Most businesses that have a standard set of terms and conditions of sale will also include a clause providing for interest in the event of non-payment. Often such clauses will provide for interest at a rate that is tied to the 90-day bill rate or the official cash rate.

Default interest

Most businesses that have a standard set of terms and conditions of sale will also include a clause providing for interest in the event of non-payment. Often such clauses will provide for interest at a rate that is tied to the 90-day bill rate or the official cash rate. However, this can present significant headaches when it comes time to calculate the amount of interest actually payable under the clause, particularly if payment is not made for some months or years.

Preferably, from an enforcement perspective and for ease of calculation, default interest provisions should provide for a flat rate of interest payable from the due date for payment until the date payment is actually made. The question then becomes: what is an acceptable rate to charge?

Penalties

The temptation, of course, is to set the interest rate as high as possible in order to encourage prompt payment by your debtors. However, setting the rate too high could result in the default interest provision being deemed a "penalty".

A "penalty" is a legal term for a clause in a contract that is designed to make the consequences of breach so frightening that a debtor will not default on its obligations under a contract. Such clauses are often referred to as “in terrorem” clauses (literally, “in fear”). An extreme example of such a clause would be a contract for sale of goods worth $1,000 and a clause in the contract which said: if the purchaser breached the contract by not paying for the goods by the due date, $50,000 would become payable. The courts will normally strike down these types of clauses as unenforceable.

This principle has also been applied by the courts to default interest clauses. Although parties are entitled to agree at the outset that a certain rate of default interest will be payable, such agreement should constitute a genuine pre-estimate of what the loss to the innocent party would be if there were a default in payment under the agreement. There have been a number of cases where the courts have struck down interest clauses on the basis that the interest rate is too high and therefore the relevant clause is a "penalty" (and unenforceable).

What happens then if the court decides your default interest clause is a penalty clause? Once a court decides that the clause is a "penalty", the court could decide to discard the “penalty” rate and impose what it considers a reasonable commercial rate. However, the court could instead decide to remove the default interest clause from the contract altogether as if it had never existed. That would mean there would be no ability to charge interest under the contract for late payment.

What to do?

So what is a reasonable rate? Much will depend on the nature of your business and the industry you are in as well as the economic climate. As a rule of thumb, the default interest rate you select should be your cost of credit (what kind of return you could have been getting on that money if it had been paid on time) plus a margin for administrative time spent following up on unpaid accounts. This margin should be a few percent per annum.

As mentioned above, it is much easier for enforcement purposes if the default interest rate is a flat rate specified in the contract. However, your terms and conditions should include a provision allowing you to review that rate from time to time and to notify your customers of any resulting increase (or decrease) in the default interest rate.


Further information