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When is default interest penal?

01/10/2013

Locations

United Kingdom

In our last edition we commented on the risk that default interest under a loan agreement may be unenforceable as being penal.

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In our last edition we commented on the risk that default interest under a loan agreement may be unenforceable as being penal.  The prevailing market view was that charging an additional 2 or 3% per annum was unlikely to be treated by the courts as penal, but the only recent authority on the point in a lending context was a decision in which an additional 1% was held to be non-penal.

The latest decision of the Privy Council in the long-running dispute between the Cukurova Group and Alfa Finance provides useful support for the view mentioned above, but it is only support, because it was not among the matters in issue in the case, and because a decision of the Privy Council is not binding on the English courts, although it is persuasive.

It was not, in fact, argued that the increase in the rate of interest of 3.5% per annum on default amounted to a penalty.  But two members of the Council made it clear that they would not have regarded the increase as penal.  Lord Neuberger described the decision not to argue the point as "realistic", and commented that particularly in the context of a high contractual rate of 8% over LIBOR and a loan agreement between two very large commercial parties a default rate which predicated an increased risk due to the very existence of a default, could not, fairly be characterised as penal.  Lord Sumption commented that "No one suggests that the terms fixing the rate of interest or the obligations of the debtor are penal".

Cukorova Finance International Limited and Cukurova Holding AS v Alfa Telecom Turkey Ltd [2013] UKPC 20.

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