Is my default interest a penalty? - Quick reads - Gateley
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Is my default interest a penalty?

Gateley Legal

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Default interest clauses in loan and credit agreements are essential provisions for lenders for two main reasons...

  1. they provide lenders with a means of recovering the extra costs they will incur if a borrower does default; and
  2. they provide an incentive to borrowers not to default on their loans,

It makes sense then that lenders would instinctively wish to set a rate of default interest that is high enough to adequately cover their position in respect of both these issues.

However, due to a quirk of English law, any clause of an agreement that is deemed to penalise one party unfairly can be rendered unenforceable. As a result lenders have historically acted cautiously when setting default interest rates ensuring they are high enough to cover genuine losses incurred as a result of a borrower’s default, but low enough not to be considered a penalty.

The immediate question therefore, is when could a default interest clause be deemed a penalty clause? The general rule was that a clause would not be a penalty if it seeks to recover a ‘genuine pre-estimate of loss’ however there was little guidance on what would be considered a reasonable rate of interest to achieve this aim.

Recent guidance

Lenders should therefore be comforted by recent case law[1]  that has provided welcome guidance on the factors which will be considered when determining whether a default interest clause is unfair.

In summing up its reasoning on two recent cases, the Supreme Court considered penalty clauses in wide enough terms to cover default interest provisions. The test of whether or not a provision is unenforceable as a penalty is that the provision must not be “exorbitant or unconscionable” taking into account the innocent party’s “legitimate interest” in the agreement.

Deterrents allowed

In reaching this view, the court accepted that the purpose of such a provision was not solely to recover losses a lender may incur as a result of a borrower’s default, but also to motivate a borrower

  • not to default on the agreement in the first place; and
  • to quickly rectify a default that had already occurred.

In other words, the court is saying that if lenders charge a rate of default interest that is higher than required to recover the losses they genuinely envisage they will incur as a result of a borrower’s default, it will not automatically be deemed a penalty. Lenders will be given leeway to charge higher rates of default interest in order to deter borrowers from defaulting on the proviso that the rate is not unreasonably high.

Despite this ruling, it is unlikely that lenders will rush to raise rates of default interest, especially from a corporate banking view point. To do so may well affect the commercial relationships a lender has with its customers and such a move could risk losing business. There is also still the requirement that any rate applied not be “exorbitant”.

What the finding does do though is provide some reassurance to lenders that the courts realise the commerciality of provisions such as default interest clauses and will consider a wider variety of factors before determining whether a default interest clause is a penalty.

[1] Cavendish Square Holding BV v El Makdessi and ParkingEye Ltd v Beavis [2015] UKSC 67

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