credit-worthiness upon non-payment is one of the many imponderables which the lenders have to take into account in assessing what should be the appropriate default rate uplift.  Nor do I accept the argument that an increase in interest rate upon default is prima facie penal.  The reasoning in Lorsvale of the commercial necessity for a higher interest rate, when the credit risk of the Borrower is increased, shows the fallacy of that argument.  Further the fact that the bank has security in the form of the mortgage of the vessels does not in any way detract from the necessity of a higher rate uplift upon default.  Banks 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 coexistence do not therefore suggest that default uplift is exorbitant or extravagant.  Both are needed for the proper protection of the Banks.

24. In these circumstances, I conclude that Clause 9.3 is not a penalty and is enforceable against the defendants.

Applicable period for the default rate

25. The non-payment of an instalment on 17 February 2003 was an event of default as defined by Clause 14.1.1.  The Bank upon the occurring of an event of default is entitled to call in by written notice the entire loan and thereby accelerate the repayment obligation of the Borrower (see Clause 14.2.1).  But the immediate obligation to repay everything depends on the written notice of the Bank under Clause 14.2.1.  That written Notice was the document in English dated 16 April 2003.  Until that written Notice was served, notwithstanding that an event of default had occurred, the Bank was not entitled to the immediate repayment of the entire loan.  It is clear by even a casual reading of the letter dated 19 March 2003 (page 187) from the Bank to the Borrower that the Bank in March 2003 was only looking towards repayment of the then outstanding instalment and not the entire loan.

26. It seems to me thereafter that on general principle, the Bank could not seek default interest on the entire loan for a period before it called in the whole loan by its letter dated 16 April 2003.  Clause 9.3 cannot be read so as to give the Bank the right to default interest on the entire loan, when the loan had not been called into default by written notice under Clause 14.2.1 and when there was no obligation on the part of the Borrower to repay immediately the entire loan.  The plaintiffs in my view are mistaken on this aspect of the dispute and the default interest can therefore be only applicable to the period from 16 April 2003 and not from 17 February 2003.

Post-judgment interest

27. At the time of the judgment on 16 December 2003, it was anticipated by the plaintiffs that there would be payment out (from the Funds in court) to the plaintiffs of the judgment in respect of principal on the 17^th of December 2003 and it was for that reason that the judgment provides at paragraph 7(b) that plaintiffs be paid interest for one day (16 to 17 December 2003) at the rate of 3%.  Due to the administrative banking arrangements made by the court, the plaintiffs were not paid the judgment sum until 23 December 2003.  The plaintiffs quite rightly felt that six days’ interest was owing to them.

28. If the plaintiffs are not given the six days’ interest then the Fund in court would have earned an extra six days’ interest (from the bank deposit) and the ultimate beneficiary of that windfall will be the defendants.  There is really no basis in either law or justice for the defendants to contend that they should have the benefit of that windfall.  The plaintiffs are in my judgment properly entitled to six days’ interest but interest rate would be at the bank rate earned by the court on the Fund deposit. 

Conclusions

29. My conclusion on the disputes between the parties is that :

(1)    the plaintiffs are entitled to claim the additional default interest under Clause 9.3 which I hold to be not a penalty;

(2)    the plaintiffs however are limited to claim the Default Interest on the entire amount of the loan outstanding from 16 April 2003; and

(3)    the plaintiffs are entitled to six days’ interest on the judgment sums at the same interest rate as earned by the Fund placed by the court on deposit.

30. I direct that an agreed draft order to carry out my aforesaid judgment be prepared and submitted to the court for approval and that in default of agreement, there will be liberty to the parties to apply to the court for further direction or order.

31. I further make an order of costs nisi that costs of the hearing relating to these disputes be to the plaintiffs.