TGIF 1 May 2026 – Court clarifies enforceability of default interest clauses in non bank construction loan agreements

This week’s TGIF considers the recent Supreme Court of New South Wales decision in Crescent Capital Ltd as trustee for the Rockdale Central Security Trust v Chanine [2026] NSWSC 371 on the enforceability of a default interest provision in a commercial construction loan agreement with a non-bank lender.

Key takeaways

• The nature of a default interest provision is such that there is an inherent risk of a borrower challenging liability to pay default interest on the basis that it is an unenforceable contractual penalty.
   
• A high default interest rate may withstand challenge, provided it is not disproportionate to the commercial interest that the lender intends to protect with the default interest provision.
   
• A lender can better protect itself against such a challenge by documenting the rationale for the default interest provision at the time of writing the loan.

The dispute

The plaintiff security trustee brought proceedings against the defendant borrower and guarantors seeking judgment regarding a debt owing under a loan agreement where the lender had financed the construction of a mixed-use property development. 

By the conclusion of the trial, the defendants had abandoned all aspects of their defence except for one: whether a provision of the loan agreement that provided for 10% per annum default interest upon the failure of the borrower to repay the loan on time was unenforceable as a penalty. 

What is a contractual penalty? 

A penalty is a term of a contract that provides for the defaulting party to pay a specific sum of money to the non-defaulting party as punishment for the default. Common law does not permit a penalty to be enforced. This penalty doctrine is one of the few incursions the law makes upon the freedom of parties to strike their own contractual bargains.  

However, a term of a contract providing for a defaulting party to pay a specific sum of money to the non-defaulting party may have a legitimate non-penal purpose. For example, courts have previously acknowledged the commercial reality that a defaulting borrower poses a higher credit risk to the lender which merits a commensurately higher rate of interest. 

Whether the term is a penalty is a question of construction of the contract by reference to its terms and the surrounding circumstances judged at the time of the making of the contract (not at the time of the default). The question is whether the term is so extravagant or disproportionate to the interest that the lender purports to protect by the provision.  

The burden of proving a contractual provision is a penalty is on the party asserting it. However, the provision may be sufficiently ‘heinous’ on its face that the burden is discharged simply by putting the contract into evidence, with the result that the burden shifts to the party seeking to enforce the provision to explain why it is not a penalty. 

In the context of loan agreements, the defaulting party might discharge that burden by tendering the loan agreement which provides for a substantial default interest rate which applies to a variety of default events regardless of the severity of those events. 

The rationale for the default interest provision

The plaintiff adduced evidence from two witnesses from the lender who were responsible for the origination of the loan to explain the rationale for the default interest provision. 

Those witnesses explained the managed investment fund that owned the lender sourced funds from investors on the basis that the fund’s objective was to achieve a 20% internal rate of return (IRR) on the invested funds and that the fund manager would not deploy funds into deals which forecast a return that did not achieve this objective. 

The witnesses said that achieving the targeted IRR was important for the reputation of the fund manager, encouraging future investment into other funds managed by the same manager, and continuation of the manager’s business. 

The plaintiff put into evidence an investment recommendation paper that had been prepared and signed off by those witnesses at the time of origination of the loan that considered the impact of a range of default scenarios, including a failure by the borrower to repay the loan on time, on the targeted IRR and how the default interest provision mitigated those impacts and allowed the targeted IRR to be achieved in at least some of those default scenarios. 

The Court’s decision

The Court found that the default interest provision was not a penalty. 

First, the Court attributed significance to the sophistication of the borrower and the guarantors and the negotiation of the pricing of the loan between the parties such that there must be good reason for the Court to interfere with the agreement they had made.  

Second, the Court was not satisfied that the defendants had discharged their burden of proof by tendering the loan agreement in this case. The Court found that 10% interest was not obviously high in the absence of evidence of the rates of interest available in the market for the same type of loan. The Court also considered it significant that the 10% default interest applied only to maturity default and not all defaults.  

Third, the Court accepted the evidence advanced by the plaintiff as to the lender’s rationale for the default interest provision and the commercial interests that the provision sought to protect. The defendants failed to demonstrate that the 10% default interest was disproportionate to those commercial interests. 

Comment

The nature of a default interest provision is such that there is an inherent risk of challenge by a borrower on the basis that it is an unenforceable penalty. 

A default interest provision that provides for a substantial default interest rate upon the occurrence of any one of many events, regardless of severity, is more susceptible to a finding that it is a penalty than a provision that provides for different default rates for different defaults. However, a high default interest rate may withstand challenge provided it is not disproportionate to the commercial interest that the lender intends to protect.  

A lender can better protect its contractual entitlement to default interest by documenting its rationale for the default interest provision at the time of writing the loan. Depending on the nature of the lender’s business, this rationale might include the increased risk, the costs of capital, increased operational costs, profitability, or loss of opportunity. In this case, the rationale for protecting a business interest was to align the default rates for a matured non-compliant loan to ensure investor metrics were still met in a default scenario. 

Ensuring that rationale forms part of the credit submissions will stand as key evidence in defending a challenge to a default interest rate on the basis that it constitutes a penalty.

Corrs acted for the successful plaintiff security trustee in this matter.