Nullity of the contractual clause for reward interest due to violation of morality

I. Introduction

In the field of contractual relations, the principle prevails that the parties are free to determine the content of the contract concluded between them. The provision of Art. 9 of the Obligations and Contracts Act¹ however, it sets limits to this freedom – as long as the agreed content does not contradict the imperative norms of the law and good morals.².

This article examines the cases in which the contractually agreed remuneration interest exceeds these limits, which in turn leads to the most severe sanction provided for in the law, namely its nullity. The following lines will examine the questions in which cases this nullity can be assumed to exist.

II. Nullity of the remuneration interest agreed between the parties

1. Regarding the contractual remuneration interest

1.1. Contractual interest constitutes a civil fruit. It is a price due for the use of a sum of money provided by the other party under a contract or other replaceable items that are provided for a period specified in the contract. The obligation to pay contractual interest is periodic and accessory in nature.³. It is determined according to the amount borrowed and the duration of its use. It can arise both on the basis of a civil and commercial legal relationship.⁴. Contractual interest should be distinguished from interest that is compensatory in nature.⁵.

1.2. At the same time, the provision of Art. 10, para. 1 of the Contractual Contracts Act provides for the authority for the Council of Ministers to set a mandatory upper limit for the contractual interest. Such a limit was set by Order No. 1238 of the Council of Ministers of 25 June 1951.⁶, according to which the amount of the contractual interest is no more than 5.5%. It was subsequently amended by Decree No. 5 of the Council of Ministers of 18.01.1991 on interest rates on deposits, deposits and loans of the population and companies⁷, which determines only the amount of the statutory interest. Later, Order No. 1238 was repealed by Decree No. 72 of the Council of Ministers of 1994 on determining the statutory interest on overdue debts in levs and in foreign currency.⁸.

However, the existence of a legally established upper limit on contractual interest is not unknown to Bulgarian law. There have even been laws against usury, and some of the violations of the prohibitions established by them have been elevated to crimes.⁹. In turn, Art. 573, para. 2, clause 2 of the repealed ZZD¹⁰ has established that the contractual interest rate can in no case be greater than "twelve hundredths per year".

1.3. The following clarifications should also be made – first of all, the nullity of such an agreement can be discussed in the loan agreement regulated in the ZZD, next – in the loan agreement concluded by a pawnshop with a client, but also in consumer credit agreements under the ZPK. Currently, a regulatory limitation on the contractual remuneration interest exists with regard to the activity of providing cash loans by profession, secured by a pledge on movable property, established by the Regulation on the Activity of Pawnshops¹¹. In Art. 18 of it it is expressly stipulated that the maximum monthly interest rate on loans cannot be higher than three percent. Since July 23, 2014, an amendment to the provision of Art. 19, para. 4 of the Consumer Credit Act has also been in force.¹², which sets five times the statutory interest on overdue debts as the maximum limit up to which an annual percentage rate of charge under consumer credit agreements can be negotiated.

The courts accept that, even if the consumer credit agreement in question was concluded before the aforementioned amendment to the provision of Article 19 of the Civil Procedure Code, the agreements contained therein with excessively high interest rates (many times higher than the statutory interest for late payment) are unfair within the meaning of the Civil Procedure Code (referring to the reference to Article 24 of the Civil Procedure Code) and are contrary to good morals, and are therefore null and void.¹³. It is assumed that it was the existing public morality before the implementation of the aforementioned legislative changes that justified the amendment of Art. 19, para. 4 of the Civil Procedure Code, which would limit the possibility of the economically stronger participant in the turnover imposing conditions on the weaker participant in the contract between them, under which he would realize an unreasonably high income, leading to a conclusion of a lack of due diligence of the good merchant. The lender should assess the solvency of all its clients and not transfer the risk of non-fulfillment of the contracts concluded by it to the few solvent debtors, which in turn leads to significant income exceeding the costs of its activities, the usual profit that is due in such cases, without providing any additional benefit beyond the loan. Public morality condemning such actions has led to the need to amend the existing legal framework, with the courts accepting that the legislator's goal is to create a rule of conduct that would guarantee a balance between the interests of non-bank loan users and professional lenders.

1.4. Case law assumes that commercial transactions or individual clauses thereof may also be declared null and void – Art. 26, para. 1, item 3 of the Contracts and Arbitration Act in view of the express reference to Art. 288 of the Commercial Code. Given this, Art. 430, para. 2 of the Commercial Code cannot justify the possibility of agreeing on an unlimited amount of remuneration interest in a commercial transaction.¹⁴.

