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Is your default interest clause enforceable?

09/04/2013

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United Kingdom

Is your default interest clause enforceable?

Finance brief - April 2013

 

The vast majority of loan agreements will contain a default interest provision which provides a contractual sanction against non-payment of a sum of money. Care must be taken however in the lender's choice of default rate and the manner in which it becomes payable, otherwise such provision may risk being invalid as a penalty. Recent case law has confirmed the new approach which a court will adopt when considering whether a particular provision can be regarded as a penalty (and will consequently be void and unenforceable).

When deciding whether or not a contractual term is penal, the traditional approach of the courts has been that the clause will be enforceable if it does not exceed a genuine attempt to estimate in advance the loss which the claimant would be likely to suffer from a breach of the obligation in question.

However, in relation to default interest clauses, any future "loss" following breach of a loan agreement is likely to be very difficult for a lender to quantify. English law has recognised this and default interest clauses are nevertheless commonly upheld despite not being genuine pre-estimates of the loss, provided that the increased rate of interest is not "commercially unreasonable".

The two usual justifications for a lender charging a higher rate of interest following a borrower's default are:

  • it reflects the lender's enhanced credit risk by it being effectively forced to lend to a borrower who, by the very fact of its non-payment, has become a questionable credit risk; and
  • a loan which has gone into default involves more time and expense to administer and monitor. 

The modern approach:

It appears that above attitude in respect of default interest provisions now applies to all contractual terms when analysing if they are penal or not and courts' are now reluctant to strike out a specified amount as penal just because the amount specified is greater than the actual loss.

The recent case of Cavendish Square Holdings BV v Makdessi [2012] EWHC 3582 confirms the modern approach i.e. that when considering whether a term is a penalty, emphasis is not placed on whether or not the term equates to a genuine pre-estimate of loss, but rather to focus on whether the term is commercially justifiable in the circumstances of the transaction.

In this High Court case, the dispute was over various clauses in a share purchase agreement (rather than default interest clauses) and whether these constituted penalties. However, usefully, the judge set our four key questions to use when deciding whether or not a term is penal:

  1. was there a commercial justification for the term?
  2. was the term extravagant or oppressive?
  3. was the predominant purpose of the term to deter breach?
  4. were negotiations on the term on a level playing field?

Although this case was of course particular to its own facts and is only a first instance decisionof the High Court, the above four questions provide a helpful guide for lenders when considering whether a specific default interest provision (or indeed any other provision obliging a party to pay a large sum of money if it is in breach) is likely to be deemed a penalty or not.

It is generally accepted that 1 – 2% above the interest rate which is ordinarily payable under the loan agreement, or 3 - 4% above base rate of a clearing bank, will be reasonable default rates for a lender to impose.  However imposing these rates is still not without risk and what will be deemed to be acceptable will depend upon what is deemed to be commercially sensible in the circumstances and at the time of negotiation of that particular contract.

 

Hannah Salton, Associate, Finance at Field Fisher Waterhouse LLP

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