NSW Supreme Court Signals Increased Scrutiny Of Default Interest Clauses

The Supreme Court of New South Wales has delivered an important judgment for lenders, reaffirming the limits of default interest provisions.

In Haiyong Su v 5 Blackman Cres Macquarie Pty Ltd [2026] NSWSC 875, the Court held that despite the loan documents being valid and enforceable, a default interest rate of 3% per month, compounded monthly, was unenforceable as a penalty. The decision scrutinises increased default interest rates and serves as a warning to lenders who continue to rely on traditional standard rate versus discounted rate lending structures.

Background

The proceedings concerned a loan of $100,000 pursuant to a Deed of Loan, secured by mortgage over a property. The loan was originally for a short-term period and accrued interest at a rate of 2% per month, compounded monthly. This was defined as the “Discount Interest Rate” in the loan documents. Upon default, the borrower became liable to pay interest at a higher rate of 3% per month, also compounded monthly.

Following the borrower’s failure to repay the loan, the lender commenced proceedings seeking to recover the outstanding principal together with default interest, enforcement costs and various related expenses. While the borrower challenged several aspects of the lender’s claim, the Court ultimately accepted that the documents had been validly executed and were generally enforceable. The controversy concerned the lender’s entitlement to recover interest at the higher default rate and its claim for enforcement expenses.

Validity of the Loan Documents

Before considering the default interest provisions, the Court addressed the validity of the transaction. The borrower argued that the relevant loan and security documents were not enforceable against the corporate borrower. The Court rejected those arguments, finding that the sole director, secretary and shareholder of the company held the requisite authority to execute the documents and bind the company. As a result, the Deed of Loan and mortgage were enforceable under the relevant provisions of the Corporations Act 2001 (Cth).

This aspect of the judgment provides reassurance to lenders that courts will continue to uphold properly executed commercial lending arrangements. However, the enforceability of the loan documentation itself did not guarantee the enforceability of every provision contained within those documents.

Default Interest Found to be a Penalty

The most significant aspect of the decision concerns the Court’s treatment of the default interest provisions. Although the loan distinguished between a lower “Discount Interest Rate” and a higher interest rate applicable upon default, the Court emphasised that labels chosen by contracting parties are not determinative. What matters is the practical operation and commercial substance of the provision.

The Court considered whether the higher interest rate protected a legitimate commercial interest of the lender or whether it operated predominantly as a deterrent designed to punish the borrower for default.

The Court ultimately concluded that the increase from 2% per month to 3% per month, coupled with monthly compounding, did not show any genuine estimate of loss likely to be suffered by the lender upon default. There was no evidence demonstrating that the increased rate corresponded to additional funding costs, heightened risk exposure or any other commercially justifiable consequence of the borrower’s default. In those circumstances, the Court held that the default rate operated “in terrorem” and therefore constituted an unenforceable penalty. Importantly, the Court only permitted recovery of the debt calculated using the lower interest rate.

Why the Decision is Significant

The judgment indicates that lenders should no longer assume that describing a lower rate as a discounted rate will avoid the operation of the penalty doctrine. For many years, lenders have structured loans on the basis that borrowers receive a discount for timely compliance rather than suffer a penalty upon default. Recent authorities suggest courts will look beyond this approach and focus on the commercial reality of the transaction. Where the practical effect is that a borrower becomes liable for a significantly higher interest burden following default, a lender may be required to justify the increase with evidence demonstrating a legitimate commercial rationale.

The decision also highlights judicial concern regarding compounding default interest. Even where lenders are able to identify a reasonable basis for increasing the rate following default, the additional effect of monthly compounding may increase the likelihood that a court will regard the provision as punitive or disproportionate.

Implications for Lenders Going Forward

The key takeaway from Haiyong Su is that lenders can no longer assume default interest will be enforceable simply because it is included in the loan documents. Where an increased rate applies following default, lenders should be prepared to demonstrate a legitimate commercial justification for the increase. Otherwise, there is a real risk that recovery will be limited to the ordinary contractual rate.

In light of this decision, lenders should reconsider their lending structures that rely on discounted rates reverting to higher rates upon default. A single contractual interest rate may provide greater certainty and reduce the risk of a successful penalty challenge.

Lenders should also carefully assess the use of compounding default interest. While compounding can increase returns, it may also increase the likelihood that a provision will be characterised as penal. In many cases, a commercially appropriate simple interest rate may offer a more reliable and enforceable outcome.

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