As the economic outlook tightens, and borrower’s feel the squeeze, insolvencies are expected to rise. With that, we expect that distress lending arrangements are likely to come under scrutiny - in particular, whether they can be challenged as extortionate.
If a borrower becomes insolvent, it is possible (albeit difficult) for an administrator, liquidator, or trustee in bankruptcy to obtain a Court order setting aside a loan arrangement on the basis it was an extortionate credit transaction. This is provided the arrangement was entered into during the three years prior to the insolvency. Their case is likely to turn on whether the interest rate and charges applied were grossly exorbitant.
Under the Insolvency Act 1986 a credit transaction is extortionate if, having regard to the risk accepted by the lender, the payments required in return were grossly exorbitant; or if it otherwise grossly contravened the ordinary principles of fair dealing. The problem from a lender’s perspective is that, if such an application is made, the burden of proof is on the creditor to prove that the transaction was not extortionate or otherwise unfair.
There is no prescribed level of interest that will be considered to be grossly exorbitant, presumably, to ensure that the provisions can flex with the circumstances so as not to deter commercial lending activity by lenders who would otherwise lend in high-risk circumstances at a price to reflect the risk.
If such a challenge is made, in reality, the Court will balance the risk taken by the lender against the charges levied. For example, interest rates as high as 48% have been considered reasonable where the lender took considerable risk making the loan, but lower rates have been considered unreasonable where the risk was less.
What the Court will consider when deciding whether a credit transaction should be set aside as extortionate will be fact specific, and considered by reference to:
- The credit risk. This will depend on the credit score of the borrower at the time and the checks carried out by the lender, including what other lenders were offering the borrower at the time;
- Any security taken, the nature and extent of it, and what priority it has over assets / other security; and
- Whether there was an element of urgency. An increased interest rate may be reasonable if the funds are required, and made available, urgently – especially if that limits the lender’s pre-lending due diligence.
The reality is that challenges to lending arrangements as extortionate credit transactions are both unusual and difficult. However, if one is made, it is likely to have been carefully constructed (at least one would hope), in which case a lender would be wise to give careful consideration to early settlement, especially if they want to avoid the publicity of losing such a challenge.
If you need more information, or would like some advice, please contact a member of the team.