Default Interest – Penalty or No Penalty?

We are all so familiar with the time-honoured language used in loan and security documentation that it is tempting to imagine that this language is bulletproof and can never be challenged in the courts. Under English law, however, there are a number of grounds for challenging provisions in contracts, including loan agreements, not least the possibility that an indemnity or default interest provision is void and unenforceable as a penalty. The recent case of Houssein v London Credit Ltd [2024] EWCA Civ 721 serves as a useful reminder of this and reiterates the test to be applied. It also holds a surprise for the lender who falls foul of this test!

Case Summary

The case concerned a low-grade bridging facility for a property transaction which, although well-secured, involved a high credit risk. As a result, the standard rate of interest was 1% per month and, if an event of default occurred, this jumped to a default rate of 4% per month in aggregate. When a default did occur and the lender claimed default interest, it was challenged in the High Court and the judge found in favour of the borrower. In his view the default rate was a penalty and he ruled that the standard rate of interest should continue to apply. The case was then heard before the Court of Appeal who concluded that the judge had asked himself the wrong questions and had therefore failed to apply the correct test.

There is much discussion as to the authorities and how the judge failed in his reasoning but the key conclusions are clear:

• First, on the question of whether the lender had a “legitimate interest” to protect, the Court was clear that “a legitimate interest in the enforcement of the primary obligation to repay the Loan, all interest, fees and commissions on the Repayment Date arises” and recognised that a higher rate of interest is justified when a borrower defaults because the credit risk has increased. Whilst this may seem blindingly obvious to us banking lawyers, the judge had got himself into quite a tangle over this question
• Secondly, the judge “did not address the crucial question of whether the provision is extortionate, exorbitant or unconscionable”. In their view “the judge appears to be looking for a justification for the default rate of interest rather than considering whether the rate is extortionate”
• Thirdly, the judge was wrong to conclude that because, in his view, the default rate was a penalty and therefore did not apply, the standard rate would continue to apply instead. Applying the standard rules of construction to the relevant clauses, they concluded that it was clear that the standard rate applied during the pre-default period and that the default rate applied during the post-default period. If the default rate was void and unenforceable, no rate of interest applied post default! They did however acknowledge that the lender would, in such circumstances, be able to pursue a claim for equitable or statutory interest.

The Court declined to determine for themselves whether the default rate was a penalty. “It would be unreliable and unsafe if we were to do so because it would be based on a limited knowledge of the evidence and cross examination to which we were referred. It is not appropriate for us to decide the point based on the small number of extracts from the expert evidence to which we were taken.”

Accordingly, the matter will be returned to the High Court judge, to be decided on the basis of whether the default rate was extortionate, exorbitant or unconscionable. It should be noted that these are very strong words and presumably the judge will not try to simply rationalise the default rate as he did in his original judgment.

Conclusion

What are the lessons to be learned for us as practitioners when documenting loan facilities?

• The first thing to note is that the question of penalties is not going to arise in the case of a typical loan where the default rate increases to one or two per cent above the standard rate
• It may become an issue in the case of high-risk loans such as this one where both the standard rate and default rate are much higher. Even so, as noted above, the words “extortionate”, “exorbitant” and “unconscionable” are very strong
• In commercial contracts involving liquidated damages (which are also prone to challenge as penalties) it is commonplace for the parties to agree that the liquidated damages are “a genuine pre-estimate of loss”. Whilst this would not be appropriate in the case of a loan, one could consider including wording in a default interest provision to the effect that the borrower acknowledges that the default rate is a reasonable reflection of the increased credit risk following a default. We are not aware that such a provision has been tested in the courts
• Whilst, in order to justify a default rate of interest, a “legitimate interest” has to be demonstrated, it is hard to imagine a loan transaction where a lender did not have a “legitimate interest” and therefore we do not think that this is a question which needs to be worried about
• It should go without saying that one must avoid words like “penalty”, a common mistake made by non-lawyers!
• Finally, it is important to ensure that the provisions of the loan agreement are drafted in such a way that, if the default rate is found to be extortionate, the standard rate will continue to apply.