Default Interest – an unenforceable penalty?

07 Mar 2022

 In the case of Ahuja Investments Limited v Victorygame Limited [2021] EWHC 2382 (Ch) the court held that a default interest provision in a loan agreement was a penalty clause and therefore unenforceable.
 
The law of penalties was comprehensively reviewed and restated by the Supreme Court in Cavendish Square Holding BV v Makdessi [2015] UKSC 67, [2016] A.C. 1172. Ahuja v Victorygame provides a clear case study as to how those principles apply to default interest clauses commonly found in finance agreements. The principles are:
  • Penalty clauses are secondary obligations.
  • Whether a clause imposes a secondary liability upon a breach of contract is a question of substance and not of form.
  • Does the clause impose a detriment that is out of all proportion to the legitimate interests of the innocent party or which is exorbitant, extravagant or unconscionable?
  • The burden of proof lies on the party alleging that a clause is a penalty to show that the secondary liability is exorbitant, extravagant or unconscionable.
  • The courts are slow to interfere with parties freedom to contract.
Ultimately, Judge Hodge QC decided that, despite the fact that the default interest provision had been freely-negotiated between two experienced commercial parties both represented by solicitors at the time, the rate of 12% per month compounded monthly and representing a 400% increase in the interest rate applicable prior to default, was properly to be characterised as a penalty.

The Judge went on to say that whilst he would be prepared to accept, 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, as a rule of thumb, he would expect the evidential burden to pass to a lender to adduce evidence to justify any greater increase, at least where the lender enjoys additional personal and real security for its loan.
 
Ideally, lenders should keep a detailed note of why the default interest clause was agreed at that particular rate. Evidence of the following matters will help a lender to defend the clause:
  • Market interest rates at the time of the loan agreement and at the time of default.
  • The rationale for the default interest rate.
  • The particular factors affecting the credit risk posed by a defaulting borrower, taking into account any guarantees or security provided for the debt.
For further advice in relation to the issues raised in this article, please contact James Colvin, Commercial Litigation Partner, by email or by phone on 01293 558565, or your usual DMH Stallard member of the team. 

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