Default rate clauses in facility agreements and the law against penalties

Before the Late Payment of Commercial Debts (Interest) Act 1998 was enacted, there was no implied right under English law to charge interest on a debt or loan which was paid late and therefore one needed to include express provisions in the commercial agreement. Even following its enactment, the act is not relied on in the context of bank loans and express default rate provisions are still inserted. The current market practice in credit agreements is that a borrower should normally pay on any amount not paid on its due a rate that is higher than the standard interest rate. The increase we commonly encounter in bank loans is generally between 1% and 2% above the standard rate (with 2% being far more common). 

The said practice has largely formed because of the law on penalties which could be held unenforceable under English law. It all started with several 19th century mortgage cases where increases in mortgage payments on default were struck down as penalties. The current leading case on the law against penalties is the 2015 Supreme Court decision in Cavendish Square Holding BV v Makdessi /ParkingEye Limited v Beavis¹ which sets the criteria for determining whether an increased payment obligation could amount to a penalty.  In this case it was held that the test as to whether a payment is a penalty is now "whether the impugned provision 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" or alternatively a sum would be a penalty if it was "…exorbitant or unconscionable when regard is had to the innocent party's interest in the performance of the contract."

Some guidance on what might be considered "unconscionable" in terms of default interest has been provided by the case of Ahuja Investments Limited v Victorygame Limited.²  In that case, the standard interest rate under the agreement was 3% per month, which upon default increased to 12%, compounded monthly.  This meant that the rate increased by 400%.  Judge Hodge QC found that, even though the default interest provision had been freely negotiated between two experienced commercial parties both represented by solicitors at the time, a 400% increase to the standard interest rate was rightfully characterised as a penalty.  The Judge did, however, say that if the increase had been lower (200% or less), then he might have been prepared to accept the provision as non-penal.  However, again it might not be safe to consider the said rates as set in stone, as the legitimacy of the rate of the increase might as well depend on what the initial standard rate was. In 2023 again at first instance a judge found that the increase of an interest rate from 1% per month to 4% per month upon any default could be considered penal if there were no circumstances specific to the borrowers or the security which could justify charging a higher rate for a riskier loan. What could have led to the said conclusion was also the fact that the default rate applied regardless of the breach (in this case the breach was a covenant not to reside in a particular property, rather than a payment default) and this indicated that the higher rate was not really seeking to protect legitimate interest against enhanced risks. On a final note, the judge also held in the context of this case that he considered a rate in the region of 3% as a typical default rate.³  

The said case law could safely lead us to the conclusion that a disproportionate increase of the interest rate upon a payment default or the imposition of a default rate on the totality of the loan on instances where there is no payment default could be problematic from a penalty law perspective raising concerns as to the enforceability of such provisions.

1  [2015] UKSC 67
2  [2021] EWHC 2382 (Ch)
3  Houssein and others v London Credit Limited and others [2023] EWHC 1428 (Ch), 12 June 2023

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