Whether enhanced interest for default constitutes an unenforceable penalty
In Houssein v London Credit Ltd, decided in June 2024, the Court of Appeal considered whether the High Court had reached a proper conclusion when reviewing a default interest rate clause contained in a loan facility agreement, and in particular whether it constituted a penalty clause. If it was a penalty clause, this would render the default interest provision unenforceable in law.
The facts of the case were that a lender, LCL, agreed to lend £1,881,000 to CEK Investments Limited for a period of 12 months. The loan was secured by a debenture over CEK’s assets, personal guarantees from CEK’s directors and mortgages over five buy-to-let properties, as well as the directors’ family home. The facility agreement prohibited CEK itself from occupying the family home as well as “related persons”. That definition included spouses and relatives but not the directors themselves. Under the terms of the agreement, the standard rate of interest was 1% per month and the default rate was 4% per month.
A month after the drawdown of the loan, LCL alleged that CEK was in breach of the agreement because related persons were in 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.
The High Court decided that the default interest rate was unenforceable as an unlawful penalty. It also held that the standard rate of interest continued to apply to the loan balance after the repayment date of the loan (rather than the default interest rate).
The Court of Appeal found that the High Court had incorrectly applied the appropriate test to determine whether the default interest rate in the agreement constituted a penalty. This test, following a case called Cavendish Square Holdings BV v Makdesi, required the court to consider, separately, whether a legitimate business interest was protected by the default clause (and if so, what interest) and, if such an interest existed, whether the sum required to be paid was nevertheless extravagant, exorbitant or unconscionable in the circumstances. The High Court had concluded that the default interest provision did not protect any legitimate interest of LCL for reasons that included that the default interest rate was the same irrespective of the nature or severity of the breach or the size of the sum outstanding. This, the High Court reasoned, made little sense because different breaches would give rise to different levels of risk. Furthermore, the actual rate was higher, according to expert evidence, than the norm in agreements of this type.
The Court of Appeal found that the High Court had confused the concept of “legitimate interest” with the effect of the clause. It was, the Court of Appeal found, self-evident that a lender has a good commercial justification for charging a higher rate of interest after a payment default because, having defaulted, the borrower is a greater credit risk. That was the inevitable conclusion here and satisfied the first part of the test. The High Court also appeared not to have addressed the key question of whether the default interest was in fact extortionate, exorbitant or unconscionable, i.e the second part of the test.
The Court of Appeal referred the issue of whether the default interest rate constituted a penalty back to the High Court to decide on application of the correct test.
The Court of Appeal also ruled that the High Court had wrongly concluded, on the wording of the agreement, that contractual interest continued to accrue after the loan’s repayment date at the non-default rate (assuming the default interest rate was itself struck down as an unenforceable penalty). The Court of Appeal interpreted the facility agreement as providing that the default interest rate became applicable if an event of default occurred or if the borrower failed to repay any amount on its due date. There was no room for an interpretation that allowed the interest rate to revert to the non-default rate if the default rate could not be charged. The entitlement to standard rate interest had come to an end once the repayment date had passed. The standard rate and the default rate were mutually exclusive. If the default rate was an unenforceable penalty (after the High Court had reconsidered the matter applying the test correctly), then if LCL was to claim any interest, it would have to be on some equitable or statutory basis.
The case provides a useful reminder of the test to be applied to establish whether a default interest rate clause is unenforceable as a penalty and the importance of ensuring that each stage is addressed separately and consequentially. It also serves to underline the importance of considering and providing for the potential consequences if a term of the contract is found to be unenforceable.
It should be noted that where agreements that are made with consumers contain penalty clauses, there is the potential for restrictions to apply to interest charged, which is not necessarily limited to whether or not they are deemed to be penalties.
Disclaimer: this article is not to be relied upon as legal advice. The circumstances of each case differ and legal advice specific to the individual case should always be sought.