At the same time, legal theory advocates the opinion that such a solution contradicts the spirit of commercial law and even if the Council of Ministers were to set a maximum limit for the contractual remuneration interest, it should not be applied on the basis of Art. 288 of the Commercial Act.¹⁵ to the clauses of a transaction in which both parties are merchants or if the borrower is a merchant. In connection with the position advocated, the following arguments are given: that interest between merchants is due even when not agreed; that it is possible to agree on interest on interest; that merchants can agree on a high penalty without the possibility of reduction and with a recent maturity¹⁶.

With regard to the above-described opinion, several clarifications could be made. Undoubtedly, equality in the maximum permissible amount between contractual interest rates under civil contracts and contracts between traders would not be in line with the principles of commercial law. However, such a statement should not be made absolute and lead to a conclusion that it is impossible in principle to legally regulate a maximum limit also with regard to transactions in which both parties are traders or only the borrower has such a capacity. It must be assumed that such a limit should be determined, but it should be significantly higher than the one applied in civil legal relations. Even with regard to a trader, agreeing on an excessive interest rate could lead to a violation of good morals and the principles of justice and the prevention of unjust enrichment. There should be no equality between different types of traders - thus, the sole trader would be considered equally treated with joint-stock companies, which by their nature require larger capital and accumulate more property, as well as with the limited liability company, whose partner, upon concluding a transaction with a significant imbalance in benefits, would lose only what was invested in the company, but not his personal property.

In connection with the limitation on the reduction of the penalty in commercial transactions with Interpretative Decision No. 1/2009, the Supreme Court of Cassation and Arbitration accepts that the autonomy of the parties' will to freely determine the content of the contract, and in particular to agree on a penalty, is limited by the provision of Art. 9 of the LZD in two directions: the content of the contract no may contradict mandatory norms of the law, and to an equal extent – and good mannersThe restriction applies to both civil, and for commercial transactions – argument from Art. 288 of the Commercial Code. The possibility to agree on interest on interest should also not be unlimited. Such an agreement also could be negligible if the interest on interest is too high.

By systematically interpreting the provisions of the commercial law, it can be concluded that good morals are accepted as a limit to contractual freedom in commercial transactions as well. Examples include Art. 70, para. 1, item 4 in fine; Art. 303a, para. 1, clause 2; Art. 303a, para. 2, clause 2; Art. 309a, para. 3, clause 1 in fine; Art. 341, clause 1 of the Commercial Code. The opposite would have the opposite effect and would lead to the danger that newly established commercial enterprises would be placed in a worse position compared to economically stronger and already established traders, who could impose too harsh conditions on their inexperienced counterparties, which would put them in constant danger of having their commercial activity terminated and the law would prove powerless against such unscrupulous contractual behavior.

1.5. Other authors assume that the basic interest rate, determined by the BNB in accordance with Art. 35 of the BNB Act, represents the legal remuneration interest, but in the case of loans between traders, the provision of Art. 10, para. 2 of the LZD applies, which does not determine a maximum amount of the contractual remuneration interest and it can be freely negotiated between traders, without the possibility of its reduction, and such a request is considered unfounded.¹⁷.

In practice, the lack of explicit regulation in Art. 10, para. 2 of the LPA motivates lenders to often set obviously disproportionately high interest rates – on the order of 200% per year.¹⁸, and with regard to consumer loan contracts, cases are identified where the annual percentage rate of charge reaches over 900%¹⁹. Therefore, it should be assumed that, even in the absence of an upper limit for the contractual interest rate established by the Council of Ministers, the court could declare it null and void due to its contradiction with good morals on the basis of Art. 26, para. 1 of the Contractual Contracts Act, in conjunction with Art. 9 of the Contractual Contracts Act. The assumption that there is no upper limit for the negotiation of interest rates would lead to a violation of the basic principles of our civil law – justice, good faith and prevention of unjust enrichment.

2. About good manners

As already stated²⁰, in the field of contractual relations, freedom of negotiation reigns. However, it is not unlimited. Its limits are good morals and imperative legal norms. Good morals are moral norms that exist in modern society, and to which the law gives legal significance, and the consequences of their violation are equated with a contradiction of the contract with the law. Whether there is a violation of good morals should be assessed specifically, according to the legal facts established in the case, determining the disputed legal relationship. Violation of good morals within the meaning of Art. 26, para. 1, item 3 of the Labor Code is present when violates a legal principle, which may not be explicitly formulated in law, but its observance has been carried out by creating other provisions that are part of the current law. Such are the principles of justice, good faith in civil and commercial relations and the prevention of unfair advantage.²¹Their violation, leading to a clear inequivalence of the counter-performances, aiming at unjustified high enrichment, gives rise to the nullity of the transaction or the specific agreement between the parties.²²This in turn violates contractual equality.²³A contradiction with good morals occurs when unreasonably high prices are agreed upon in the transaction.²⁴, economically weaker participants in the turnover are treated unequally or the lack of material resources of one entity is used to benefit (or even just create such an opportunity) another²⁵.

