Every now and then the English courts throw up something which impacts on the finance world, which sends lender and borrowers rushing off to check their documentation. The Court of Appeal's recent judgment in Houssein & Ors v London Credit Limited & Ors [2024] EWCA Civ 721 is one of those cases. The point at hand in this case was default interest.
Background
London Credit Limited (the Lender) had extended a £1,881,000 loan to CEK Investments Limited (CEK) for a period of 12 months, secured against CEK's assets and mortgages over various properties. The facility letter included a standard interest rate of 1% per month (the standard interest) and a default interest rate of 4% per month (the default interest). Following an alleged breach by CEK of a term of the facility letter, the Lender demanded full repayment with default interest and appointed receivers when payment was not made.
At first instance, the judge found that the default interest was an unenforceable penalty having concluded that it did not protect any ‘legitimate interest’ of the Lender. In addition, the judge held that, in the absence of default interest, the Lender was entitled to seek standard interest for the period following the breach of the facility letter.
Court of appeal’s decision
The Court of Appeal found that the judge at first instance had not applied the Cavendish test correctly and emphasised that the correct approach involves a two-stage test: first, determining if the clause protects a legitimate interest of the lender; and second, determining whether the clause is “extravagant, exorbitant, or unconscionable.”
The Court of Appeal held that the judge should have recognised that "it is inevitable that a legitimate interest in the enforcement of the primary obligation to repay the loan, all interest, fees and commissions on the repayment date arises here" and had not considered whether the default interest was "exorbitant, extravagant, or unconscionable" at all. This question was remitted to the first instance judge for reconsideration on the basis that the Court of Appeal had not heard the evidence and cross examination at the original trial.
The Court of Appeal also found that, if the default rate was held to be a penalty, there was no scope to interpret the facility letter so that standard interest would apply after the repayment date instead of the default rate.
Implications for lenders
Whilst the Court of Appeal's judgment reinforces the two-stage test for determining whether default interest will amount to a penalty, lenders should still carefully consider the following when setting default interest rates:
- Application of default rate: Where the default rate applies to any breach rather than just a payment breach (which is the LMA standard), the courts may not accept that the lender is protecting a legitimate interest.
- Rate of default interest: The rate of default interest will be scrutinised with courts considering whether it is "exorbitant, extravagant or unconscionable" on the facts of the case. Lenders proposing higher default rates (e.g. above 2%) should keep a detailed record of the rationale and discussions, as evidence may be required if challenged.
- Fallback provisions: Loan agreements may need to include a fallback mechanism so the standard rate of interest will apply if the default interest is deemed to be a penalty (this is particularly important where the lender has opted for a high default rate applicable to any default which are more likely to be challenged).
The Houssein decision reinforces the need for both lenders and their solicitors to give careful consideration to default rate interest provisions on a case-by-case basis to ensure they do not cross into penalty territory and that the standard rate of interest will apply automatically where the default rate is found to be unenforceable.