Piquing your interest: Court of Appeal re-affirm three-stage test to be used in determining when default interest becomes a penalty.
Brief facts of Houssein & Others v London Credit Limited & Another [2023]:
London Credit Limited (LCL), agreed to provide a £1.9 million loan to CEK Investments Limited (CEK), owned by two individuals, who in return granted security over five buy-to-let properties and the owners’ former residence. The loan was subject to a standard interest rate of 1% that could increase to 4% following an event of default. A condition of the loan being granted was that the former residence remained vacant during the 12-month loan term. However, one month after drawdown, LCL alleged that the former home was being occupied and demanded repayment of the full loan amount plus default interest. This demand went unpaid, following which the case proceeded to trial.
CEK argued that the 4% interest rate was unenforceable as it amounted to a penalty. In determining this point, the High Court applied the test in Cavendish v Makdessi which questioned whether the default rate protected the “legitimate interest” of the lender. The Judge accepted that a higher rate of interest could be commercially justified if a borrower had an enhanced credit risk. However, decided that as LCL applied a 4% rate to all those who borrowed from it, this rate had not been set with the specific risks of CEK, as a borrower, in mind. Consequently, it constituted an unenforceable penalty.
Court of Appeal Analysis:
Following appeal by LCL, the Court of Appeal (CoA) was in unanimous agreement that the High Court had applied the wrong test. Instead, it was the three-stage test used in Vivienne Westwood v Conduit Street [2017] that was the correct test to determine whether a particular default interest rate amounted to a penalty and in this situation was as follows: -
- Was there a secondary obligation engaged upon breach of a primary obligation?
- What was the extent and nature of the legitimate interest of LCL in having the primary obligation performed?
- Having regard to that legitimate interest, was the secondary obligation exorbitant or unconscionable in amount or in effect?
Referring to the first stage, the CoA did not believe the High Court judge had considered this question but nevertheless, stated that it was implicit and presumably not in issue. This is unsurprising given that the secondary obligation (to pay default interest) arose upon a breach of the primary obligation (to observe the terms of the facility letter).
The CoA, in relation to stage two and referring to the previous judgement, noted that the question was not whether LCL had a legitimate interest in applying the default interest as this was not the primary obligation. The primary obligation in this circumstance was repayment of the Loan, all interest, fees and commissions on the Repayment Date, and it was inevitable that LCL would have a legitimate interest in enforcing this obligation.
Finally, in relation to stage three, the CoA held that the High Court Judge was wrong to try and determine whether LCL had a justification for the default rate being 4%. Rather, the consideration should have been whether the rate was extortionate. The CoA however, declined to decide on this point as it had not heard all the factual and expert evidence and remitted this case to the trial judge to decide upon.
Conclusion:
We now await an answer as to whether the 4% default interest rate applied in this case constitutes a penalty. However, the CoA judgement provides useful guidance on the correct approach to take in determining whether a particular % interest rate would be enforceable if a borrower defaults on their loan. The CoA’s conclusion on stage one and two of the test would appear favourable to lenders who are trying to enforce their default interest rate following an event of default. Additionally, the clarification provided in the final stage, that a set rate must be extortionate to constitute a penalty, should be encouraging to lenders as this is arguably a high threshold. It will be interesting to see whether the outcome will change for LCL if and when a second decision is made.
Court of Appeal case: Houssein & Others v London Credit Limited & Another [2024] EWCA Civ 721
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