In the case of Houssein -v- London Credit Ltd, the High Court had to decide if default interest would be recoverable under a loan agreement. Under the terms of the loan, the lender was entitled to charge interest at a default rate of 4% per month if the borrower missed one of the payments. If the borrower made the repayments in accordance with the Loan Agreement, then the rate would be just 1% per month.
After defaulting under the agreement, the borrower challenged the 4% interest rate by arguing that this charge amounted to a penalty which is not enforceable in English law.
According to the so-called Makdessi Test which was developed by the courts in a case with this name, a provision in a contract will be an unenforceable penalty if the following three criteria are met:
- the default provision/penalty is engaged when one party does not comply with its obligations;
- the clause was not intended to protect the legitimate interests of one of the parties;
- the charge triggered by the default is ‘extortionate, extravagant or unconscionable’.
The High Court carried out a review of the contract and decided that the default interest rate was not a penalty. The judge noted that the rate of 4% per month would apply if the borrower breached a number of different obligations, not just the obligation to make repayments which suggested that the rate reflected the increased risk and cost of the loan to the lender.
The default rate of 4% was not considered to be ‘extortionate, extravagant or unconscionable’ because, although the rate was undoubtedly high, it was still within a range of acceptable interest rates. The borrower was an experienced commercial party which had been professionally advised and had chosen to borrow money from London Credit in circumstances where it had other borrowing options. The lender’s status as an experienced commercial party was another reason why the interest charge was found to be reasonable.
Given the need to try to avoid disputes about whether default provisions in contracts are unenforceable as penalties, the commercial parties could, on the basis of the decision in this case, consider applying a variety of interest rates to different types of breach to reflect the risk to the party which will potentially suffer loss. If the lender communicates to the borrower the reasons for proposing to charge a higher interest rate following certain breaches then this could later be relied upon to justify the charges by reference to the commercial rationale which underpins them.
Alexander Haddad works in the Litigation Department and deals with commercial disputes including those about loan repayments.