| 
Interest-ing Times – Navigating Default Interest Clauses
Ajith Prasad
While default interest clauses are standard in most lender agreements, they can constitute a penalty if they are extravagant, exorbitant or oppressive. If a default interest clause amounts to a penalty, then the lender will not be able to recover the default interest.
The rules on what constitutes a penalty were considered in the Supreme Court case of Cavendish Square Holdings BV v Makdesi (2015)[1]. In this case, the Supreme court reviewed the law of penalties and set out a 3-stage test:
- Penalty clauses are secondary obligations
- Drafting should reflect the legitimate interests of the non-defaulting party and not be exorbitant, extravagant, or unconscionable
- The burden of proving that a clause is exorbitant, extravagant, or unconscionable lies with the defaulting party
The recent Court of Appeal’s decision in Houssein & Ors v London Credit Limited & Ors (2024)[2] delved into this further.
Background
London Credit Limited (“LCL”) a bridging finance specialist agreed to loan £1,881,000 to the CEK Investments Limited (“CEK”), for a period of 12 months. The loan was secured by a debenture over CEK’s assets, personal guarantees from CEK’s directors, the First Appellant and her husband, and mortgages over 5 buy-to-let properties and their family home. Under the terms of the facility letter in respect of the loan the standard rate of interest was 1% per month and the default rate was 4% per month, compounded monthly.
The facility letter prohibited CEK or its “Related Persons” (who included spouses and relatives of the directors of CEK) from occupying the family home. A month after the drawdown of the loan, LCL alleged that CEK was in breach of the facility letter by reason of the occupation of the family home. It subsequently demanded repayment of the full loan amount, plus default interest. When that demand went unpaid, LCL appointed receivers to sell the buy-to-let properties and the family home. CEK obtained an interim injunction prohibiting them from doing so, and the matter then progressed to trial.
The High Court Decision
In the first instance the High Court concluded that the default interest rate was a penalty clause and therefore unenforceable. The judgment emphasised that the rate did not reflect a reasonable estimate of the loss suffered due to the delay.
The Appeal
The High Court decision was appealed by CEK. It was argued that the interpretation of the facility letter was incorrect. It was suggested that LCL was not entitled to standard interest following the breach of contract and based on the facility letter, the entitlement to standard interest had come to an end and payment of default interest was unenforceable as a penalty. Therefore, no interest was payable following the breach.
LCL cross-appealed, arguing that the High Court’s decision that the default interest rate was a penalty, was wrong. They submitted that the High Court applied the wrong test and reached the wrong conclusion as a result.
The Court of Appeal Decision
The Court of Appeal found that the High Court had not applied the Cavendish test correctly and had:
- Conflated the concept of ‘legitimate interest’ with the effect of the clause; and
- Approached the issue subjectively i.e. considering what he believed the lender was trying to protect, rather than objectively assessing whether the clause was exorbitant or unconscionable.
The Court of Appeal emphasised that the correct approach was the test set out in Cavendish Square Holdings BV v Makdesi (2015). The Court of Appeal found that the High Court had not:
- Considered the commercial justification for charging a higher rate of interest after a default in repayment because a person who had defaulted was a greater credit risk; and
- Considered the second limb of the test, i.e. whether the default interest rate was ‘exorbitant, extravagant, or unconscionable’.
As a result, the Court of Appeal referred the matter back to the High Court for reconsideration.
Comment
The case underscores the test to be applied in establishing if a default interest rate is unenforceable as a penalty. We await the High Court’s decision when the correct test is applied to see if it reaffirms that the default interest rate in this case constitutes a penalty.
[1] https://www.bailii.org/uk/cases/UKSC/2015/67.html
[2] https://www.bailii.org/ew/cases/EWCA/Civ/2024/721.html