Penalty Interest
When someone wrongs you, one of the little voices inside your head may say, "how can I get them back?" If you own a small business and the wrong is that one of your customers isn’t paying you (and you’ve ruled out acts of physical violence) the answer that may occur to you is to charge them interest.
Small business people are often a little vague on the basics of contract law - in this case, that you can’t add the right to charge interest to your contract at this late stage. And as we’ve said in an article in this journal last year (December 1999), if the new coalition government follows the UK example and brings in something similar to their Late Payment of Commercial Debts (Interest) Act 1998, you won’t need interest in your original contract.
Of course, if it was in your original contract, no problem... or is there? Interest and penalties is an area with a few more traps. Creditors should get professional legal advice, but also keep an eye on your lawyers to make sure that their solutions are practical.
Obviously, the main reason for including interest in your contract is as a penalty to deter your debtors from not paying, but ironically, you must avoid setting the rate so high that the courts see it as a penalty to deter your debtors from not paying. Under contract law, courts will only allow creditors to recover actual loss. In order to be valid the rate should be a fairly genuine attempt to "pre-estimate damages" - that is, to predict what the debtors' default will cost you. Typically, the actual cost of late payment to the creditor is the interest rate on its own overdraft, plus a small additional margin for administrative costs and hassle.
Company lawyers are aware of this problem and many write contracts which state that you, the creditor, will charge interest at your own overdraft rate plus 2% (or something similar). But your overdraft rate changes regularly. Calculating this varying rate (plus 2%) then adding it to the debtor's balance is beyond the ability of most accounts receivable software. Charging interest is therefore a very manual process, which usually isn't done, unless or until the debtor is sued, and often not even then. Many debt collectors find it too hard.
The point is: if you want to charge interest, make it an easy calculation. Set a reasonable rate - 1% to 2% per month is probably within a reasonable range - and leave it at that.
When you sue your debtor, the rules change somewhat. Creditors can sue for interest from the date the debt was incurred until the date of judgment even if it's not in their contract. The rate of interest which the Judge can award under the law (section 62B of the District Courts Act) is currently 11% per annum. It changes from time to time as economic conditions change. If interest is specified in the contract, the Court may make an award up to that rate, if it is specifically asked for in the statement of claim.
If you issue proceedings and the debtor doesn’t defend you can enter judgement by default - without any court appearance being necessary. In that case you can enter judgement including interest calculated under the contract. Theoretically you can’t get the interest under s 62B but some Courts may allow this. This may be reviewed if the debtor is either unhappy or knowledgable, but that’s another saga!
After judgment, debts exceeding $3000 attract interest at (currently) 11%, or as awarded in the judgment (that is, at the rate provided for in the contract). If the judgment debt is less than $3000, interest will only apply if it has been awarded in the judgment.
There are lenders who are charging interest on their home loans of say 7%. We hear rumours that some of them are very keen to get judgment against defaulters so they can raise the interest rate to the Court’s rate.
In respect of interest, lenders are generally in a significantly different position to other creditors. The Credit Contracts Act 1981 applies to all financiers or businesses acting for the purpose of any sale as financiers (including, for example, a car dealer which is providing finance). For creditors who require payment on the 20th of the month following invoice and only charge interest if the account is in default, the Act will not apply.
Considerable effort and legal advice is usually put into ensuring that standard contracts used by finance companies and banks comply with the Act. If the contract is right, and your organisation is efficient enough to calculate interest rates and the "finance rate" correctly, and put the appropriate disclosure documents in the post at the right time, there are few problems. If the contract is wrong, one day you’ll find yourself off to Court.
One of the major issues under the Credit Contracts Act is whether the contract was oppressive at the time it was made. Factors such as excessively high interest rates or excessive premiums have been found to be oppressive (for example, a booking fee amounting to 57% of the loan was considered oppressive). On the other hand a lender of last resort who charged 42% regular interest and 84% percent on default (admittedly back in the heady days of the mid 1980’s) was not found to have acted oppressively - there was no abuse of the relationship.
Another matter of "interest". Mortgages will usually specify the penalties for early repayment. If they don’t then mortgagees are legally allowed to ask for interest to the end of the term. Depending on the circumstances, the interest or penalties imposed may be oppressive. The courts have held that 3 months interest on a residential mortgage is not oppressive.
As we were writing this article a client rang asking about their proposed penalty interest clause. Interest was to be charged at the bank overdraft rate and "up to" 5%. The first question asked was whether their accounts receivable systems could cope with changing interest rates. Clearly they couldn’t! The uncertainty in the words "up to" are also likely to create problems - a better option is fixing a reasonable rate.
The key messages then are: do have an interest clause in your contracts, and keep the rate charged simple.
Chartered Accountants Journal of New Zealand