Facts
Mr and Mrs Houssein had a portfolio of residential properties, which were either held in their sole names or in their joint names, with all being subject to mortgages. In June 2020, the Housseins sought to refinance one of their secured loans through their company, CEK Investments Limited (“CEK”), of which they were both directors.
That loan was financed by LCL for a period of 12 months, with a standard interest rate of 1% per month and a default rate of 4% per month. The loan was secured by, among other things, a mortgage on the Housseins’ family home.
The facility agreement included a provision prohibiting CEK or its “Related Person”, which included the spouses and relatives of the “Borrower” from occupying the family home. Shortly after the loan had been drawn down, LCL alleged that CEK was in breach of the facility agreement because the Housseins occupied the family home and demanded repayment of the loan plus default interest.
First instance decision
A key question considered at first instance was whether the default interest provision amounted to an unenforceable penalty clause. The leading authority of an unenforceable penalty is El Makdessi v Cavendish Square Holdings BV [2015] WLUK 78. In that case, the Supreme Court held that, in determining whether the provision is an unenforceable penalty clause, it is necessary to consider:
- whether the “impugned provision” is a secondary obligation that imposes a detriment on the breaching party, that is out of proportion to any “legitimate interest” of the innocent party in enforcing the primary obligation;
- whether any (and if so what) legitimate business interest is served and protected by that clause; and
- whether, assuming such an interest does exist, the provision made for the interest is nevertheless in the circumstances “extravagant, exorbitant or unconscionable”.
Following the Supreme Court’s decision, Mr Fancourt QC (as he then was) later set out a three-stage analysis for how the Cavendish test is to be applied in Vivienne Westwood v Conduit Street [2017] EWHC 350 (Ch), which is discussed below.
The judge at first instance held that:
- In principle, default interest rates would not automatically amount to a penalty clause because a lender could have a legitimate interest in charging a higher rate in circumstances where there had been a default and, therefore, where the credit risk of the borrower was higher.
- However, the default interest provision in this instance was a penalty clause because it did not protect the legitimate interests of LCL. In support of this position, the Judge found that the default interest rate was the same regardless of the breach, notwithstanding that different breaches could be expected to give rise to different credit risks and had not been tailored to the specific credit risk of the borrower. In addition, it was agreed by the parties’ experts that a default rate of 3% per month was a more typical default interest rate and there was nothing to justify the additional 1% charged by LCL.
- Where the default interest rate was unenforceable, the standard interest rate would apply to the loan after the repayment date.
The Court of Appeal Judgment
As to whether the default interest rate was an unenforceable penalty clause, the Court of Appeal held that the High Court judge had applied the wrong test. The Court of Appeal endorsed the three-stage approach set out by Mr Fancourt QC (as he then was) in Vivienne:
First and as a threshold issue, is the default rate of interest in substance a secondary obligation engaged upon breach of a primary obligation?
The first instance decision did not address this threshold question, but on the facts of the case it was met (i.e. the obligation of the claimants to pay the default interest rate arose upon a breach of the facility agreement).
Second, what is the “extent and nature of the legitimate interest of the promisee in having the primary obligation performed”? As was made clear in Cavendish, the Court of Appeal held that “whether a clause is penal or not depends on its purpose, which is an inference from its effect and that determining this issue is a matter of construction” [para 51].
The first instance judge had “approached the issue in an illegitimate and confused manner” [para 50] by taking a subjective approach when assessing the purpose of the clause. In contrast to the first instance decision, the Court of Appeal found that it is inevitable that there is a legitimate interest in the lender performing its primary obligation to repay the loan.
Third, is the default interest clause extortionate, exorbitant, or unconscionable in light of the nature and extent of the legitimate interest?
The first instance judge had not addressed this question at all; instead, he appeared to be looking for a justification for the default rate of interest, rather than considering whether the rate is extortionate. The Court of Appeal remitted the question to be considered by the first instance judge.
As to whether the standard rate of interest applies after the repayment date if the default interest rate is found to be unenforceable, the Court of Appeal held that the judge at first instance had misinterpreted the interest provisions. The standard interest rate and the default interest rate are mutually exclusive and there is “no room for an interpretation which allows either the standard rate…or the default rate… to spring back if the other rate is not “applicable”” [para 72].
Commentary
The Court of Appeal endorsed Mr Fancourt QC’s helpful three-stage analysis of the Cavendish test as the correct approach to assessing whether a clause constitutes a penalty clause. The case also emphasised that when analysing the purpose of the clause, one must adopt an objective and not subjective approach.
While the Court of Appeal’s judgment provides comfort that lenders have a legitimate interest in charging default interest, care must still be taken to ensure that the interest charged is not extortionate in view of the lender’s legitimate interest.
Further, the Court’s ruling on the applicable interest rate also provides a useful reminder that if a default interest rate provision is held to be unenforceable as a penalty clause, then the standard interest rate will not apply if, on a proper construction, the provisions are mutually exclusive. If there is any concern that a default interest rate clause may amount to a penalty clause, care must be taken to ensure that the standard rate position applies in the alternative.
Client Alert 2024-201
