Default interest rates in loan agreements – penalty or legitimate interest?
The default interest clause in a loan agreement is a standard boilerplate clause which is rarely negotiated, save for the rate of the default interest to be applied by the lender.
Default interest is charged on any unpaid amounts from their due date up to and including the date of payment of the unpaid amount. The default interest rate is set at a higher rate than the standard rate interest, so as to reimburse the Lender for any additional costs incurred as a result of the borrower’s non-payment and/or default. Since the case of Lordsvale Finance plc v Bank of Zambia [1996] 3 All ER 156, it has been market practice for lenders to charge a compounding default rate of 1 – 2% above the standard contractual interest rate. However, some lenders argue that they can justifiably charge a higher default rate due to the nature of the transaction in question.
Rule against penalties
An important consideration for lenders when setting the default interest rate is to consider the rule against penalties. If deemed to be a penalty, a default interest clause could be unenforceable.
A three-stage test for establishing whether a clause amounts to a penalty was confirmed in the 2015 Supreme Court case of Cavendish Square Holding BV v Talal El Makdessi. This case established that a clause will not amount to an unenforceable penalty, provided:
- the clause is a secondary obligation triggered by a breach of contract;
- the clause is in furtherance of a ‘legitimate interest’ which the innocent party (e.g. the lender) has in the performance of the primary obligation; and
- the clause is not “extortionate, exorbitant of unconscionable”.
Case law has further emphasised the following further considerations to be considered in relation to penalties:
- The uplift should not be overly high: the rate of the default interest should be compared against market rates and the rate then applicable under the Late Payment of Commercial Debts (Interest) Act 1998 to establish whether or not it is to be considered to be too high (Cavendish Square Holding BV v Talal El Makdessi)
- Period for charging default interest: default interest should only be charged whilst a default continues; it cannot be charged with retrospective effect or for an arbitrary future period (Lordsvale Finance plc v Bank of Zambia)
It is important to note that the rule against penalties does not apply to interest payable where the party responsible for payment is not in breach of the applicable agreement. In other words, standard contractually agreed interest rates are not affected.
Houssein v London Credit Ltd [2024] EWCA Civ 721
The recent Court of Appeal case of Houssein v London Credit has provided further clarification of the test to be applied in determining if a default interest rate is to be considered an unenforceable penalty, and the applicability of the standard contractual interest rate if the default interest rate is unenforceable. It also set out a further consideration to be taken into account when determining whether the lender has a legitimate interest in setting the default rate higher than expected.
Background
The case concerned a £1.9 million facility agreement entered into between London Credit Limited, as lender, and CEK Investments Limited, as borrower, which was secured by way of a legal charge over the family home of Mr and Mrs Houssein, directors of the borrower. Under the facility agreement, the borrower covenanted not to occupy or allow any related party to occupy the secured property. The facility agreement also contained provisions noting that in the event of a material breach of the facility agreement, the lender was entitled to appoint a receiver and apply default interest at the rate of 4% per month. Prior to drawdown of the loan, the secured property was inspected to ensure it was unoccupied.
When the lender realised that the Housseins were in occupation of the secured property, the lender sent a letter to the borrower noting an alleged breach of covenant and requesting that the breach be remedied. As the Housseins remained in occupation, two months from the lender’s initial letter, the lender demanded immediate repayment of the loan and payment of default interest under the default interest clause.
High Court decision
At first instance, the High Court found that:
- the lender knew the secured property was the family home of the Housseins at the time the facility agreement was entered into;
- during an inspection of the Property, the staged and selective photographs were taken to make the property look unoccupied;
- according to expert evidence, the market rate for default interest was materially lower than the default interest rate set out in the facility agreement; and
- the fact that the borrower had an enhanced credit risk was already factored into the standard interest rate in the facility agreement; there was therefore no commercial justification for setting the default interest rate at the level it was set.
The High Court ruled that the default interest rate, which was four times above the standard rate, was an unenforceable penalty as it did not protect the legitimate interest of the lender.
The High Court further found that since the default interest rate was unenforceable, the standard interest rate would continue to apply to any unpaid sums due after the final repayment date.
Court of Appeal decision
Following an appeal from both sides, the Court of Appeal reconsidered the case law around penalties and set out the three-stage test established in El Makdessi. The Court of Appeal found that the High Court had wrongly applied this test and, in particular, approached the question of whether there is a legitimate interest to protect in an ‘illegitimate and confused way’ (the second limb of the test in El Makdessi). Accordingly, the Court of Appeal overturned the High Court's judgment on the second limb of the test, finding that the lender had a legitimate interest in securing repayment of the loan, interest and fees by the final repayment date, which the default interest clause was designed to protect. Further, the Court of Appeal concluded that the question of whether the default interest rate was extortionate, exorbitant or unconscionable (the third limb of the test in El Makdessi) was not addressed separately or at all.
Notwithstanding their findings, the Court of Appeal decided that, due to their limited knowledge of the evidence that was presented at trial, it was not in a position to substitute their decision for that of the High Court and therefore remitted back to the trial judge the question of whether (having regard to the lender’s legitimate interest) the default interest clause is extortionate, exorbitant or unconscionable, and therefore a penalty
The Court of Appeal further ruled that having looked at the natural and ordinary meaning of the words used in the relevant clause of the facility agreement, it was wrong to decide that the standard rate of interest should be applied from the final repayment date if the default interest rate was found to be unenforceable. It follows that if the default interest clause is determined by the trial judge not to be a penalty, then the default interest rate will apply from the repayment date. If the default interest clause is a penalty, then no rate of interest will apply after the repayment date.
Key takeaways
It is yet to be seen whether the High Court will reaffirm its decision that the 4% per month default interest rate is unenforceable as a penalty when applying the correct test.
Regardless, Houssein v London Credit provides helpful clarification and a reminder to lenders on the correct test to be applied when determining whether a default interest rate is a penalty or not, and emphasises the need for a precise and methodological application of the three-stage test in El Makdessi. It also confirms that it could be commercially justifiable to charge a higher rate of default interest where the borrower poses a greater credit risk.
The case also highlights that should the default interest rate be found to be unenforceable, no other contractual interest rate will be due on an unpaid loan following its repayment date. In such a situation, however, the lender could still be entitled to claim statutory interest.
Lenders should carefully review their interest and default interest provisions to ensure that (1) the default interest rates set are proportionate to the risks they would face in a default scenario, and (2) they do not lose all contractual entitlement to interest should the default rate be ruled unenforceable.
