Could your Default Interest Clause be unenforceable?

In the recent High Court decision of Ahuja Investments Limited -v- Victorygame Limited [2021] EWHC 2382 (Ch) the court considered if a default interest clause was a penalty clause and unenforceable. 

Historically cases focused on whether the penalty being imposed was a genuine pre estimate of the loss suffered by the non-defaulting party but in 2015 in the case of Cavendish Square Holding BV -v- Makdessi [2015] UKSC 67, [2016] A.C. 1172 (Makdessi) the Supreme Court reviewed the law of penalties and set out 4 principles:

1. Penalty clauses are secondary obligations
2. Drafting should reflect the legitimate interests of the non-defaulting party and not be exorbitant, extravagant, or unconscionable
3. The burden of proving that a clause is exorbitant, extravagant, or unconscionable lies with the defaulting party
4. The courts should be slow to interfere with parties freedom to contract

This latest case considered how these principles should apply to default interest clauses used in finance agreements.

Background 

The claimant (Ahuja) had bought a shopping centre from the defendant (Victorygame) which had been partly funded by a loan of £800,000 which was advanced by Victorygame to Ahuja. The pre-default interest rate specified in the loan agreement was 3% per month, which increased to 12% per month on the amount that remained outstanding at the redemption date, compounded monthly which meant that the rate actually increased by 400% if the original loan was not paid in full on the contractual redemption date. 

Victorygame contended that the 12% default interest rate was not a penalty and that the provision did not operate on breach of contract and was a primary obligation to pay the lender interest at 12% per month on the amount outstanding at the redemption date. The judge rejected this argument holding that whether a clause imposes a secondary liability upon a breach of contract is a question of substance and not of form: ‘If the substance of the contract is the imposition of a punishment for a breach of contract, the concept of a disguised penalty may enable a court to intervene’ and held that the obligation to pay default interest was in fact a provision which operated upon any breach of the borrower’s primary obligation to repay the loan. It therefore fell within the scope of the rule against penalties as it was not a secondary obligation. 

The judge went on to consider the second principle and if the default interest rate was excessive in nature; in particular, to assess whether it was ‘exorbitant, extravagant or unconscionable’, in comparison with the lender’s legitimate interest, such that it was penal in nature and unenforceable. The judge noted that if the provisions did not constitute a penalty and was enforceable, Ahuja would owe over £80 million in interest on an initial loan of £800,000 taken out just 30 months previously. In the circumstances, the court was satisfied that a default rate equivalent to a 400% increase in the primary interest rate was, when combined with a provision for monthly capitalisation of interest, ‘so obviously extravagant, exorbitant and oppressive’ that it should properly be characterised as a penalty. 

In its judgment, the court accepted that a lender has a legitimate commercial interest in applying a higher rate of interest to a borrower who is in default because that borrower represents an increased credit risk but that there are limitations to this principle. In any given case, whether the default interest rate applied is penal will depend on whether, in all the circumstances, it is ‘exorbitant, extravagant or unconscionable’. 

The burden of proof falls on the party alleging the penalty (usually the borrower) and it must make its case on the balance of probabilities to succeed. 

Interestingly, the judge commented that he would be prepared to accept, as a rule of thumb and without supporting evidence, an increase of up to 200% in the applicable rate of interest on default to reflect the greater credit risk presented by a defaulting borrower but would, however, expect a lender to adduce evidence justifying any greater increase, particularly where the lender benefits from additional personal and real security for the loan such as a guarantee or other security. 

Whilst the judge also commented that “clever” drafting is key, this case provides a stark reminder to lenders that when drafting contractual default interest clauses, they should be mindful of the key rules and principles including that (1) the rate and, particularly, the uplift should not be excessively high, judged by comparison with market rates at the time the loan agreement is made; (2) interest should run only while the default continues and provisions should not purport to operate retrospectively or for an indefinite or arbitrary future period; and (3) any secondary liability imposed upon a defaulting party must be in proportion to the legitimate interest of the innocent party, specifically the objective value of that legitimate interest. 

Lenders should also be able to provide the court with evidence detailing: (1) market interest rates at the time of the loan agreement; (2) the risk factors involved; (3) the rationale for the default interest being set at such a high rate compared to the interest rate applicable prior to the redemption date; and (4) a genuine assessment of the borrowers creditworthiness in the event of default and keep a detailed record of this with their underwriting records in order to support their position. 

In all cases, parties should be mindful that even the most careful drafting will not prevent an extortionately high default interest rate from being scrutinised by the courts and struck out where it amounts to a penalty in disguise even if the borrower is represented at the time and is an experienced commercial party. 

For more information on this topic, please contact Sharon Williamson.