An interest-ing question: when is a default interest rate a penalty?

A breached covenant

Mr and Mrs Houssein took out a loan which they were late in repaying. This resulted in an increased, default interest rate applying (from 1% to 4%). The High Court held amongst other things, that the default interest rate provision was a penalty clause and was therefore unenforceable. This was appealed.

The test for penalty clauses

The Court of Appeal held that the High Court should have (but had not) followed a three-step analysis:

1. Was the clause a secondary obligation (i.e., was it engaged only on the breach of a primary obligation)?
2. Did the clause protect a legitimate interest? In determining this, an objective approach should be taken instead of focusing on the parties’ subjective intentions.
3. Was the clause “extortionate, exorbitant or unconscionable” (by reference to the relevant legitimate interest)? 

The Court of Appeal also approved prior judgments that require a cautious approach to determining whether a clause is a penalty clause.  That is because the rule on penalties is an interference with the principles of legal certainty (of the written contract) and freedom of contract. Parties are, after all, “the best judges of what is legitimate in a provision dealing with the consequences of breach”.

In the context of default interest rate clauses

On the facts, it was “implicit” that the default interest clause was a secondary obligation and that default interest rate clauses do protect a legitimate interest – the increased rate is to account for the fact that a party in default of payment is a higher credit risk. Therefore, the only question left was whether the rate was so high as to be extortionate.

The Court of Appeal referred to the High Court’s ruling in Ahuja v Victorygame that “a 400% increase in the interest rate prior to the default, was obviously extravagant … so as to constitute a penalty” but that “an increase of up to 200% in the applicable rate of interest on default… as a rule of thumb” would be acceptable (without further evidence from the lender).

The case was remitted to the High Court to determine if the rate was extortionate as the Court of Appeal considered itself unable to decide the issue on the limited evidence before it.

Judgment: Houssein v London Credit