When does a 1% per month default interest rate become excessive?
When London Credit Limited advanced a bridging loan to CEK limited for nearly £2 million, they received a number of securities over property and assets, and agreed a rate of interest that would be applied if the borrower breached the agreement. When one of those terms was breached, LCL called in the loan and applied the default rate – the borrowers, however claimed that the interest rate was a penalty rate – and therefore unenforceable.
A default interest rate is a higher rate charged when a borrower breaches the terms of a loan agreement. These rates aim to encourage timely payment and compensate the lender for the added risk of default. However, under English law, if these rates are seen as punitive—designed to punish rather than compensate—they are usually unenforceable. A penalty clause that imposes excessive charges, beyond what the lender actually lost, may be struck down by the courts. For a default interest rate to be enforceable, it must protect a valid business interest.
Before 2015, a 90-year-old case, Dunlop v New Garage, set the standard for determining if a penalty clause was enforceable. The rule was that if a penalty (like an increased interest rate) wasn’t a genuine effort to compensate the lender for losses, it couldn’t be enforced.
In the recent Houssein vs. London Credit Ltd. case, the Court of Appeal examined whether the default interest clauses in the lender's loan agreements were enforceable, focusing on whether these clauses amounted to penalties.
Legal Background
English law generally treats clauses that impose penalties as unenforceable unless they meet certain conditions. The 2015 case Cavendish Square Holding BV vs. Talal El Makdessi replaced Dunlop and introduced a new test to determine if a clause is a penalty. This test has three key parts:
- Secondary Obligation: The clause must only be triggered by a breach of the main terms of the contract.
- Legitimate Interest: The lender must have a valid interest in including the clause that goes beyond just punishing the borrower.
- Proportionality: The penalty must be reasonable and not excessively high compared to the lender's interest in ensuring the loan is repaid.
In Houssein, the Court of Appeal applied this test to determine whether the default interest clause was enforceable.
Case Summary
The case involved a loan agreement between a borrower and London Credit Limited (LCL).In 2020 LCL loaned £1,845,000 to CEK limited, and the loan was guaranteed by the Houssains as directors and by a mortgage over their home. The Housseins breached a requirement that the house would remain unoccupied, and LCL demanded repayment of the loan, and daily interest of £2,473.64. The borrower challenged the validity of the default interest rate, leading to a legal dispute. The default interest rate was 1%
The High Court initially ruled that while the borrower had defaulted, the default interest clause was unenforceable because it didn’t protect a legitimate interest for LCL.
The court said the borrower only had to pay the standard interest rate, even after the default.
Both parties appealed, and the case went to the Court of Appeal.
Court of Appeal Ruling
The Court of Appeal had to decide whether the default interest clause was a penalty by applying the Makdessi test. They found that the High Court had misinterpreted the test, particularly the part about the lender’s legitimate interest.
The Court of Appeal emphasised that LCL had a valid interest in making sure the loan was repaid promptly, especially since default increases the lender’s risk. Therefore, charging a higher interest rate in the event of a default was justified. The Court criticised the High Court for focusing too much on the effect of the clause rather than the reason it was included.
The Court also said that the High Court had incorrectly interpreted the clause subjectively. Instead, the clause should be understood objectively in the context of the whole contract.
Ultimately, the Court of Appeal ruled that LCL had a legitimate interest in applying the default interest clause. However, they left it to the trial court to decide if the clause was "exorbitant or unconscionable."
Interest After the Repayment Date
A secondary issue was what interest rate would apply after the repayment date if the default interest clause was found unenforceable. The borrower successfully argued that the standard interest rate couldn’t automatically apply after the repayment date, as the contract clearly distinguished between the two rates. The Court of Appeal agreed and rejected LCL’s argument that the standard rate could serve as a fallback.
Key Takeaways
The Court of Appeal's decision offers several important lessons for lenders and borrowers:
- Precise Drafting: Contracts need clear language, especially when distinguishing between standard and default interest rates. Lenders should ensure their agreements are carefully written to avoid disputes.
- Applying the Makdessi Test: The ruling highlights the importance of considering all three parts of the Makdessitest when evaluating penalty clauses. Lenders should clearly define their legitimate interest and ensure the penalty is reasonable.
- Review Default Interest Clauses: Lenders should regularly review their loan agreements to ensure default interest clauses comply with legal standards and are not overly punitive.
This case reaffirms that default interest clauses can be enforceable, but only if they are proportional and serve a legitimate business purpose.
