Home / Default Interest Rates
23rd September 2024
Much like Football’s VAR (virtual assistant referee), the Court of Appeal (CoA) has overturned a penalty decision. But how clear and obvious was the error from the court at first instance?
In contract law it is acknowledged that you cannot insert a clause into a contract that serves to penalise any party that breaches the contract. This would be considered a penalty clause and would be unenforceable.
Lenders will often include in their loan agreements a provision for default interest to be charged when there has been a breach of the loan terms or (if secured) the mortgage conditions, until the breach has been remedied.
In Houssein & Ors -v- London Credit Ltd & Anor [2024], the CoA overturned a decision that held a default interest rate of 4% per month as a penalty clause and, therefore, unenforceable. The case has been referred back to the original court for re-evaluation, but with clarity as to the appropriate test to be applied when considering whether a contractual clause is a penalty clause.
London Credit Limited (LCL) loaned circa £1.8M to CEK Investments Limited (CEK). The loan agreement set the standard rate of interest at 1% per month and the default rate of interest at 4% per month. The directors of CEK offered up (amongst other properties) their residential homes (the “Security Property”) as security for the loan.
To comply with mortgage and consumer credit legislation, many lenders cannot allow borrowers or related individuals to occupy security properties. Accordingly, the loan agreement restricted CEK or any related person from occupying the Security Property. Just one month following completion of the loan, LCL considered that CEK had defaulted on the loan agreement due to the Security Property being occupied. LCL demanded immediate repayment of the loan from CEK, together with interest at the default rate of 4%.
CEK failed to comply with the demand for payment, so LCL instructed joint receivers to sell the Security Property. Before the Security Property was sold, CEK obtained a court order temporarily restraining LCL and its joint receivers from dealing with or selling the Security Property.
Civil proceedings were issued with a view to resolving the dispute.
The lower court considered that, LCL had visited the Security Property before the loan completed to verify that it was not occupied, and LCL had seemingly staged photographs to make it appear as though the Security Property was not occupied (when in reality it was), the non-occupation requirement was waived by LCL.
The court also determined that the default rate of interest was a penalty and unenforceable, reducing it to the standard 1%.
LCL appealed the decision, arguing that the court had applied the wrong test and that the default interest was therefore not a penalty and should be enforceable.
The CoA found several issues with the original ruling. First, the lower court failed to consider whether the default rate was a secondary obligation triggered by CEK’s breach of its primary obligation to pay the loan and keep the Security Property unoccupied. The court also failed to follow established case law which allows for a higher rate of interest following default, given the greater risk a defaulting borrower poses. Further, the judge of the lower court had considered the default interest clause subjectively, rather than objectively. Finally, the court didn’t address whether the default interest clause was extortionate, exorbitant or unconscionable.
The CoA stepped in to correct the clear and obvious errors made by the lower court by overturning the decision which held the 4% default interest rate as a penalty clause and unenforceable, and requiring the lower court to properly apply the test set out in Cavendish Square Holdings BV -v- Makdessi [2015].
The CoA directed the lower court to consider:
A high default rate of interest will not necessarily be considered a penalty clause and be deemed unenforceable.
When preparing loan agreements, you must consider whether the relevant default interest clause creates a secondary obligation that is triggered by the breach of a primary obligation under the same loan agreement.
A default interest clause must be drafted with a view to protecting a legitimate interest, rather than penalising any party who breaches the loan agreement.
A default interest rate must not be extortionate, exorbitant or unconscionable.
Should you have any queries or concerns regarding a loan agreement you have offered, been offered, or entered, or the interest rates applicable to such loan agreements, please don’t hesitate to contact Sam Jackson (Banking) or Callum Duff (Dispute Resolution).