XCHRX SOUTH CHINA STRATEGIC LTD. v. CELSION CORPORATION

HCA 9963/2000

IN THE HIGH COURT OF THE

HONG KONG SPECIAL ADMINISTRATIVE REGION

COURT OF FIRST INSTANCE

ACTION NO. 9963 OF 2000

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D E C I S I O N

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1. These are appeals by the plaintiff and the defendant against orders of Master C B Chan made on 22 May 2001 by which, upon an application by the plaintiff for judgment under Order 14, and striking out the amended defence under Order 18, rule 19, and the defendant's application for a preliminary issue to be determined under Order 14A and/or Order 33, she gave judgment for the plaintiff for the sum of US$114,778.00, unconditional leave to defend as to the balance of the plaintiff's claim, and made no order on the application by the defendant.

2. These proceedings arise out of two agreements entered into between the plaintiff and the defendant dated 29 December 1994 ( the first agreement), and 11 December 1995 (the second agreement). The first agreement was for the purchase by the plaintiff and the sale by the defendant of certain medical equipment for the total sum of US$433,125.00, with a deposit of US$108,281.00 payable on signing the agreement, and the balance not later than 30 September 1995. The deposit was paid by the plaintiff on or about 24 December 1994. In 1995 the defendant experienced difficulties in carrying out its part of the agreement, or repaying the deposit, and the parties entered into negotiations for the cancellation of the agreement and terms for repayment. The result of this was the second agreement by which the defendant agreed to pay, by monthly payments to April 1996, a total of US$114,778.00 (the Principal Sum), being the deposit with accrued interest thereon of US$6,497.00 to 31 December 1995, and further interest on the reducing balance of 1% per month. The agreement further provided for an event of default by the defendant, in clause 3, in the following terms:

"3. Should we default in any of the repayment instalments on the above repayment dates, South China Strategic shall be entitled to charge further interest on the aggregate total of the outstanding balance of the Principal Sum and interest at the rate of 2% per month to be compounded monthly until full repayment and we shall forthwith upon demand pay to South China Strategic an additional sum of US$21,686.00 as the pre-assessed damages to South China Strategic but not as penalty."

3. No payments were made by the defendant, and the plaintiff claimed the sum of US$114,778.00, being the agreed principal and interest as at 31 December 1995, default interest on this at 2% per month compounded monthly, the rate agreed in clause 3, and the sum of US$21,686.00 as pre-assessed damages under the same clause. For the purposes of this appeal, the plaintiff claims only the default interest, leaving the matter of the pre-assessed damages to trial. The defendant does not dispute liability to pay the first sum, but contends that the terms of clause 3, and the payments of the interest and lump sum therein provided, amount to a penalty which the court should not enforce. They also originally claimed that the rate of default interest and the lump sum are extortionate and should be reopened by the court under section 25 of the Money Lenders Ordinance, Cap. 163. This latter claim was not pursued by Mr Shaw for the defendant at the hearing, following my decision to allow the plaintiff to rely on two further affidavits, with evidence purporting to show that the issued share capital of the defendant was in excess of $1,000,000.00, and the transaction was accordingly exempted from those provisions.

Construction of clause 3

4. The first matter I have to consider is what, on a proper construction of clause 3, it means. In support of his contention that the rate of default interest amounts to a penalty, Mr Shaw submits that the effective rate of interest would be 3% per month compounded monthly. He says that this must follow from the fact that the second agreement allows for 1% interest per month on the reducing balance, and clause 3 then goes on to permit the plaintiff to charge a further 2%. The inevitable outcome of this, he maintains, is that the total interest is the sum of the two. I regret that I do not agree with this argument. Clause 1 of the second agreement sets out the precise payments of principal and interest to be made each month as follows:

Date of Repayment	Principal and Interest accrued to 31/12/95	Interest on Outstanding Balance from 01/01/96	Total Repayment
31 December 1995	US$25,000	US$ -	US$25,000
31 January 1996	25,000	897	25,897
29 February 1996	25,000	648	25,648
30 March 1996	25,000	398	25,398
30 April 1996	14,778	148	14,926
	US$114,778	US$2,091	US$116,869
	=========	========	=========

5. The monthly interest of 1% was accordingly calculated for the period of the intended repayment in specific amounts, and there was no provision in that clause for the interest to continue at that, or indeed any, rate after conclusion of the repayment period. This was provided solely by clause 3. In this context the word further can only mean the rate to be paid, at most, in addition to the actual sums set out above, but more likely to be paid after those above, in respect of the balance outstanding at the time of default. The worst interpretation of this clause, from the defendant's point of view, is that, had they defaulted after, say, two months payments, the balance outstanding, both as to principal and the interest instalments set out, would be subject to the 2% monthly rate. This would mean that the defendant would effectively pay the equivalent of 3% on the balance until 30 April 1996, the end of the repayment period, but the amount then due both as to principal and interest would then be capitalised and be subject to 2% from then onwards.

