Interest disguised as a royalty payment?

By Jan-Hendrik Gous on 10 October 2019
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In the case of De Vasconcelos & others v Business Partners Limited (637/2018) [2019] ZASCA 80, the Supreme Court of Appeal considered a loan arrangement which was structured to include both a royalty payment and interest charges.  The court had to determine whether such an arrangement was against public policy, and furthermore whether the additional obligation to pay a royalty triggered the operation of the in duplum rule (rule which prevents arrear interest accumulating beyond the outstanding capital amount).

Facts of the case

A trust represented by the first appellant, Mr De Vasconcelos, entered into two agreements with Business Partners Limited, the respondent, for the purpose of raising working capital for one of Mr De Vasconcelos's close corporations:
  1. A loan agreement in terms of which the respondent money lender lent and advanced R8 million to the trust.  The loan was repayable in monthly instalments over a period of seven years and was to attract interest at the prime rate plus 1%.  
  2. A royalty agreement which required the trust to pay a royalty to the lender at the end of the seven-year period for repayment of the loan.  The value of the royalty was calculated as the higher of R12,896,964 or 24% of the future market value of a property owned by the trust from which the first appellant's business was operated.  The royalty agreement was also subject to an acceleration clause should the trust fail to meet its repayment obligations.
The trust eventually fell into arrears with its instalments under the loan agreement, leading to the lender issuing summons against the appellants, who bound themselves to the lender jointly and severally as sureties and co-principal debtors in respect of the trust's indebtedness.  The lender sued for payment of the outstanding balance of the loan agreement and the further "royalty" amount of R12,896,964.

The trust eventually settled the outstanding balance under the loan agreement, but action was then pursued by the lender for the outstanding royalty payment, including interest thereon.  The North Gauteng Division of the High Court found in favour of the lender, pursuant to which the appellants appealed to the Supreme Court of Appeal.

Appellants' defences

The appellants' principal defence was that the royalty agreement purported to levy an excessive interest payment for the loan in addition to the interest already payable under the loan agreement.  It was argued that the royalty payment was extortionate, oppressive or akin to fraud and therefore contra bonos mores (against public policy) and unenforceable. 

The appellants argued that the loan was adequately secured by the loan agreement and the interest provided for therein.  It was argued that the royalty payment was nothing more than additional interest, not commensurate with the risk undertaken by the lender, and did not confer any benefit on the trust.  

It was furthermore averred that the lender did not fully disclose the extent, impact and implications under the royalty agreement to the first appellant before concluding the agreements.  The lender allegedly failed to disclose the real interest rate payable by disguising it as a royalty.  It was argued that the trust would not have entered into the royalty agreement had it realised that additional interest was in effect payable.

Court's decision

The court at the outset found that in the absence of a statutory limitation (such as in cases where credit legislation is applicable), the mere fixing of a high amount of interest for repayment of a loan is not unlawful.  The National Credit Act, No. 34 of 2005, did not apply in this case, given that the debt exceeded R250,000 and is accordingly considered to be a "large agreement" to which the Act does not apply.  The main issue to be decided by the court was whether the royalty agreement offended public policy by reason of being "tainted by oppression, or extortion or something akin to fraud".

The Supreme Court of Appeal rejected the appellants' argument that the agreement was unenforceable due to it being against the public policy.   The court found that there was no evidence of the lender's conduct being akin to fraud, extortion or oppression.
  
The court emphasised the lender's business model of financing mainly small to medium enterprises in cases where traditional banking institutions would not provide finance, thereby taking on a relatively higher degree of risk in exchange for a commensurate return.  The lender would accordingly structure its transactions in various ways in line with this risk so as to ensure it would receive adequate return.  Other common financing arrangements would involve the lender taking up equity in a borrower company, or sharing in the future turnover or profits of the borrower.

The court found that the crux of the matter came down to whether the trust understood the nature and extent of the obligation imposed on it.  The court emphasised the fact that the first appellant held a doctorate in business administration and that the various financing models were explained to and carefully considered by him.  The court accordingly found that there could have been no doubt in the mind of the first appellant as to the nature and extent of the repayment obligations undertaken in terms of both the loan and royalty agreements.  

The court furthermore held that absent any trace of extortion, oppression or something akin to fraud, any argument that the royalty obligation was not commensurate with the risk undertaken is not a ground for invalidating the agreement.  The court found that the "appellants' real complaint is that the Trust stuck a bad bargain, not an illegal one.  That unfortunately happens daily in commercial life".  

In duplum rule

The appellants had a second defence based on the so-called in duplum rule.  The rule determines that arrear interest ceases to accrue once the sum of the arrear unpaid interest equals the capital amount outstanding at any time.  The appellants argued that they were not obliged to make the royalty payment given that such payment in effect amounts to interest on the loan, and that payment thereof would be in contravention of the in duplum rule.
  
The court rejected this argument on the basis that the royalty payment did not constitute interest on the loan amount, but represented a separate obligation for the risk that the lender undertook in providing credit to the trust.  

Analysis of decision 

The judgement is important insofar as it relates to the varying methods in terms of which financing arrangements between private parties can be structured.  The judgement has the effect that in order to protect and incentivise lenders for additional risk undertaken by them, obligations in addition to the obligation to pay interest can be imposed on borrowers.  Such additional obligations can be structured in various ways, for example by way of providing for a royalty payment. 

Provided that the National Credit Act does not apply and that the lender did not act in a manner akin to fraud, extortion or oppression, the mere fact that the sum of the obligations imposed on the borrower is not commensurate with the risk undertaken by the lender, will be immaterial.   The only issue to be determined is whether the borrower understood the nature and extent of the obligations undertaken.

Should the lender decide to impose these additional obligations on the borrower, the in duplum rule will also not come into play given that these additional obligations are not construed to be interest on the loan amount.  It is accordingly important for a potential borrower to carefully consider how a proposed loan arrangement is structured in order to assess whether it is viable to commit to the various obligations which are to be imposed on it.

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