A point of (default) interest

In-depth analysis

A recent Court of Appeal judgment in the case of Houssein & Ors vs London Credit Limited & Ors [2024] EWCA Civ 721 provides a useful reminder on the law of penalties in the context of default interest and practical guidance for those drafting and negotiating documents providing for default interest to be levied.

Background to the Case

The original case brought before the High Court concerned the interpretation of the interest provisions set out in a facility letter entered into between London Credit Limited (the Lender) and CEK Investments Limited (CEK) in July 2020 (the Facility Letter). The loan made available to CEK was secured by, inter alios, mortgages granted over certain properties owned by the directors of CEK, Mr and Mrs Ali and Nuray Houssein, including a particular property in Barnet, North London (the Barnet Property). The Facility Letter contained a restriction on the Barnet Property being occupied during its term and a representation from CEK that there was no intention for anyone to occupy the Barnet Property (the operation of these provisions being the Non-Occupation Requirement).

In September 2020 the Lender wrote to CEK alleging that the Non-Occupation Requirement had been breached, as the Houssein family were residing in the Barnet Property, and such breach constituted an "Event of Default" under the Facility Letter. The Lender claimed that as a result of the breach, it was entitled to levy default interest on the outstanding amounts due under the Facility Letter until such time as the breach was remedied. The Housseins however continued to occupy the Barnet Property and CEK did not pay the amount demanded as default interest.

In early November 2020 the Lender referred CEK again to a breach of the Non-Occupation Requirement and demanded immediate repayment of all sums outstanding under the Facility Letter. The sum demanded by the Lender included an amount constituting default interest, and provided that default interest would continue to accrue at a daily rate of around £2,500 until such time as the sums demanded were paid. Over the coming months the Lender appointed receivers to exercise its powers under the security over the properties mortgaged in its favour.

The Housseins and CEK brought proceedings against the Lender (the Original Proceedings) with a view to stopping the enforcement process in respect of which the key issues to be determined included:

whether the Non-Occupation Requirement had been waived such that there had been no Event of Default under the Facility Letter entitling the Lender to charge default interest
whether the default rate of interest provided for by the Facility Letter was unenforceable by reason of it being a penalty.

The judge who heard the Original Proceedings; Mr Richard Farnhill, determined on these issues that the Lender had been aware, via its agents, that the Houssein family were in occupation of the Barnet Property and accordingly had waived compliance with the Non-Occupation Requirement, but also found that the default interest rate specified to be payable under the Facility Letter was an unenforceable penalty.

One might consider this a victory for CEK and the Housseins, however Farnhill J further determined that interest continued to accrue under the Facility Letter following its scheduled maturity date (in respect of sums which were, at such time, unpaid) but at the standard contractual rate of 1% (the Standard Rate) as opposed to the unenforceable default rate of 4% (the Default Rate).

CEK, Mrs Houssein and the Housseins' son (as executor for Mr Houssein, who had since passed away) (the Appellants) brought an appeal contesting that Farnhill J had erred in his construction of the Facility Letter in determining that interest would continue to accrue following the scheduled repayment date and that in fact no interest should have accrued from such date, at either of the potential rates of interest provided for in the Facility Letter.

The Lender brought a counter-appeal, contending that the Default Rate was not a penalty and was therefore enforceable. The Lender agreed with Farnhill J that interest continued to accrue from the scheduled repayment date, but at the higher Default Rate rather than the Standard Rate determined to apply by Farnhill J.

Terms of the Facility Letter

The critical provisions of the Facility Letter considered by the Court of Appeal included:

the Repayment Provision which held that interest due on the loan should be paid, together with the outstanding principal amount and all other sums due under the Facility Letter by noon on the Repayment Date (being 7 August 2021), with the facility being cancelled in full on the Repayment Date
the Standard Interest Provision which held that interest would be payable on all outstanding amounts under the Facility Letter at the Standard Rate
the Default Interest Provision which held that upon the occurrence of an Event of Default and/or if the Borrower failed to repay any amount when due, interest would accrue on the overdue amount from the date the sum was due to be paid until the date of payment at the Default Rate
the EOD Provision which held both that on the occurrence of an Event of Default the Lender could demand immediate repayment of the loan together with interest, and that any monies falling due for payment under the Facility Letter which were unpaid would bear interest at the rate specified in either the Standard Interest Provision or the Default Interest Provision, if applicable, until the date of payment.

The Facility Letter provided for an upfront payment of all interest which would accrue and be payable during the term (at the Standard Rate). This sum was deducted from the loan advanced following the Facility Letter being signed.

It was not contested that there remained outstanding amounts to pay as at the scheduled Repayment Date. The Appellants accepted that, were it not unenforceable as a penalty, the Default Rate would on the face of the Facility Letter apply to any unpaid sums on and from the Repayment Date.
Accordingly the Court of Appeal turned first to the question of whether the Default Rate was a penalty rendering it unenforceable before considering the issue of whether interest should apply after the Repayment Date – if it could be determined that the Default Interest Provision was enforceable, the parties would be in agreement that the Default Rate applied, at least, to the sums that had been outstanding from the Repayment Date.

The Law on Penalties

Lady Justice Aplin's judgment in this case provides a useful summary of the English law authorities on penalty clauses and when such clauses may be found unenforceable, which has been developed through case law. The key principles in this area were neatly distilled in Cavendish Square Holding BV v Makdessi [2016] AC 1172 by Lord Neuberger JSC and Lord Sumption JSC as being whether the relevant clause "is a secondary obligation, which 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".
Accordingly, when considering if a clause is an unenforceable penalty clause, one should determine:

whether the relevant clause is a secondary obligation, i.e. is it only engaged on breach of a primary obligation
if so, does the non-breaching party have a legitimate interest in the performance of that primary obligation
if so, is the secondary obligation proportionate to such interest, or is it, to use the words featured most frequently in the relevant case law "extravagant", "exorbitant" or "unconscionable" in this context?

