Variable interest rates–when are they illegal

Not all variable interest rates are enforceable. Some are void for uncertainty. In this in-depth advice, we examine when a variable interest rate is enforceable and when it is void.

Kabwand

In Kabwand Pty Ltd v National Australia Bank Ltd [1989] ATPR 40-950; BC8908158, the Full Court of the Federal Court had before it a loan agreement containing the following provision:

Interest shall initially be calculated at the rate set out in Item 3 in the Schedule, but the Bank may at any time hereafter at its sole discretion vary either by way of increase or decrease the said rate of interest conforming with general movements in the bank’s interest rates without any obligation on the bank to notify you of such variation.

In that case, the borrower alleged that the above clause was void for uncertainty.

In the joint judgment of Lockhart, Hartigan and Hill JJ, their Honours found that there were three applicable principles. The first of those principles was that “if parties to a contract do not agree upon a fundamental term there will be no contract at all”. The second relevant principle was that “there is an objection to a contract if one person is left to choose whether he will perform it “as the consideration from that person is, in the circumstances, illusory. This third principle was that “there can be no concluded bargain if a vital matter has been left to the determination of one of the parties”.  The second and third of those principles were drawn by the court from the High Court’s decision in Godecke v Kirwan (1973) 129 CLR 629.

The court in Kabwand then stated:

Whether there be three principles or but one, it is clearly established that where an agreement produces a liability to pay a sum of money and the amount is not determined by the agreement the agreement will ordinarily be construed as requiring a reasonable sum to be paid. Provided the parties select some criteria which is capable of objective determination, the Court will enforce their agreement.

The court then found that the clause was not void for uncertainty, noting:

Is the case where a loan agreement provides that the lender may select any interest rate it pleases, the present is not that case. Here the rate of increase or decrease of interest must conform to the general rates of interest charged to customers of the bank, that is to say there is an objective market standard to be applied at all times. In these circumstances we do not think that it can be said that any of the three principles sought to be applied have application. As the trial Judge said, and we agree, the present clauses as to interest are not to be construed as giving to the [lender] a power at large. A borrower may challenge any increase on the basis that it has been fixed otherwise in conformity with the general movements referred to”.

Parist Holdings

In Perpetual Nominees Ltd v Parist Holdings Pty Ltd [2005] NSWSC 1345, Brereton J considered a loan in which the higher and lower rates of interest were variable according to a formula which referred to a “Benchmark Rate”: the lower rate was fixed as 3% above the Benchmark Rate, and the Higher rate was fixed at 7% above the Benchmark Rate.

The Benchmark Rate was defined in the loan documentation as follows:

the rate as determined by the lender on 1 December 2004 and then as redetermined by the lender quarterly on or about the first business days of January, April, July and October in each year. The lender will (but without having any obligations to do so) when determining and redetermining the Benchmark Rate refer to the level at which 90 day bank bill products have been trading by the major Australian trading banks rounded up to the nearest five basis points.

The borrower contended that the above provision was invalid as it left the determination of the important matter of interest to the discretion of the lender.

Brereton J referred to several authorities, including Kabwand and Cross v National Australia Bank Limited (FCA, 29 April 1994, unreported). In the latter, a provision that a interest on arrears of rental could be charged “at such rate as is determined by the bank from time to time” was found to be void in circumstances where the clause in question did not even refer to the bank’s own benchmark rate. Breton J then summarised at [32] the relevant law as follows:

These cases establish that while determination of a price or payment under a contract may be left to the party entitled to receive the price or payment, that will be so only where there are criteria – either express, or such implied criteria as “fair and reasonable” – by which that party’s decision can be tested, and that where an express formula is provided, there is no room to imply criteria such as “fair and reasonable”.

Brereton J then found at [33] that the fate of the Benchmark Rate clause depended upon the application of the third principle in Kabwand

since this is not a case in which the parties have not agreed on a fundamental term, nor is it a case in which one party has been left to choose whether it will perform the contract. The question is whether a vital matter, namely the rate of interest – or more precisely, one component of it, being the benchmark rate – has been left to the determination of one of the parties, namely Perpetual, without a criteria against which Perpetual’s determination can be tested.

