Commentary: Court Of Appeal Strikes Down “Clever Drafting” Designed To Circumvent The Penalty Doctrine: A Case Of Too Clever By Half?
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In 2020, the Court of Appeal (the “CA”) reiterated that the penalty doctrine is restricted in its application to secondary obligations; primary obligations are insulated from the doctrine: Leiman, Ricardo and another v Noble Resources Ltd and another  2 SLR 386. It described this restriction as the “threshold issue.” The rationale for this differential treatment was explained by the UK Supreme Court in Cavendish Square Holding BV v Makdessi  AC 1172 (“Cavendish”) in the following terms (at ): “There is a fundamental difference between a jurisdiction to review the fairness of a contractual obligation and a jurisdiction to regulate the remedy for its breach. Leaving aside challenges going to the reality of consent, such as those based on fraud, duress or undue influence, the courts do not review the fairness of men’s bargains either at law or in equity. The penalty rule regulates only the remedies available for breach of a party’s primary obligations, not the primary obligations themselves.”
The following year, the apex court acknowledged that “the threshold of a breach of contract may be thought of as being too easy to circumvent by clever drafting”. To prevent this, it cautioned that “the problem of drafting is dealt with in the way that courts have always dealt with problems of construction – by prioritising substance over form, bearing in mind all the circumstances of the case in line with the contextual approach to contractual interpretation”: see Denka Advantech Pte Ltd and another v Seraya Energy Pte Ltd and another and other appeals  1 SLR 631 (“Denka”) (at ).
The apex court’s recent decision in Ethoz Capital Ltd v Im8ex Pte Ltd and others  SGCA 3 provides an excellent example of “clever drafting” which did not find favour with the court.
The appellant, Ethoz, is an “excluded moneylender” under the Moneylenders’ Act. It agreed to extend certain facilities (the “Facilities”) to the 1st respondent, Im8ex. The Facilities comprised 4 loans of varying amounts (the “Advances”) at a flat interest rate of 3.75% per annum for a period of 15 years. Thus, the aggregate interest payable by Im8ex over the 15 years was 3.75% x 15 years x Advances = 56.25% of the Advances (the “Total Interest”).
Under the Facilities’ terms, Im8ex was to repay the Advances and Total Interest in 180 equal monthly instalments based on the formula “Advances + Total Interest/15 years”. The loan documents also contained the following provisions:
- Clause 5(A) provides that in default of payment of any of the instalments, Ethoz “may treat the whole of [the Facilities] or the balance thereof … together with interest thereon and all other sums due and owing under this Agreement as immediately due and payable without any demand.”
- Clause 14 provides that an event of default will occur if Im8ex does not pay any of the “sum[s] payable under [the Facilities] when due” and that this will entitle Ethoz to declare that “all amounts due and owing under [the Facilities], including the Advance and the Total Interest and any default interests … be immediately due and payable.”
- Most significantly, Clause 7(B) provided that the Total Interest “shall be deemed earned and accrued in full upon the drawdown of the Advance”.
Im8ex defaulted in repayment of the instalments in the first year prompting Ethoz to recall the Facilities. Pertinently, in doing so, Ethoz insisted that Im8ex was obliged to pay the Total Interest. Im8ex objected arguing that the requirement for it to pay the Total Interest violated the penalty doctrine. Ethoz countered by pointing out that the effect of Clause 7(B) was that the Total Interest was an accrued debt due from Im8ex from the time of drawdown. In other words, it was Im8ex’s primary obligation to pay the Total Interest and thus, the penalty doctrine is wholly inapplicable. The High Court Judge disagreed with Ethoz, ruling that the penalty doctrine was contravened. Ethoz appealed the decision.
The CA dismisses Ethoz’s appeal
In dismissing Ethoz’s appeal, the CA proceeded as follows.
First, it clarified (at ) that the term “clever drafting” (as used in Denka) “is a reference to a form of drafting which is intended to obscure the true nature of a provision by obfuscating its substance as a secondary obligation.” It went on to say (at  – ) that:
2 … [s]uch practice should not be encouraged, and if such drafting is brought to the attention of the court, it will be subject to rigorous analysis and we will not hesitate to strike it down if it is found in substance to be a secondary obligation that is in fact a penalty.