6. The next matter to consider is whether that rate of interest is such as to amount to a penalty which should not be enforced by the court, either by itself, or combined with the payment of US$21,686.00, described as pre-assessed damages.

7. The approach to this by the courts was summarised by Suffiad J in Japan Leasing (Hong Kong) Ltd v. Fully Well Investment Ltd HCMP 4359 of 1998, where he said, at page 4, referring to the decision of the Privy Council in Philips Hong Kong Ltd v. Attorney General of Hong Kong [1993] 1 HKLR 269:

" (1) The court should not adopt an approach which would defeat the purpose of a liquidated damages clause, which is to enable contracting parties to know the extent of one's protection in the event of breach;

(2) It is normally insufficient that the provision could result in the payment of a larger sum;

(3) So long as the sum payable is not extravagant, having regard to the range of losses it could reasonably be anticipated, it should be upheld by the court;

(4) The court should only intervene if the sum payable is totally out of proportion to the possible range of losses; and

(5) The court must be careful not to set too stringent a standard and what the parties have agreed should normally be upheld. Any other approach would lead to undesirable uncertainty, especially in commercial contract."

Rate of interest as penalty

8. I have been shown a number of calculations by both sides purporting to demonstrate the effective rate of interest here at the rate in the second agreement. Mr Shaw has taken the total amount of interest which would have accrued over the whole period since January 1996 at that rate, divided it by the number of years since then, and quoted that as a percentage of the original deposit repayable of US$108,281.00, producing an annual figure of 122%. This is a fallacious method of looking at the matter. Apart from the fact that the figure agreed by the parties as the principal sum at 31 December 1995, inclusive of interest to that date, which is not in dispute, is US$114,778.00, his calculation produces a totally artificial figure. Any debt which attracts interest compounded or capitalised at regular intervals, and remaining unpaid for a number of years, will increase at an ever greater rate until the sum owed, inclusive of interest, will be an increasingly larger percentage of the principal. The fact that the interest is compounded or capitalised is not in itself evidence that the provision as to the default rate amounts to a penalty, and is a common requirement of the larger licensed banks.

9. The only way I consider that I can look at this is by the rate itself, not by what is now owing by the defendant as a result of their failure to pay. That rate is 2% compounded monthly, which, as Mr Law for the plaintiff has calculated, comes to a simple interest rate of 26.8% per annum. If one were to add to that the sum which should have been paid by way of interest at 1% for the 4 months repayment period, namely US$2,091.00, it increases to 28.65% for the first year, before reverting to 26.8% thereafter. I note here that the plaintiff is not claiming, and has not claimed, anything more than the 2% on the principal of US$114,778.00.

10. Is this so high that it amounts to a penalty? It is clear that an increased rate of interest in the event of default may be penal if it operates with retrospective effect or the increase is exceptionally large. There is no serious suggestion here, and Mr Shaw has not argued, that the provision has retrospective effect, the rate is claimed only from the date of default. The only question is whether the increase is sufficiently large to amount to a penalty. Taken in isolation, I have to say that I find the rate unremarkable. It is a rate comparable to that charged by many financial institutions on, for instance, credit card outstanding balances, and it has never been suggested that this is penal in nature. Neither is it particularly remarkable that it is compounded. As I have noted above, it is not uncommon for licensed banks to claim default interest on a similar basis and at a similar rate. The only possible argument here as to the amount of the rate is by comparison to the first agreed rate of 1% per month simple interest, making an increase of more than double.

11. The only issue here is whether the provision for increased interest in the event of default was in terrorem the defendant with its sole function to ensure compliance with the repayment schedule agreed, or to compensate the plaintiff for breach of it. It cannot be disputed that it is a common provision of agreements for credit or for loans that an increase in interest will occur upon default. The rationale was explained by Colman J in Lordsvale Finance Plc v. Bank of Zambia [1996] QB 752 where, at page 763 he says:

"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 there is a good commercial reason for deducing that deterrence of breach is not the dominant contractual purpose of the term.

It is perfectly true that for upwards of a century the courts have been at pains to define penalties by means of distinguishing them from liquidated damages clauses. The question that has always had to be addressed is, therefore, whether the alleged penalty clause can pass muster as a genuine pre-estimate of loss. That is because the payment of liquidated damages is the most prevalent purpose for which an additional payment on breach might be required under a contract.