As ever, the courts are typically reluctant to interfere with freedom of contract, and case law has established that the relevant bargaining strength of the parties and whether or not they received legal advice on the terms of the relevant contract could be relevant here. Similarly, it is clear from a review of the authorities that the courts are reluctant to provide specific guidelines on penalties (e.g. that a rate of X% is okay but not Y%) as what is extravagant or unconscionable will be highly fact dependent. It is highlighted in many of the relevant judgments that the words "extravagant", "exorbitant" or "unconscionable" suggest a level of extremity and set the threshold for a penalty to be found unenforceable reasonably high.

Applying the law to default interest clauses specifically, the courts have generally recognised that lenders do have a legitimate interest in ensuring they are paid on schedule (in fact in Cargill International Trading Pte Ltd v Uttam Galva Steels Limited [2019] EWHC 476 (Comm) this was stated to be "self-evident"), and prima facie an increase in the interest rate in such circumstances would be proportionate bearing in mind the increased credit risk to the lender (as riskier credit is more expensive) although courts have found certain default interest provisions to be unenforceable penalties on the basis the actual default rate levied by a lender is high enough to be considered extravagant, exorbitant or unconscionable.

Judgment

Here the Court of Appeal determined that the High Court had failed to apply the correct test to the facts before them in considering whether or not the Default Interest Provision was an unenforceable penalty. In particular, while the "legitimate interest" test was discussed, it was determined to have been incorrectly applied with Farnhill J taking a subjective approach to the question of which interest the Lender was seeking to protect. Farnhill J found this to be the interest in the Barnet Property remaining unoccupied (which interest he felt was illegitimate given it was driven by requirements that did not apply to a corporate borrower) rather than an interest based on the function of the Default Interest Provision in the context of the Facility Letter, where to Aplin LJ it seemed inevitable that the function of such clause was to protect the Lender's legitimate interest in repayment of all outstanding amounts ahead of the Repayment Date. She further noted that, having drawn a conclusion that the Default Interest Provision did not protect any legitimate interest, the High Court then failed to consider whether it was "extravagant, exorbitant or unconscionable". She declined to form a view on this question, having not had access to the expert evidence and cross examination that would have been available to the High Court, and accordingly referred the question back to them to be reconsidered.

Leaving open that the High Court may determine, in line with the correct test, that the Default Interest Provision remains an unenforceable penalty, Aplin LJ returned to the question of whether interest was payable for the period after the Repayment Date and, if so, at what rate.

Aplin LJ noted that the EOD Provision specifically refers to overdue payments, and states that interest on such sums will accrue at either the rate set out in the Standard Interest Provision or the rate set out in the Default Interest Provision, depending on which was applicable. A reading of those provisions made very apparent that they were each intended to apply in specific circumstances and each would apply individually while those specific circumstances prevailed. Aplin LJ did not find it possible to interpret the Facility Letter such that if the circumstances for one rate to apply were not present, the other rate would naturally apply. This meant that if it were found that the Default Rate was not enforceable in circumstances where it was expressed to apply, one could not fallback to the Standard Rate as the circumstances in which it was stated to apply (principally prior to the Repayment Date) had ceased. Aplin LJ noted that in these circumstances it could be open for the Lender to pursue a claim for statutory or equitable interest.

Comment

The case will not be fully determined until, at least, the High Court have reconsidered whether the Default Rate amounts to an unenforceable penalty so we will be watching, if you'll forgive the pun, with interest for further updates to see how the High Court reappraise the Default Rate.

In the meantime however, the case does provide a helpful reminder of the key principles to bear in mind in relation to default interest clauses, both for lawyers who are drafting these and/or advising clients on the same, and on the principals determining what rate should apply and when default interest should be levied.

It is helpful to see the courts continue to find that default interest is likely to protect a legitimate interest where applied to overdue payments, and indeed the default interest clause as set out in the LMA's template forms of facilities agreement on which many debt instruments are based provides only for default interest to be levied in these circumstances. More caution may need to be taken if the parties wish to expand the application of the default interest provision to other breaches, as per the Facility Letter, as it may be harder to demonstrate in those circumstances that applying an increased interest rate is an appropriate means of protecting a legitimate interest and not simply punitive, a means of deterring breach or a route to gain further economic "upside", particularly on the basis the same default rate will likely apply to all breaches regardless of their nature/impact, depending on how the provision is drafted.

We don't know yet whether the courts will determine the Default Rate in this instance to be exorbitant, extravagant and/or unconscionable, and as stated it is hard to provide a hard and fast guideline as to what level of default interest will fall the wrong side of this line as it will be fact dependent. We would recommend this is considered on a case by case basis, rather than as a point of lender "policy", and that records are kept of the factors considered to be relevant in setting a default rate, which might include potential repercussions for the lender from late payment and the quality of the lender's other credit protections, such as the security and guarantees given for the loan.

Finally, the case serves as a helpful warning as to the consequences of a default rate being found unenforceable. Care should be taken to ensure that in these circumstances any standard rate of interest provided for in the contract will still prevail in this instance to avoid the lender being left relying on a claim for statutory or equitable interest, which may not be adequate in the circumstances.