Banking and Finance case note: When establishment fees may be construed as a penaltyMay 2, 2018
The recent case of Melbourne Linh Son Buddhist Society Inc v Gippsreal Ltd  VSCA 161 provides guidance on the factors a Court will consider in determining whether an establishment fee is enforceable against a borrower.
By a 2-1 majority, the Victorian Supreme Court of Appeal held that the establishment fee charged by the Lender was a penalty and unenforceable.
Important lessons for Lenders
The Lender, a first mortgage debt fund, and the Borrower, an incorporated association, agreed to the terms of a $1,775,000 loan secured by a first ranking property mortgage at a 50% LVR.
The agreed terms were the product of many months of negotiations during which the parties had made several unsuccessful attempts to agree terms — notable in each previous attempt, the relevant term sheet included provision for an establishment fee equal to 1.5% of the loan amount.
The final expression of interest signed by the parties set out an establishment fee in a fixed sum of $26,625 (notionally 1.5% of the loan amount). Relevantly, the document also provided for liquidated damages (which included an amount of $26,625) payable by the Borrower if the loan did not proceed to settlement for reasons out of the Lender’s control.
Subsequent to an unfavourable valuation of the security property, the loan amount was reduced to $500,000, which reflected an LVR of 50% on the new valuation. Despite this, the Lender retained its fixed sum establishment fee of $26,625, now equal to a notional 5.3% of the new loan.
The Borrower did not proceed with the loan within the availability period.
The Lender subsequently withdrew its offer of finance and sought to enforce its claim for liquidated damages.
Victorian Court of Appeal
In the Victoria Supreme Court trial, the Lender was awarded (amongst other damages) the entire amount of the establishment fee as liquidated damages.
The Borrower appealed this decision.
Although not directly related to its decision to allow the appeal, the court proceeded on its own investigation of whether the establishment fee constituted a penalty at law (an ancillary issue in the context of the case but relevant for lenders).
In advancing evidence on this issue, the Lender went to some lengths to claim that the $26,625 did not represent a percentage of the loan amount but instead was a global fixed sum justified by the Borrower’s history of unsuccessful loan applications and the significant administrative time expended by the Lender.
The Lender also claimed that the $26,625 priced default risk presented by the method by which the loan was to be serviced by the Borrower through donations from its members.
Following the principles set out by the High Court in Paciocco v Australia and New Zealand Banking Group Limited  HCA 28, the court held that, “the establishment fee [was] extravagant and unconscionable and out of all proportion to the likely loss that the [Lender] might suffer as a result of [the failure by the Borrower to proceed to settlement]; and that its purpose [was] to punish the [Borrower] rather than to protect a legitimate commercial interest of the [Lender]."
Factors working against the Lender were:
- the Lender’s inability to clearly articulate a basis upon which the $26,625 was claimed as liquidated damages;
- the administrative time, effort and costs expended by the Lender occurred prior to the alleged breach by the Borrower and so did not flow from the breach;
- the default risk is not relevant when a loan does not proceed; and
- the industry standard for establishment fees is between 1% and 2.5% of an approved loan amount.
Lessons for Lenders
In assessing the relevance of this case for Lenders, a distinction must be made between the dual purposes that are served by an establishment fee.
The first purpose is as an amount deducted from the advance of a loan at settlement. The second is in the form of liquidated damages, payable if the loan does not proceed, i.e. the non-refundable component.
It is this non-refundable component of an establishment fee that must be justifiable to protect the legitimate commercial interest of the Lender and not punish the borrower. It must also be reasonably justifiable against quantifiable loss that would flow from a breach by a borrower if it does not proceed to settlement of the loan.
Where a borrower alleges that an establishment fee is a penalty, it is immaterial that the borrower agreed to the establishment fee.