However, the jurisdiction in relation to penalty clauses is concerned not primarily with the enforcement of inoffensive liquidated damages clauses, but rather with protection against the effect of penalty clauses. There would therefore seem to be no reason in principle why a contractual provision, the effect of which was to increase the consideration payable under an executory contract upon the happening of a default, should be struck down as a penalty if the increase could in the circumstances be explained as commercially justifiable, provided always that its dominant purpose was not to deter the other party from breach."

12. He went on to cite with approval decisions from other jurisdictions which had held that default interest rates will not generally be struck down as penalties, and in particular the comment of the Court of Appeals in the United States in Ruskin v Griffiths (1959) 269 F 2d 827:

"The Court's analysis suggested that variable rates simply reflected the heightened risk of repayment that the creditor bears upon entry of default. Indeed, the Court observed that debtors might fare worse in the future if creditors were not allowed to impose variable rates, because creditors would then impose higher rates for the full life of the loan in order to reallocate the risk."

13. The present state of the law is accordingly that an increase in the rate of interest upon default will not be classed as a penalty provided that it is not retrospective, and it is not excessive. What then, in the context of Hong Kong, is excessive? It cannot be denied that an increase of over 100% in the rate is a large increase. But I am not convinced that it is appropriate to look at the percentage increase alone, but at the resulting rate, and then in commercial terms. On that basis an annual rate of 26.8% (or even 28.65% for the first year) can hardly be said to be extortionate, being, as I have observed above, not dissimilar to rates charged by the large financial institutions on certain transactions. Neither can it be said to be excessive when looked at in the light of the interest rates which are considered extortionate (48%), or illegal (60%), under the Money Lenders Ordinance.

14. I am accordingly persuaded that what has been agreed here, by, I would add, two commercial entities negotiating at arms length and on equal terms, albeit with financial constraints from the defendant's point of view, is nothing more than a provision which reflects the altered situation of the parties upon default, and the change in status of the defendant from a mere debtor to a defaulting debtor. I am therefore of the view that the agreement as to interest alone is not such that this could be defined as a penalty.

Liquidated damages as penalty

15. However, when I come now to consider the question of the lump sum of US$21,686.00, different criteria apply. While the same principles as summarised by Suffiad J and set out above must be the main guide as to the approach, I must also look at the nature of the proposed payment in the context of the transaction between the parties. It is clear on the authority of inter alia Philips Hong Kong Ltd v. Attorney General of Hong Kong supra that a lump sum specified as liquidated damages may be recoverable where there has been a genuine attempt to estimate the actual loss which would be incurred in the event of default. This may be a comparatively simple task where the contract is for the sale of goods or provision of services, and it is possible to judge how the sum has been arrived at. Here the agreement is for payment of money only, and no explanation has been offered as to how the sum claimed as liquidated damages has been arrived at.

16. One of the tests suggested by Lord Dunedin in Dunlop Pneumatic Tyre Co. Ltd v. New Garage & Motor Co. [1915] AC 79 to assist the task of construction of such clauses was, at page 86:

"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."

I can no reason not to apply that test in this case. Where an increased rate of interest may be acceptable within limits, an apparently arbitrary sum of money to be paid in addition, not only to the interest, but to the sum owed, cannot be described as an estimate of loss, as any loss is already amply compensated by interest. I accordingly find that the lump sum stipulated by clause 3 is clearly a penalty and should not therefore be enforced by the court.

Combined effect of interest and lump sum?

17. Mr Shaw has submitted that, were I to find as I have done in respect of the interest and the lump sum, then the whole clause must fail, as these provisions are inextricably linked. However, the agreement goes on, in clause 5 as follows:

"5. If any provision of this Agreement shall be held to be illegal or unenforceable, the enforceability of the remainder of this Agreement shall not be affected."

He contends in respect of this that it relates to whole clauses, not parts of clauses, and an objectionable part cannot be severed from the unobjectionable.

18. I cannot see why not. Clause 5 refers to "any provision" of the agreement, not to "any clause". A clause may contain more than one provision, as here, of which one is enforceable and the other not. This seems to me to be the situation here, and I do not consider that the penal nature of the lump sum payment in any way affects the enforceability of the provision as to interest.

Conclusion

19. I accordingly allow the plaintiff's appeal and find that they are entitled to judgment under Order 14 for the contractual rate of interest of 2% per month, compounded monthly from 31 December 1995 to the date hereof. I also allow the appeal of the defendant to the extent that, upon determination of the issue as to the penal nature of the provisions of clause 3 of the agreement under Order 14A, that relating to the sum of US$21,686.00 is a penalty and therefore unenforceable by the court, and the plaintiff's claim for that sum is dismissed.

20. I will hear the parties as to costs.