His Honour found that there was no such fixed criteria, because even though there was reference to the lender considering of the 90 day bill rate of other banks when fixing the Benchmark Rate, the clause expressly stated that the lender had no obligation to consider such rates. In consequence, Brereton J found that the Benchmark clause was void, but that the clause in question could be severed from the contract.

Brereton J rejected an argument by the lender that the Court should then itself fix a “fair and reasonable rate” of interest in lieu of the rates contained in severed clause, his Honour stating that “there is no room to imply such a term where the parties have made provision for a particular formula and criteria” (at [35]). His Honour instead effectively treated the Benchmark Rate as 0%, and thus found the lower rate under the mortgage was 3% per annum, and the higher rate 7% per annum.

Pua Hor Ong

In Pua Hor Ong v Wu You Yang Pty Ltd [2008] SASC 365, a loan agreement was written in Chinese. It contained an interest provision which was translated differently by different translators, but which was to the effect that the interest on the loan would be calculated in line with the interest rate used by Australian banks. The case was an appeal from an interlocutory decision of a Master, and hence Burley J did not have to determine finally whether the clause was valid, merely whether there was a reasonable argument that it was valid.

After reviewing authorities (including Kabwand and Parist Holdings), Burley J stated at [45] that the following principles could be distilled from those authorities:

First, where the parties to a commercial arrangement intended to reach a concluded bargain or believed that their agreement was capable of execution, courts should strive to give their agreement a construction that is sufficiently certain to be contractually binding. Secondly, a term will be sufficiently certain if it’s effective operation depends on a fact, circumstance or state of affairs that is susceptible of proof. Put in another way, the second proposition is that an agreement is contractually binding if its terms, properly construed, yield a certain result when applied to the facts and circumstances on which the agreement operates.

Burley J found that although different banks had different rates for different types of loans, it was at least reasonably arguable that the interest clause should be construed as providing that the rate was to be the median of the rates of the various Australian banks for commercial loans of the same type as that the subject of the agreement. His Honour thus found that there was a reasonable argument that the interest clause was valid. He found further that even if the interest clause was invalid, it was reasonably arguable that it could be severed from the agreement.

QCoal

In QCoal Pty Ltd v Cliffs Australia Coal Pty Ltd [2010] QSC 479, Ann Lyons J had to consider the question of whether a legal costs agreement that provided that legal fees were to be charged by the solicitors at “our current rate from time to time”. The costs agreement specified that fees would be determined on a time-charge basis, and the current hourly rates of solicitors at the firm was specified, although with the statement “We may change these rates from time to time”. Another document held to form part of the costs agreement stated that generally the firm reviewed its rates annually, but could do so at any time.

There was evidence before her Honour that the solicitors had at the time a practice of reviewing the rate for each staff member at the start of the financial year, that the fees were then normally kept constant for the entire financial year and were set to reflect the post-admission experience of each solicitor. The solicitors would, however, sometimes vary these rates in the course of a financial year after negotiations with individual clients.

Her Honour found at [47] as follows:

Accordingly, in my view, the rates to be paid were always able to be ascertained by objective criteria. The rates were not set in an arbitrary way but rather the applicable rates to be charged were set pursuant to policy of annual review and were usually fixed for a year. All rates charged were on the basis of the firm’s usual rates at a particular time unless a different rate had been specifically negotiated. It is clear that the rate to be charged for any work done was always able to be objectively ascertained by reference to objective criteria. In any event the rates charged did not ever exceed the rates set out in [the schedule of current charges in the costs agreement].

Conclusion as to the relevant principles

By extension from the above authorities, one can draw the following principles in relation to interest rates fixed at the discretion of the lender:

  1. If the lender’s discretion to fix interest rates is completely unfettered and not expressly or by implication limited by some “objective criteria”, the term in question is void.
  2. It does not take much for a court to construe an agreement as providing “objective criteria” for the fixing of an interest rate. If the lender is obliged to consider, even if only in a vague fashion, the relevant market rate, that is sufficient. Even an implied term that the lender will act “reasonably” in setting the rates is sufficient.
  3. The “objective criteria” does not necessarily have to involve reference to actions and events outside the control of the lender. A requirement that the lender will vary the interest rate applicable to one customer in line with changes in the rates offered to others of its borrowers is sufficient to save an interest clause- although, possibly, only if the lender has an actual practice at the relevant time of setting its rates according to market forces.
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