3 On the other hand, there is nothing intrinsically objectionable for parties to draft appropriate clauses to reflect their agreement that an obligation is a primary obligation even if it is a particularly onerous one …
Second, the CA agreed with Ethoz that Clause 7(B) had the effect of constituting the Total Interest an accrued debt (at ). However, the difficulty with the clause was that “[w]hilst it informs us that Total Interest is deemed earned and accrued as a debt and thus its payment is a primary obligation, it does not tell us when and how this payment is to be made. This is critical because … there is a difference between its payment in instalments, and its full and immediate payment.” Thus, “the key inquiry is: which of the two situations (i.e., the payment of the Total Interest in instalments or the immediate and full payment of the Total Interest) is the primary obligation, and which one is a secondary obligation triggered upon breach of contract?” (at ).
Third, the CA set out the following guidelines to identify and distinguish between primary and secondary obligations (at  – ):
- A primary obligation is defined as the “essential purpose” of the contract. On the other hand, a secondary obligation is one that is incidental to the primary obligation.
- The distinction is not always clear and there is a concern that parties may be able to circumvent the “threshold issue” of the penalty doctrine by drafting contracts in a way that masks a secondary obligation as a primary obligation. Such attempts, however, can be revealed by exploring several factors: (a) “the overall context in which the bargain in the clause was struck”; (b) “any particular reasons for the inclusion of the clause”; and (c) “whether the clause was contemplated to form part of the parties’ primary obligations to secure some independent commercial purpose, or was only to secure the affected party’s compliance with his primary obligations”. The broad principle is that a substance over form approach should be adopted and it is important that the court analyse the whole contract, not just the impugned clauses in isolation.
Fourth, applying the aforesaid principles, the CA concluded that Im8ex’s primary obligation was to pay the Total Interest in instalments whilst the obligation to make immediate and full payment of the Total Interest was a secondary obligation (which therefore attracted the penalty doctrine). Its reasons included the following (at  – ):
- Clause 5 was headed “INSTALMENT PAYMENTS.” Relevantly, Clause 5(A)(1) provides that, “[i]n consideration” for the Facilities, Im8ex “covenants that it will repay to Ethoz the Advance and interest thereon” in 180 equal instalments. While there is no explicit reference to the Total Interest, it is clear that “interest thereon” refers to the Total Interest because Clause 5(A)(1) also states that the “respective amounts of principal and interest payable on each Instalment Date is set out in Schedule 3” and the aggregate of the monthly instalment payments in Schedule 3 includes the Total Interest. Thus, what Im8ex had “promised to do” was to pay the Total Interest in 180 equal instalments.
- There is nothing in the loan documents that suggests that Im8ex had promised to make full and immediate payment of the Total Interest absent default. Instead, on the plain text of the Facilities, such payment would only occur in the event of default as provided for in Clause 14(B)(2) of the Facilities. This is a strong indicator that the immediate and full payment of the Total Interest is a secondary obligation that only arises upon breach.
- This conclusion is also supported by the commercial context. The Facilities are loan agreements and in most loan agreements, the primary obligation of the borrower is to repay the loan sum and pay interest instalments tied to the time that the borrower has use of the loan sum. It would make little sense for a borrower to agree to pay for the future use of the loan sum if it no longer has use of it.
Fifth, having ruled that Im8ex’s obligation to make immediate and full payment of the Total Interest was a secondary obligation (and thus subject to the penalty doctrine), the CA, applying the tests set out in Dunlop Pneumatic*, concluded on the facts that the obligation was a penalty (at  – ) (*In Denka, the CA rejected the new test formulated in Cavendish as to what constitutes a penalty).
The important takeaway from the decision
This is the first case in which the apex court had to consider whether what was in reality a secondary obligation was masqueraded as a primary obligation. As mentioned earlier, the CA began its judgment by stating that if an appropriately drafted clause makes clear that a certain obligation was intended by the parties as a primary obligation, the court will not invoke the penalty doctrine to strike it down no matter how onerous it may be. In the instant case, what eventually led to Ethoz’s failure was that “the provision that it relies on was grafted into the contract without paying sufficient attention as to how it would interact with the other terms, leading to a document with seemingly contradictory clauses such that the nature of the obligation in question was unclear” (at ). This decision therefore underscores the importance of careful drafting and the need to avoid clever drafting.
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