English High Court ruling provides clarity for lenders over default interest

The court rejected a claim by CEK Investment that a default rate of interest of 4% per month (compounded), under a loan it obtained from London Credit, amounted to a penalty clause.

Deputy High Court Judge Richard Farnhill said 4% was above market rates but not, itself, unreasonable and represented the lender protecting itself in offering high-risk, short-term lending, which was legitimate.

Eilidh Smith, a financial services disputes expert with Pinsent Masons, said the decision provided clarity in respect of the application of the test for penalty clauses, as pronounced by the UK Supreme Court in its judgment in Cavendish Square Holdings v Makdessi in 2015, to default interest rates. 

The Makdessi judgment established that a clause will be an unenforceable penalty if it is a secondary obligation – such as an obligation to pay default interest if a primary obligation under a loan agreement, such as a repayment obligation, is breached – and imposes a detriment on the party in breach which “is out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation.”

“This judgment provides guidance as to how courts will approach the application of the Makdessi test to default interest rates in lending, which lenders will need to be aware of,” Smith added.

“It is an indicator that even above market rates can be enforceable, so long as they are commercially justifiable and such justification can be evidenced. This will be welcome news particularly to lenders offering high risk lending, such as bridging loans.”

The long-running case revolved around a £1.88m bridging loan CEK had obtained from London Credit, secured against various properties including the family home of CEK’s directors Mr and Mrs Houssein, which carried interest of 1% per month, plus the 4% per month default interest. London Credit had alleged that CEK was in breach of the terms of the agreement and took enforcement action, including seeking default interest. 

The particular event of default on which CEK relied was that the Housseins resided at the family home contrary to a non-residence requirement in the loan agreement. After London Credit appointed fixed charge receivers to sell the properties the loan had been secured against, CEK and the Houssein family raised the action, arguing that the default interest rate was a penalty clause.

In June 2023 the High Court had ruled that the default ratewas in fact an unenforceable penalty, but this was overturned by the Court of Appeal the following year on the basis that the High Court judge had applied the wrong test, and the issue was sent back down for the High Court judge to reconsider.

“While the decision will be welcomed by lenders, it does demonstrate the need for careful consideration of any proposal to apply a single or ‘static’ default rate of interest in the event of breaches of any of a number of different primary obligations – for example, non-payment by the contractual repayment date and breach of a non-residence requirement,” explained Emilie Jones, a commercial litigation expert with Pinsent Masons.

“The court in this case found that, where this is the approach taken, it is necessary to consider the legitimate interests underlying each of the primary obligations and whether the default interest is extortionate by reference to any of them.  As the judge explained: “If, by reference to any one interest, the provision is extortionate, it fails in relation to all of them.” 

“In this case, the judge identified a number of categories of legitimate interests for the lender which were protected by the default interest rate and concluded that the rate was not extortionate in relation to any of them.  For example, the lender had a ‘very strong interest’ in repayment of the loan, but also had a ‘strong interest’ in the non-residence requirement given the potentially ‘catastrophic consequences’ of providing loans to individuals secured against their primary residence given London Credit’s status as an unregulated lender.

“The default interest rate was not extortionate by reference to either of these interests, nor by reference to further interests which the judge labelled the security interest, the credit risk interest and the representations interest.

“It will, however, be important for lenders who are considering applying a single default interest rate in the event of breaches of diverse primary obligations to consider whether the rate can be justified by reference to legitimate interests underlying each and every one of those primary obligations, and to record their rationale.”