Interest on Late Payments - Liquidated Claim or Penalty?

There is a general acceptance in the law that a contractor should be able to recover interest on late payments (click here to view this previous Law-Now article). But what should the rate be?

Construction contracts often provide that interest will accrue on late payments at X% (per month, or per year). Broadly speaking, the rate of interest payable is whatever the parties agree. There are, however, two big provisos: (1) the rate must represent a substantial contractual remedy for late payment; but (2) the rate must not be so high as to constitute a "penalty" for late payment.

Penalties for breach of contract are unenforceable in law. The law does not enforce them because they seek to punish the party in breach of contract, rather than compensate the innocent party for its loss. Construction cases dealing with penalty clauses are few and far between. There have, however, been a couple of recent decisions that bear on the question of whether an interest clause in a construction contract is likely to constitute a penalty.

• In the Australian case of Katherine v CCD, a clause providing for an effective interest rate of 180% per annum on late payments to the contractor was held to be a penalty, and as such was unenforceable. In order to reach this conclusion, the court compared the contractual interest rate with the interest/additional overheads that the contractor would have had to pay in the event of late payment. Given that the additional cost to the contractor was not within even a remote distance of the interest payable at the contractual rate, the court concluded that the contractual rate was so disproportionate that it had to be regarded as a penalty.
• In Landfast, a considerably lower (compound) interest rate of 36% per annum was subject to criticism by the TCC. The rate claimed was not specified in the relevant contract. Rather, it was claimed that financing costs had actually been incurred at an effective rate of 36% as a consequence of a breach of contract. Without deciding whether the claimed rate was excessive, Mr Justice Akenhead indicated that "on its face", a rate of 36% per annum appeared excessive.

Although neither of these decisions is binding (the former being an Australian decision and the latter being an obiter comment by Mr Justice Akenhead), they do provide some clues as to what the courts are likely to consider excessive. As to what interest rate may be considered reasonable, the Late Payment of Commercial Debts (Interest) Act 1998 provides that a supplier is entitled to simple interest on monies owed at a default rate of 8% per annum over the base rate. This is a useful starting point.

Unfortunately (although understandably), the courts remain reluctant to issue specific guidance in the form of a threshold, above which a contractual interest rate would be struck out as penal and below which it would be upheld (provided that it afforded a substantial remedy for late payment). Despite the absence of guidance, prudent contracting parties should try to come up with an interest rate that bears some correlation to the actual interest rate that would be incurred (on borrowings) or foregone (on investments) as a result of any late payments. If there is a "wide gulf" between the actual or likely interest rate and the contractual interest rate (i.e. the latter is significantly greater than the former), there is a real risk that the interest provision will constitute a penalty.

Two further points:

• The question of whether a particular rate is or is not a penalty is context and industry dependent. For instance, in the context of high-risk lending a high interest rate may reflect the risk profile of the borrower. There is no rule of law that any particular rate of interest constitutes a penalty without more.
• It is critical to bear in mind that the question of a contractually-required payment represents a "penalty" usually only arises where the trigger for the obligation to pay is a breach of contract, not some other condition of a contract that does not amount to a breach. As another recent case demonstrates, however, the line between the two is not always easy to divine, (click here to view this previous Law-Now article).

References:

Katherine Pty Limited v The CCD Group Pty Ltd [2008] NSWSC 131

Landfast (Anglia) Ltd v Cameron Taylor One Ltd [2008] EWHC 343 (TCC)