3. When is the remuneration interest agreed between the parties null and void?

3.1. In principle, the contractual remuneration rate should be agreed in the contract clear and understandable, as the nullity of such a clause can be discussed in the following cases: excessiveness on the same²⁶Excessiveness can manifest itself as in an explicitly agreed large high percentage amount of interest, as well as in negotiating such payment method on debt²⁷, according to which the interest paid is excessive in view of the amount of the entire debt, the term of repayment and the collateral provided. In legal theory, a distinction is also made between the cases of nullity of the contractual interest and those in which there is excessiveness, which would serve as a basis for its reduction when establishing the hypothesis of extreme need under Art. 33 of the Contractual Contracts Act²⁸.

3.2. According to the prevailing part of the existing case law, the parties could agree on a remuneration interest rate above the amount of the legal interest rate.²⁹At the same time, the assessment of whether there is a violation of good morals within the meaning of Art. 26, para. 1 of the Labor Code is made dependent on the ratio between the amount of the agreed interest rate and the amount of the statutory interest for late payment, taking into account whether the creditor's claims are secured or not.

It is accepted that in order to assess whether a specific clause is contrary to good morals, the court must: to formulate a rule, which to correspond to the inner need of the honorable person and what is shared by the majority of people in society, taking into account for this purpose the permissions given in repealed laws, which regulate similar matters, such as the laws against usury of March 31, 1931, of July 30, 1933 and of August 14, 1946, as well as Decree No. 5 of January 18, 1991 on interest on deposits, deposits and loans of the population and companies. The position must be supported that the sociological approach, related to establishing the moral views shared by the majority of people in society, is criticized with reasonEstablishing such data is practically impossible in any particular case, and the judge's assessment should be made on the basis of political-legal approach, i.e. whether the specific provision corresponds to the system of moral concepts embedded by the legislator in the content of the legal system, and with the legal principles and political ideas enshrined in the Constitution³⁰.

3.3. According to existing case law, the agreed contractual interest rate in the event of unsecured claims of the creditor is deemed null and void due to violation of good morals if it exceeds the threefold amount of legal interest³¹At the same time, if the creditor's claims are secured, a contractual interest rate exceeding the double amount of legal interest³²As an argument for taking into account the presence of collateral, it is stated that when a mortgage is established, it also secures the interest receivables, respectively, the risk of not returning the borrowed amounts is lower.³³.

The consideration of the type of collateral should be supported in the assessment of whether the agreement violates good morals or not, since in practice the amount of the interest rate is related to the security of the creditors' claims. However, case law does not accept the type of collateral as a criterion that influences this assessment.³⁴. The clause on the contractual interest rate is considered null and void to the extent that it exceeds twice the amount of the legal interest. However, different collaterals could reduce the risk of non-return of the borrowed amount to different degrees. It should be clarified that the assessment of the nullity of the agreement should be carried out in an assessment of the facts at the time of the transaction³⁵ and the court should do specific assessment in each individual case according to the collateral provided, its type and what part of the creditor's claims they secure, respectively whether there is over-collateralization of the creditor's claims.

In this sense, in the presence of an established mortgage, it should be assessed what the value of the property was at the time of concluding the contract, what part of the creditor's claims is secured and whether his claims are partially, fully or oversecured. In the event of an obligation to provide a guarantee, an assessment should be made as to whether the guarantor is one or several, what their property was at the time of concluding the contract, respectively what part of the creditor's claims they secure. In the presence of an established pledge, it should also be assessed what the type of pledge is, the nature and value of the property securing the claim is.

As can be seen from the above, different collaterals guarantee the timely satisfaction of the creditor in different ways and to different extents, therefore it would not be fair to set precise parameters for the nullity of the agreed remuneration interest without taking into account the specifics of the specific case.

3.4. In another decision of the Supreme Court of Cassation, it is accepted that there is no established universal criterion for assessing when the agreed interest rate is immorally high and exceeds the limits of what is morally permissible. It is indicated that this issue is being resolved specifically on a case-by-case basis, taking into account all the circumstances of the case – not just her size, but also the size and the currency of the capital provided, the deadline of use; the circumstances, where the obligation for interest was assumed, its function, as well as all other terms and conditions of the contract, which could possibly have an impact on its size³⁶.

