When does default interest become a penalty?

In a mixed decision for lenders, the recent Court of Appeal decision in Houssein & ors v London Credit Limited & ors[1] has confirmed the applicable test in determining whether a default interest rate constitutes an unenforceable penalty and whether the standard interest rate can still be recovered following default if the default rate is not enforceable.

Background

In August 2020, London Credit Limited (LCL) entered into a loan facility with CEK Investments Limited (CEK) secured by, amongst other things, a legal charge over what was the Housseins’ family home (the Property).  Mr and Mrs Houssein were directors of CEK.

It was a term of the loan that CEK and “Related Persons” would no longer occupy the Property. Contrary to that term, the Housseins remained in the Property post drawdown.

On 8 September 2020, LCL wrote to CEK alleging an event of default and that it was therefore entitled to default interest on the outstanding sum until the breach was remedied.  LCL reserved the right to issue a demand and enforce its security and/or commence legal proceedings if the breach was not remedied by 8 October 2020.  The Housseins remained in occupation. 

On 3 November 2020, LCL demanded immediate repayment of the loan together with continuing default interest.  Proceedings were issued in April 2021. 

First Instance

The High Court held that the default interest rate (4% per month) did not protect any ‘legitimate interest’ of LCL and that it was an unenforceable penalty.  The Court further declared that interest at the standard contractual rate (1% per month) was payable instead on any unpaid sums after the specified repayment date. 

The Housseins and CEK appealed the High Court’s construction of the relevant terms, arguing that since the default rate was found to be a penalty and unenforceable, no interest should accrue after the repayment date – even at the standard contractual rate.  LCL cross-appealed, contending that the default rate was not a penalty and was enforceable. 

Court of Appeal decision

The Court of Appeal’s unanimous judgment was handed down on 28 June 2024. 

Whether the default rate was a penalty

Having reviewed the authorities, Lady Justice Asplin (giving the lead judgment) concluded that the correct test had not been applied.

• First, the Judge had not addressed the ‘threshold question’[2], namely whether the default rate was a secondary obligation engaged on the breach of a primary contractual obligation.

• Secondly, although the Judge considered the extent and nature, if any, of the ‘legitimate interest’ to be protected, it was not clear that he was considering the legitimate interest alone.

  • In particular, the Judge did not appear to have taken any real account of the conclusion in Cargill[3] that it is self-evident that there is a good commercial justification for a lender to charge a higher rate of interest following default because a borrower who has defaulted is, inevitably, a greater credit risk.

  • The Judge had also confused the question of legitimate interest with the effect of the relevant clause, and therefore approached the question in an impermissible way.

  • Whether a clause is penal depends on its purpose, which is a matter of construction in the context of the factual and commercial position and the answer cannot depend on evidence of the parties’ actual intentions alone.The Judge had, however, taken a subjective approach in referring to what it seemed to him that LCL was seeking to protect.

• Thirdly, the Judge did not appear to have considered the crucial question, following Cavendish, of whether the provision was extortionate, exorbitant or unconscionable, in light of the nature and extent of the legitimate interest.That question was remitted back to the Judge.

Application of the standard rate

• The relevant terms stated that monies which had fallen due for payment would bear interest at the rate specified in both the standard contractual and default interest clauses, “if applicable”.There was no room for an interpretation which allowed either the standard rate or the default rate to ‘spring back’ if the other rate was not “applicable”.They were mutually exclusive. If the circumstances were such that the default rate applied, the circumstances necessarily would not be such that the standard rate applied.

• The Judge was incorrect to find that the standard rate would apply in place of the default rate if it constituted a penalty. In other words, if on considering the question remitted back the Judge, he found again that the default rate was a penalty and unenforceable, then the standard contractual rate would not apply in its place.

Key takeaways

Default interest clauses are standard in loan agreements (and in many commercial contracts) and this is a helpful decision for lenders in clarifying the correct test to be applied. 

Whether a rate of 4% per month will be held to be extortionate, exorbitant or unconscionable in the context of LCL’s loan (LCL is a bridging lender, so engaged in relatively more risky lending) remains to be seen. 

Lenders should also review their default interest provisions to avoid the risk of losing all contractual entitlement to interest if the default rate is ruled to be unenforceable. If the provisions suggest a binary choice between contractual or default interest then, following Houssein, there is a risk of a lender being left without any contractual right to charge interest. Clauses that state that a default rate will be applied in addition to the standard rate should, however, mean that the standard rate can still be recovered irrespective of whether the default rate is not enforceable.

This publication is intended for general guidance and represents our understanding of the relevant law and practice as at July 2024. Specific advice should be sought for specific cases. For more information see our terms & conditions.