Establishment fees in private financing transactions
As the banks have tightened their lending criteria, we have been working with a number of private financiers who have increased their activity to satisfy the demand for debt finance in the SME market. Most lenders charge borrowers an establishment fee to help recover the costs of establishing a loan facility. The general position at law is that if a term of a contract is a penalty then that term will be unenforceable. A term is a penalty if a party is required to pay an agreed sum which exceeds what a court would consider to be a genuine pre-estimate of damage likely to be caused by a breach.
In a recent case in the Victorian Court of Appeal (Melbourne Linh Son Buddhist Society Inc v Gippsreal Ltd), the court found the establishment fee charged for the loan to be a penalty. The establishment fee was originally 1.5% of the loan amount but remained unchanged when the loan amount was reduced (making the establishment fee over 5%). It was held to be a penalty because the establishment fee was extravagant, unconscionable and out of proportion with the loss suffered, and it did not relate to any possible damage to, or interest of, the lender arising from a breach by the borrower. The court also inferred that the purpose of the establishment fee was to punish rather than to protect the legitimate commercial interests of the lender.
In light of this case, there are a few things to bear in mind in relation to establishment fees in offer letters from lenders:
- Avoid making the establishment fee a fixed amount (ie. where the fee remains the same irrespective of the likely loss)
- An establishment fee of 1% to 2.5% of the loan amount is currently considered acceptable industry practice
- If the proposed establishment fee is higher, it is important for lenders to retain evidence to help establish that the fee is a genuine pre-estimate of loss
- The goodwill of the lender and the risk inherent in the loan is irrelevant to quantifying the possible loss that might arise from a breach by the borrower
- The establishment fee should not be designed to punish or penalise a borrower for defaulting or failing to follow through with a loan. The purpose should be to protect the legitimate commercial interests of the lender.