Other court decisions add that nature of the obligation should also be taken into account, as well as the possibility of the creditor becoming impoverished from the lending of items related to the growth in the prices of basic material values (e.g. gold and real estate) during the specific period, the course of the main interest rate of the BNB, resp. the three-month LIBOR³⁷ for the respective type of currency, etc., stating that an application could be found in Interpretative Decision No. 1 of June 15, 2010, issued under interpret.d. No. 1/2009 according to the inventory of OSTK³⁸.

The conclusions of the above-cited case law should be supported. They allow the judge to perform specific judgment of violation of good morals without placing him before initially determined and limited parameters (the security of the creditor's claims and the ratio between the amounts of legal and remunerative interest), which seem not to be interested in the particularities of the specific case. Therefore, in view of the existing regulations, the court should make an assessment based on the complex data available to it in the specific case, including the ones mentioned above.

3.5. In the older arbitration practice, the opinion that the contractual remunerative interest cannot be reduced is also advocated³⁹. However, such a position cannot be shared. The lack of possibility for the reduction, respectively for the annulment of the contractual clause with which the contractual remunerative interest was agreed, would lead to the possibility of abuses and unjust enrichment at the expense of the economically weaker party in the legal relationship. On the contrary, the legislator has expressly limited in Art. 9 of the ZZD the freedom of negotiation with good morals.

3.6. The opinion is also shared that in this case neither the law nor good morals could serve as an objective criterion for determining the upper limit of the contractual remunerative interest⁴⁰. Indeed, good morals in themselves do not determine a specific objective criterion on the basis of which it can be accepted whether a stipulation is void or not. They allow the court to assess the particularities of the respective case. This, as stated above, is also the correct approach, as specifying explicitly listed criteria would have the opposite effect. Objectivity stems from the need for the court to justify the violation of good morals by applying a political-legal approach, not a sociological or ideological one⁴¹.

3.7. In judicial practice, there is also the opinion that the agreed rate of contractual remunerative interest no is an absolute criterion for judging whether there is a violation of good morals or not.

Hence, even if at first glance a small percentage is agreed upon, when considering the amount on which it is calculated, the agreed amount of penalty, as well as the collateral provided, a conclusion can be reached regarding the nullity of the remunerative interest clause due to the way it is calculated . Thus, it is assumed that if it is agreed that the principal is to be repaid only with the last installment on the loan and the penalty is calculated on the entire principal, for the lender there is no risk yes no received the remuneration due to him for the use of the provided amount of money. The penalty in these cases leads to undue burden of the borrower, as well as receiving a much larger amount from the lender compared to the possible damages of default. This is related to the violation of the principles of fairness and the prevention of unjust enrichment due to non-equivalence of benefits.

The final conclusion of the court is that the nullity of the contractual remunerative interest can arise not only from the method of calculation, but also on payment. Thus, if the parties agree to pay the principal in only one or only a few installments, this violates the principle of fairness. The question is very interesting and subject to further analysis in a separate text. The existing jurisprudence assumes that there is nullity when the principal is repaid in only one or several installments. With more than 2-3 principal payments, the court will most likely leave the nullity request without respect.

Such a principal payment arrangement could in practice result in a compensatory interest amount greater than half the principal amount. In turn, in these cases, the borrower would be faced with the inability to pay part of the principal (and thereby reduce the interest) before repaying the amount of interest calculated on (almost) the entire principal. Jurisprudence defines such a contractual obligation as "[…] a spiral of the borrower's obligations, where, even if an amount is paid, he will always remain in debt if he does not repay in full the entire principal, interest rate and agreed penalty."⁴²

The position that such contractual practice violates the principle of good faith must be supported. Such a stipulation leads to a significant imbalance in the rights and obligations of the parties, where even the slightest breach of a contractual obligation would result in severe economic consequences for the weaker party to the contract. In view of this, even with a seemingly small amount of the contractual remunerative interest, if the method of its payment leads to a violation of the stated legal principles, it should be considered null and void by the court due to violation of good morals.

III. Conclusion

The freedom of negotiation is not unlimited. Regardless of the absence of a legally established upper limit of the contractual remunerative interest in loan contracts, the judicial practice must be supported, which accepts that according to the particularities of the specific case, it is possible to establish that the contractual remunerative interest thus agreed between the parties is void due to a contradiction with good manners. However, one should not share the opinion that the criteria on the basis of which such a conclusion can be drawn can only be (1) the ratio between the amount of the legal interest for late payment and the contractual compensatory interest, and (2) the presence or absence of collateral.

The principle of fairness requires a differentiated approach, which makes it possible to assess the particularities of each specific case, and not only on the basis of these two criteria, but also on an overall assessment of the existing contractual relationship. Thus the principles of our contract law would be guaranteed to the greatest extent.

Peter TOPUROV, lawyer, assistant at the State and Law Institute at the BAS