Default interest clauses are a fixture of commercial lending documentation. For lenders, they serve an ostensibly straightforward purpose: to compensate for the elevated risk and cost associated with a borrower who has failed to perform. For borrowers, they can represent a significant and sometimes devastating escalation of their liability. When that escalation is sufficiently disproportionate, the law will intervene and the consequences for a lender who has relied upon such a clause can be considerable. In light of several recent decisions dealing with penalties, we considered the following noteworthy.
The Penalty Rule
The rule against penalties is a well-established exception to the general principle of contractual freedom. Courts do not lightly interfere with bargains struck between parties of full capacity. The threshold is high, and deliberately so. A provision will not be struck down merely because it lacks proportionality or imposes a burden greater than the loss actually suffered. The sum or obligation in question must be extravagant and unconscionable in amount. In other words, out of all proportion to the legitimate interests the innocent party seeks to protect.
The classic formulation, which has endured, distinguishes between a genuine pre-estimate of loss and a sum stipulated in terrorem. That is, as a threat designed to compel performance rather than to compensate for its absence. The former is enforceable; the latter is not. The question of which category a provision falls into is one of construction, assessed not at the time of breach but at the time the contract was made, and considering all the commercial circumstances surrounding it.
The penalty rule does not displace the parties’ freedom to allocate contractual benefits and burdens as they see fit. However, where the dominant purpose of a contractual provision is deterrence of breach rather than protection of a legitimate interest, the courts may refuse to enforce it.
Default Interest
Default interest provisions occupy a nuanced position within this framework. It is well accepted that a higher rate of interest charged in the event of default is not, of itself, a penalty. There is sound commercial logic for the proposition: a borrower in default is not the same credit risk as a performing borrower, and money is more expensive for a worse credit risk. A modest, rateable increase in the interest rate charged prospectively upon default reflects this commercial reality and cannot easily be characterised as penal.
The difficulty arises when the increase is not modest. A small step-up in rate, or one that can be explained by reference to a changed risk profile, increased cost of funds, or foregone lending opportunity, will generally survive scrutiny. A dramatic increase, particularly one that cannot be explained by any of these factors, may not.
There are also differences between in form and substance. What matters is the extent of the increase in real terms, not how it is labelled or structured in the transactional document. An increase that doubles a rate which is already substantial, and which compounds upon default in circumstances where the ordinary rate does not compound, warrants close examination. When the annualised effect of such a provision is calculated (taking into account both the uplift and the compounding mechanism) the resulting figure may be so far removed from any plausible pre-estimate of the lender’s loss as to be incapable of characterisation as anything other than a deterrent.
Practical Implications
The lessons for lenders are clear. Default interest clauses must be calibrated with genuine commercial justification, not drafted as deterrents with no underlying economic rationale. The further a default rate departs from the standard rate, the more difficult it will be to defend, and the more comprehensive the evidence of commercial justification will need to be.
Lenders operating in the private credit and non-bank lending markets, where rates are already elevated relative to institutional benchmarks, face acute risks of challenge. If the lender cannot explain the rate by reference to documented risk analysis, market data, or funding cost evidence, the clause may be in jeopardy. The drafting of default interest provisions should be approached not merely as a question of what the market will accept at the time of origination, but as a question of what a court will enforce at the time of default. Those are not always the same question.
For further information, please contact:
Masi Zaki, Partner, Bird & Bird
masi.zaki@twobirds.com
