In Houssein & Others v. London Credit Ltd & Another[1], the Court of Appeal considered the proper application of the common law rules on penalties to a default interest clause in a loan agreement. Contrary to the conclusion of the High Court, the Court of Appeal found that in light of relevant case law, the lender ‘inevitably’ had a legitimate interest in the enforcement of the obligation to repay the loan, which would justify a default interest clause.
Background
The case concerned a loan agreement between the third claimant borrower, CEK Investments, and the first defendant lender, London Credit. Under the terms of the agreement, CEK Investments was to pay 1% interest, compounded monthly, as standard. In the event of a default or a failure to repay any amount payable on time, default interest of 4%, compounded monthly, would accrue.
A dispute arose between the parties. London Credit alleged, among other things, that CEK Investments had failed to repay an amount payable on time, and that the default interest clause was therefore triggered. CEK Investments issued proceedings, seeking, among other things, a declaration that the default interest clause was an unenforceable penalty.
Case law on penalties
The leading case on penalties is Cavendish Square Holdings BV v. Makdesi[2], which established that a damages clause may legitimately go beyond the purely compensatory, and that the true test is ‘whether the impugned provision … imposes a detriment on the contract-breaker out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation’. This requires the court to undertake a two-stage analysis:
- Is a legitimate interest served and protected by the clause? (And, if so, what legitimate interest?)
- Assuming such an interest exists, is the provision extravagant, exorbitant or unconscionable having regard to it?
Of particular note with respect to default interest clauses in loan agreements, is Mr. Justice Bryan’s observation in Cargill International Trading PTE Ltd v. Uttam Galva Steels Ltd[3]: ‘ … it is self-evident … that there is a good commercial justification for charging a higher rate of interest on an advance of money after a default in repayment. The person who has defaulted is necessarily a greater credit risk and “money is more expensive for a less good credit risk than for a good credit risk”’.
As to the rate of default interest, His Honour Justice Hodge QC in Ahuja Investments Ltd v. Victorygame Ltd[4] commented: ‘Whilst I would be prepared to accept, without supporting evidence, an increase of up to 200% in the applicable rate of interest on default to reflect the greater credit risk presented by a defaulting borrower, in my judgment, and as a rule of thumb, I would expect an evidential burden to pass to a lender to adduce evidence to justify any greater increase, at least where the lender enjoys additional personal and real security for its loan’.
The High Court’s decision
The High Court held that the default interest rate was an enforceable penalty. While the judge acknowledged that charging a higher rate on default can be commercially justified on the basis of the enhanced credit risk of the borrower, he was of the view that this was not the interest that London Credit was seeking to protect for the following reasons:
- There was evidence that a level of credit risk had already been priced into London Credit’s 1% rate (increased from 0.7%), but there was no evidence on why late payment, even by a short period, justified an increase of a further 3%.
- London Credit’s default rate was the same regardless of the breach and was set without reference to the borrower or the loan.
- The same default rate applied to all breaches, which in addition to late payment, would encompass residence at a security address, final judgments against the borrower in excess of 20,000 pounds, and litigation or arbitration threatened or commenced against the borrower.
The Court of Appeal’s decision
The Court of Appeal unanimously determined that the High Court judge had not applied the correct test in determining whether the default interest clause was a penalty.
- Although the judge made reference to the concept of legitimate interest, he – in fact – focused on the effect of the clause and the subjective intention of London Credit.
- The judge failed to take any real account of the judge’s conclusion in Cargill that it is ‘self-evident’ that there is good commercial justification for charging a higher rate of interest after a default in repayment.
- Moreover, he did not address the second question of whether the provision was extravagant, exorbitant or unconscionable.
Lady Justice Asplin, who gave the lead judgment, concluded that, in the circumstances and in light of above authorities, it was ‘inevitable’ that London Credit had a legitimate interest in the enforcement of the obligation to repay the loan.
As to the rate of interest, the judges determined that they were not in a position to substitute their own decision for that of the High Court judge. To do so would be unreliable and unsafe given their limited knowledge of the evidence and cross-examination. Accordingly, the question of whether the 4% rate of interest was extravagant, exorbitant or unconscionable (having regard to the legitimate interest) was remitted to the High Court judge for determination.
Takeaway
This judgment is to be welcomed to the extent that it restores comfort to lenders that they will be deemed to have a legitimate interest in enforcing repayment obligations, which may be protected by imposing a higher rate of interest if a borrower fails to make timely repayment. However, the conclusion should be treated with caution given that it singularly fails to deal with the point that the default interest clause would be triggered for any breach of the loan agreement, not just a payment breach. This sort of blanket response to all breaches – whatever their nature or severity – has been considered a ‘hallmark’ of a penalty clause. Notwithstanding this judgment, parties would be well-advised to tailor default interest and damages clauses to the different categories of breaches that may occur.
[1] [2024] EWCA Civ 721.
[2] [2015] UKSC 67.
[3] [2019] EWHC 476.
[4] [2021] EWHC 2382 (Ch).
Contributors
Alex Radcliffe