Court of Appeal considers whether default interest clause is an unenforceable penalty

The Court of Appeal has found that a first instance judge erred in his application of the correct test to determine whether a default interest clause amounted to an unenforceable penalty: Houssein v London Credit Ltd [2024] EWCA Civ 721.

This decision builds on an existing line of case law which suggests that clauses in facility agreements requiring the payment of default interest upon breach of a primary obligation are, in principle, likely to be enforceable (provided that the amount of interest payable is proportionate).

As a reminder, in assessing whether a clause amounts to a penalty, the three-stage test drawn from Cavendish Square Holding BV v Talal El Makdessi (Rev 3) [2015] UKSC 67 is applicable. This test provides that a liquidated damages clause will not amount to an unenforceable penalty, provided: (1) it is a secondary obligation triggered by a breach of contract (this is a threshold question); (2) the clause is in furtherance of a "legitimate interest" which the innocent party has in the performance of the primary obligation; (3) and the clause is not "extortionate, exorbitant or unconscionable". The judgment provides helpful clarification to practitioners, who should be aware that attempts to elide the three separate limbs of this test are unlikely to prove attractive to a court.

Although a decision as to whether the particular default interest clause in this case is "extortionate, exorbitant or unconscionable" on the facts has been remitted to the trial judge, financial institutions will draw comfort from the Court of Appeal's conclusion that lenders have a legitimate interest in securing repayment of monies due under lending agreements – and that they are in principle entitled to include contractual provisions in defence of the same. This conclusion confirms and applies the High Court's earlier judgment in Cargill International Trading PTE Ltd v Uttam Galva Steers Limited [2019] EWHC 476 (Comm).

As a practice point, the approach taken to contractual interpretation in this case sounds a cautionary note. The court's unwillingness to find that a standard rate of interest provides an automatic fallback in circumstances where a default interest clause has been deemed to be an unenforceable penalty is a reminder of the importance of tight contractual drafting. Lenders should ensure that they understand fully the applicable contractual interest provisions before they seek to enforce against defaulting borrowers.

We consider the decision in more detail below.

Background

The borrower entered into a facility agreement with London Credit Limited (LCL). Following an alleged breach of covenant by the borrower and consequential event of default under the facility agreement, LCL demanded repayment of (i) the loan amount; and (ii) default interest on the outstanding sums until the breach was remedied under a default interest clause. The borrower did not pay the full sums demanded by LCL by the repayment date specified in the facility agreement. LCL subsequently appointed receivers to liquidate its security under the facility agreement and proceedings were issued by the borrower.

At first instance, the High Court found that there had been a breach of the facility agreement, but that the default rate under the default interest clause did not apply, because it did not protect any legitimate interest of LCL, and was therefore unenforceable as a penalty (per Makdessi). The High Court held that interest was payable on the standard basis under the standard interest clause, with such entitlement surviving the repayment date.

Both sides appealed, and the key issues were as follows:

1. The borrower appealed the High Court's order as to interest, asserting that the wording of the facility agreement precluded interest being payable under the standard interest clause after the repayment date (meaning that, in circumstances where the default interest clause had been determined to be an unenforceable penalty, any entitlement to interest on the part of LCL after this time would be purely non-contractual).
2. LCL cross-appealed the determination that the default interest clause constituted an unenforceable penalty, and contended that contractual interest was payable on any unpaid sums after the repayment date at the default interest rate.

The borrower also challenged the issues-based costs orders made by the High Court, but that aspect of the decision is not considered further in this blog post.  

Court of Appeal decision

Issue 1: Enforceability of the default interest clause

The Court of Appeal concluded that the High Court failed to apply the correct test for determining whether a clause amounts to a penalty, which stems from the Supreme Court's decision in Makdessi (as summarised by Mr Fancourt KC in Vivienne Westwood v Conduit Street [2017] EWHC 350 (Ch)). There are three limbs to this test for determining when a liquidated damages clause is not unenforceable as a penalty:

1. the clause must be a secondary obligation triggered by a breach of contract (this was described as a threshold question);
2. the provision must be in furtherance of a legitimate interest which the innocent party has in the performance of the primary obligation; and
3. the provision must not be out of proportion to the innocent party's legitimate interest, which requires the court to consider whether the clause is "extortionate, exorbitant or unconscionable."

The Court of Appeal accepted that the first limb of the test was not in issue in these proceedings: it was implicit that the default interest clause was a secondary obligation, engaged on the breach of a primary contractual obligation.

In respect of the second limb, the Court of Appeal ruled that the High Court had approached matters in an "illegitimate and confused manner". In particular, the High Court:

• Considered other factors in addition to legitimate interest. The High Court had placed insufficient emphasis on Cargill and instead confused the question of LCL's legitimate interest with the effect of the clause in question.  
• Failed to recognise the extent and nature of LCL's legitimate interest. Applying Cargill, the Court of Appeal determined that it is self-evident that there is good commercial justification for charging a higher rate of interest on a loan where the borrower has previously defaulted on repayment, given that the borrower is therefore naturally a greater credit risk. The High Court failed to consider the extent and nature of LCL's interest after default, and therefore failed to recognise this interest.
• Took a subjective approach to the contractual construction of the clause. Delivering the majority judgment, Asplin LJ referred to Makdessi as authority for the proposition that whether a clause amounts to a penalty is dependent on its purpose – which, in turn, is a question of construction. Although the commercial context in which a clause is drafted is relevant to this question, the High Court erred by taking a subjective approach to what it understood LCL was trying to protect.

Accordingly, the Court of Appeal overturned the High Court's judgment on the second limb of the test, finding that LCL had a legitimate interest in securing repayment under the loan and all interest and fees thereunder by the repayment date, which the default interest clause was designed to protect.

In respect of the third limb, the Court of Appeal concluded that the High Court erred by not considering whether the default interest clause was "extortionate, exorbitant or unconscionable" – whether separately, or at all.

Despite being invited by LCL to rule that the default interest clause was not a penalty clause, the Court of Appeal considered that it would be inappropriate for it to reach such a conclusion based on its limited knowledge of the evidence presented at trial. The Court of Appeal therefore decided to remit back to the trial judge the question of whether (having regard to LCL's legitimate interest) the default interest clause is extortionate, extravagant or unconscionable in amount or effect.

Issue 2: Interest after the repayment date

The Court of Appeal considered the alternative scenarios depending on whether the High Court decides (upon remittance) that the default interest clause is or is not a penalty clause.

If the clause is not a penalty, the Court of Appeal accepted that interest would be payable at the default rate. In that case, the question of whether interest is payable after the repayment date at the standard rate under the standard interest clause would not arise.

In the opposite scenario, where the clause is a penalty, the proper construction of the clause concerning interest after the repayment date would again be relevant. Here, the Court of Appeal upheld the borrower's argument that a proper construction of the facility agreement means that standard interest under the standard interest clause does not apply after the repayment date. 

As a matter of construction, the facility agreement provided for monies due to bear interest at the rate payable in the standard interest clause or the default interest clause, "if applicable". The Court of Appeal held that the phrase "if applicable" was intended to refer only to the circumstances in which the different rates applied. The two rates were mutually exclusive; whichever applied in a given instance depended on the facts, and there was no room for an interpretation in which the standard rate under the standard interest clause sprung back if the circumstances were such that the default interest clause would ordinarily apply but had been found to be unenforceable as a penalty.

Outcome

The outcome of the appeal was, therefore, to remit the question of whether the default rate of interest is a penalty to the trial judge. If the clause is not a penalty, then the default interest rate will apply from the repayment date. If the clause is a penalty, then no rate of interest will apply after the repayment date.