Determining whether a default interest clause is an unenforceable penalty

The question

How will a court determine whether a default interest rate constitutes an unenforceable penalty? 

The key takeaway

A default interest rate should protect a legitimate interest of the innocent party and the sum to be paid must not be "exorbitant or unconscionable in amount or in its effect" in light of the legitimate interest being protected.

The background

London Credit Limited (LCL) agreed to loan £1,881,000 to CEK Investments Limited (CEK) for a period of 12 months by a facility agreement. The loan was secured via mortgages over Mr and Mrs Houssein's (the Appellants) family home (the Property) and five buy-to-let properties, along with other assets.

The case concerns the proper construction of the interest provisions in a facility agreement. In the agreement, contractual interest was 1% per month from the drawdown date; default interest was an additional 3% per month on the outstanding sum. Default interest was payable on an event of default (which included a material breach) or late payment.

Clause 6, headed "INTEREST", provided:

"6.1 The Borrower shall pay interest on the amount outstanding under the Facility, as from the Drawdown Date and at a rate of 1.00% (One per cent) per month (the "Interest Rate"). The Interest Rate is a discounted rate and assumed strict compliance with the terms of the Finance Documents. Such interest shall be calculated on the basis of a year of 365 days and shall accrue on a daily basis.

6.6 Default interest:

(i) Upon the occurrence of an Event of Default and/or if the Borrower fails to repay any amount payable by it under any Finance Document on its due date, interest shall accrue on the overdue amount from the due date up to the date of actual payment (both before and after judgment) at the standard rate, being 3.00% (Three per cent) per month above the Interest Rate (the "Default Rate"); …"

It was a term of the agreement that CEK would not occupy the Property. Prior to the funds being released, the Property was inspected to check it was unoccupied. LCL discovered that the Property was occupied. LCL initially claimed default interest on the outstanding sum owed until the breach was remedied. The Houssein family did not vacate the Property or pay the sums demanded. Consequently, LCL demanded immediate repayment of the loan in full plus interest at the default rate and threatened to sell the Property. The Appellants applied for an injunction to prevent the sale and then brought proceedings against LCL alleging that i) LCL had waived the non-occupation requirement meaning there was no breach of the agreement and no default interest owed; and ii) the default interest rate was an unenforceable penalty and therefore did not apply.

At first instance, the judge found that the 4% default interest rate was an unenforceable penalty and did not protect any legitimate interest of LCL. He also found that the 1% contractual interest continued to apply on outstanding sums even after the repayment date had passed.

CEK appealed on grounds that the judge had incorrectly interpreted the facility agreement. CEK argued that LCL was not entitled to interest at the contractual rate since this rate only applied up until the repayment date. Beyond this, the default rate of interest would have applied but for the fact that it was found to be an unenforceable penalty. Consequently, LCL argued that CEK was not entitled to any interest under the agreement. LCL cross-appealed on the judge's finding that the default rate of interest was an unenforceable penalty.

The decision

Was the default interest rate clause an unenforceable penalty?

The trial judge had applied the wrong test when determining whether the term in the facility agreement regarding default interest was a penalty clause.

The Court of Appeal held that when determining if a contractual clause is a penalty, the court must consider:

i) whether and to what extent the clause protects a legitimate interest of the innocent party; and

ii) if the clause does protect a legitimate interest, whether the sum to be paid is "exorbitant or unconscionable" in amount or in its effect in light of the legitimate interest being protected.

The trial judge had failed to recognise that lenders obviously had a legitimate interest in charging a higher rate of interest after a borrower had previously defaulted in order to reflect the borrower's increased credit risk. The trial judge had also failed to consider whether the default interest rate of 4% was exorbitant, extravagant or unconscionable in light of the increased credit risk CEK posed. The Court of Appeal decided to remit the question of whether the default interest rate was extortionate, extravagant or unconscionable in amount or effect back to the High Court for reconsideration.

Was interest due after the repayment date and, if so, at what rate?

Applying the ordinary rules of construction, the contractual interest rate of 1% (clause 6.1) and default interest rate (clause 6.6) clearly applied in different circumstances. The relevant clause (clause 12.5) stated:

"Any monies falling due for payment by the Borrower pursuant to this Facility Letter and for the time being unpaid shall bear interest at the rate specified in clause 6.1 or 6.6, if applicable, calculated on a day to day basis from the date of so becoming due until the date on which payment is received by the Lender as well after as before judgment."

The judge was wrong to decide that the contractual rate of interest under clause 6.1 applied after the repayment date. The clause made it clear that monies which have fallen due for payment bear interest at the rate specified in clause 6.1 or 6.6, if applicable. "If applicable" was intended to refer to the circumstances in which the different rates apply and therefore, to the rate applicable in those circumstances. There was no room for an interpretation which allowed either the contractual rate under clause 6.1 or the default rate under clause 6.6 to spring back if the other rate was not "applicable".

It was not correct to revert back to applying the contractual rate pursuant to clause 6.1 if the circumstances were such that clause 6.6 would apply but the provision was found to be unenforceable. If the default rate of interest is found to be a penalty (after reconsideration), the contractual rate of interest will not apply on the sums outstanding after the repayment date.

Why is this important?

The case confirms the considerations that should be taken into account to determine whether a contractual clause, in this case a default interest clause, amounts to an unenforceable penalty.

Any practical tips?

Identify the legitimate interest that is being protected by the relevant provision and make that clear in the contract (including through recitals or acknowledgments).

Ensure that the remedy/interest rate is not exorbitant or oppressive given the commercial circumstances  and consider what is normal in the market. 

Be prepared to justify the proportionality of the remedy/interest rate, its significance within the overall commercial bargain, and the circumstances in which the parties entered into the arrangement.

Be clear on when the remedy/interest rate applies, and consider the effect of the remedy/interest rate being found to be unenforceable.

Autumn 2024