A property developer found himself in dire financial straits. He approached a lender who loaned him the money in return for a fixed charge over shares and granted an option to buy the developer’s shares in the development company as security for the loan.
The borrower defaulted and the lender exercised the option. The loan was repaid five days later but the lender maintained an entitlement to purchase the shares. The shares were worth about $5 million but the option purchase price for the shares was only $2 million.
The option therefore had the potential to deliver an extraordinary windfall to the lender. The borrower argued that the option was void as a clog on the borrower’s equity of redemption. Alternatively the borrower argued it was a penalty (giving a windfall gain disproportionate to any likely loss flowing from late repayment of the loan and because the loan was repaid) and claimed relief against forfeiture because full repayment had been made.
The lender counterclaimed for breach of contract and argued that the option was a separate transaction.
The court did not find the loan and the option to be separate transactions but part of the one transaction since the loan was conditional upon the option and to be executed together, as part of a single transaction.
A mortgagor’s equitable right to redeem or discharge its mortgage exists even if the loan is not repaid in time provided it is repaid before the mortgagee exercises his power of sale or a foreclosure order is made by the court. Equity intervened to prevent unconscionable conduct on the part of the lender in exercising its rights, amounting to a penalty or forfeiture.
The court found that the equity of redemption applies equally to security over shares rather than land and no additional unconscionable conduct on the part of the lender has to be separately proved because it is inherent in the transaction. The court found the option to purchase given as part and parcel of a mortgage void and unenforceable as a clog on the equity of redemption.
A collateral obligation given as security for a primary obligation that imposes upon breach, a penalty will only be enforced to the extent of the loss suffered by reason of the breach.
The court found that exercise of the option for $2m resulting in a transfer of shares worth $5m would advantage the lender by $3m. The greatest loss that could have flowed from breach was not more than $500,000 plus interest and costs. The court held that a gain of $3m, over 5 times the greatest loss was out of all proportion to the loss or risk on a $500,000 loan, and an extravagant and unconscionable amount and therefore unenforceable as a penalty.
The court found that the purpose of the option as security was achieved upon repayment and unconscionable for the lender to exercise his legal right to force a transfer of the shares where the loan had been fully repaid. The court found the unconscionability well illustrated by the $3m windfall gain in the forfeiture of the borrower’s interest in the shares so the court held that if the option had not been found void, the court would have in any event granted relief against forfeiture.
The court found no repudiation by the borrower in alleging that the option was void and seeking a court declaration, because the borrower was merely invoking court process to have the dispute determined and did not evince an intention not to be bound in any event. The counterclaim was dismissed.
The court declared the call option deed void and ordered delivery up of the share transfer form and release of the fixed charge.