Houssein & Others -v- London Credit Limited & Another [2024] EWCA Civ 721
Loan facility agreements contain provisions that impose an obligation on the Borrower to pay default interest on any overdue amounts under the relevant facility agreement (whether principal, interest or other moneys owed) from the due date of a payment. Default interest is charged at a higher rate to compensate the Lender for any additional costs that may be incurred as a result of an obligor’s failure to pay any amounts under the facility agreement when due.
In this article, we consider a recent Court of Appeal decision regarding a default interest rate provision, in light of the English law rules on penalty clauses.
Cavendish Square Holding BV -v- Makdessi [2015] UKSC 67
In 2015, the UK Supreme Court restated the English law principles that apply to penalty clauses. The Supreme Court distinguished between primary and secondary obligations. In simple terms, a primary obligation is something that the parties have undertaken to do pursuant to the contract e.g. to make funds available pursuant to a loan facility and to repay that loan. A secondary obligation arises in the event a primary obligation is breached e.g. to pay liquidated damages upon breach or to be liable for default interest.
The Supreme Court set out a three-stage test for determining whether a contractual provision is or is not unenforceable as a penalty:
- Only a secondary obligation can be a penalty, the rule against penalties does not apply to primary obligations.
- If the clause protects or furthers a legitimate interest, it is not a penalty. The Court will take an objective approach to this issue, rather than considering the parties’ subjective intentions.
- The clause should not provide for a sum that is out of proportion to the innocent party’s legitimate interest and the Court will consider whether it is extortionate, exorbitant or unconscionable by reference to that legitimate interest.
Applying this test in that case, the Supreme Court held that a provision which fixed default interest at a rate of one-month LIBOR plus 12% p.a. protected a legitimate interest of the party. In the Supreme Court’s view, it was commercially justifiable to charge a higher rate of interest on an advance of money after default because there was a greater credit risk posed by defaulters. The Supreme Court also found that the interest rate was not exorbitant nor unconscionable.
Significance of Makdessi
Prior to the Supreme Court’s ruling in Makdessi, the traditional test was whether the stipulated sum was a genuine pre-estimate of the loss that could be caused by breach of the relevant primary obligation. If the sum in question greatly exceeded the highest potential loss caused by the breach, then it would be considered extravagant and unconscionable and struck down as a penalty.
The Makdessi decision was positive for lenders because there might be a wider and legitimate interest in enforcing a default rate clause that extends beyond reflecting an estimate of a lender’s probable losses.
Houssein -v- London Credit Ltd
In this case, the Court of Appeal found that the High Court had not applied the three-limb test set out in Makdessi. Here, following the triggering of an event of default after a breach by the borrower, the lender demanded repayment of the outstanding loan and sought to apply default interest on the outstanding amounts pursuant to the default interest clause in the relevant facility agreement.
In particular, the High Court had found (among other things) that: (a) the default interest provision was unenforceable as a penalty as it did not protect any legitimate interest of the lender; and (b) that the standard rate of interest continued to apply after the term date of the loan.
Both parties appealed this decision. The Borrower claimed that under the terms of the facility agreement, the standard rate of interest did not apply following the repayment date. The Lender argued that default interest was payable on the outstanding amounts after the lapse of the repayment date.
The Court of Appeal considered whether the contractual provision for default interest amounted to an unenforceable penalty. Applying the test set out in Makdessi, the Court found firstly that the default interest provision constituted a secondary obligation and the rule against penalties was potentially applicable.
As to legitimate interest, it cited the decision in Cargill International Trading PTE Ltd -v- Uttam Galva Steels Ltd [2019] EWHC 476 (Comm), in which the Court held that there is a good commercial justification for a lender to charge a higher rate of interest following default. Further, that an increase in the interest rate in such circumstances would be proportionate because of the increased credit risk to the lender. The Court of Appeal noted that the High Court had appeared to overlook this decision.
As to whether or not the interest rate was out of proportion to the Lender’s legitimate interest, the Court of Appeal decided that the High Court had not considered whether the default interest was high enough to be considered extortionate, extravagant or unconscionable. Instead, it had mistakenly taken a subjective approach and considered the parties’ actual intentions. Whether a clause constitutes a penalty depends on its purpose, which is a matter of construction of the facts and by taking into account the commercial position. The Court of Appeal, therefore, referred this issue back to the High Court for reconsideration. The High Court had had the benefit of the expert evidence and cross-examination, which the Court of Appeal had not.
The Court of Appeal then considered, in the event the default interest clause was unenforceable, whether non-default interest would continue to accrue after the repayment date. It held, on the facts of the case, that the Lender could not revert to applying the normal rate as these were mutually exclusive.
Comment
It remains to be seen what the High Court will decide with regard to the enforceability of the default interest rate. However, the case usefully illustrates the test that the courts will apply for determining whether a clause is a penalty.
In general terms, a default interest provision that is applicable to overdue payments (e.g. the default rate clause in the LMA template) is more likely to be considered as protecting a legitimate interest, as opposed to being a penalty clause, where the default rate is applicable on all other breaches as well.
Ultimately, whether or not a particular default interest clause constitutes a penalty depends on the facts of the case. In shipping finance, a rate of around 2% above the rate which would otherwise have applied if the overdue amount was the principal constitutes usual market practice. This does not mean that in certain sectors and markets a higher rate would not be justifiable.
Nonetheless, those drafting or advising on default interest provisions should keep in mind the guidance received from the UK Supreme Court.
For further information, please contact:
Kostas Karachalios, Hill Dickinson
kostas.karachalios@hilldickinson.com
