In law, as in football, the question of whether something crosses the line into penalty territory is a fraught one. If a contractual clause is held to cross that line it can spell disaster for one party and triumph for another, rendering entire contractual obligations unenforceable.
The rules on what constitutes a penalty have been addressed in detail on numerous occasions, and most notably by the Supreme Court in the case of Cavendish Square Holdings BV v Makdesi [2015] UKSC 67. However, applying those rules is not always straightforward. This has been clearly demonstrated by the Court of Appeal's recent decision Houssein & Ors v London Credit Limited & Ors [2024] EWCA Civ 721 .
The central issue in this case revolved around a default interest rate clause in a loan agreement, and whether it constituted a penalty clause. If it did, this would render the default interest provision unenforceable under English law and give rise to further questions as to the applicable interest rate payable by the borrowers.
The Court of Appeal also considered some interesting questions in relation to the appropriate orders to make on costs. We examine this in a further article, which you can read here.
Background
The First Respondent (“LCL”) agreed to loan £1,881,000 to the Third Appellant, CEK Investments Limited (“CEK”), for a period of 12 months. The loan was secured by a debenture over CEK’s assets, personal guarantees from CEK’s directors, the First Appellant and her husband, and mortgages over 5 buy-to-let properties and their family home. Under the terms of the facility letter in respect of the loan (the "Facility Letter"), the standard rate of interest was 1% per month ("Standard Interest") and the default rate was 4% per month ("Default Interest"), interest being compounded monthly in each case. The entire year's worth of Standard Interest for the term of the loan was rolled-up and retained out of the loan amount.
The Facility Letter prohibited CEK or its “Related Persons” from occupying the family home. The definition of “Related Persons” included spouses and relatives of the directors of CEK (although not the directors themselves). A month after the drawdown of the loan, LCL alleged that CEK was in breach of the facility letter by reason of the occupation of the family home. It subsequently demanded repayment of the full loan amount, plus Default Interest. When that demand went unpaid, LCL appointed the Second Respondents as Receivers to sell the buy-to-let properties and the family home. The Appellants obtained an interim injunction prohibiting them from doing so, and the matter then progressed to trial.
First instance decision
At first instance, the Judge considered whether the Default Interest provision in the Facility Letter amounted to an unenforceable penalty clause. The enforceability of such clauses is governed by the principles set out in Cavendish.
The Judge at first instance purported to apply these principles by considering whether the Default Interest provision protected a "legitimate interest" of the lender, LCL. The Judge acknowledged that charging a higher rate of interest on default could be commercially justified due to the enhanced credit risk of the borrower. However, he concluded that in this case the Default Interest did not protect any "legitimate interest" of LCL and was therefore a penalty. The first instance Judge's reasoning included the following points:
- The Default Interest was the same regardless of the breach and was set without reference to the borrower or the particular loan, suggesting a lack of tailoring to the specific credit risk.
- The same Default Interest applied to all breaches, which the judge found implausible since different breaches would likely present different levels of risk.
- The parties' experts agreed that a more typical default rate was 3% in total per month, and the judge found no specific circumstances that justified an additional 1% per month for this particular loan.
However, the Judge held that, in the absence of Default Interest, CLC was entitled to seek Standard Interest for the period following the breach of the terms of the Facility Letter.
Court of Appeal judgment
Grounds of appeal
The Appellants appealed the Judge’s interpretation of the Facility Letter. They argued that LCL was not entitled to Standard Interest following the Appellants' breach of contract: on their interpretation of the Facility Letter, the entitlement to Standard Interest had come to an end and payment of Default Interest was unenforceable as a penalty. Therefore, no interest was payable following the breach.
LCL cross-appealed, arguing that the Judge’s determination that the default interest rate was a penalty was wrong. They submitted that the Judge had applied the wrong test and reached the wrong conclusion as a result.
Was the default rate of interest a penalty?
The Court of Appeal found that the Judge at first instance had not applied the Cavendish test correctly.
The appellate court held that the Judge had conflated the concept of "legitimate interest" with the effect of the clause. He had also approached the issue subjectively, considering what he believed the lender was trying to protect, rather than objectively assessing whether the clause was exorbitant or unconscionable.
The Court of Appeal emphasised that the correct approach involves a two-stage test:
- Is there is a legitimate interest that the clause seeks to protect; and, if so
- Is the provision extravagant, exorbitant, or unconscionable.
The Court of Appeal held that the Judge should have recognised that "it is inevitable that a legitimate interest in the enforcement of the primary obligation to repay the Loan, all interest, fees and commissions on the Repayment Date arises here". As such, the first limb of the test was clearly satisfied. The Judge had also not considered the commercial justification for charging a higher rate of interest after a default in repayment because a person who had defaulted was a greater credit risk.
Further, the appellate court concluded that the Judge had not considered the second limb of the test - whether the Default Interest rate was "exorbitant, extravagant, or unconscionable" - at all. However, the Court of Appeal considered that they were not in a position to reach a conclusion on this issue, having not heard the evidence and cross examination at trial. Accordingly, they held that this issue would have to be remitted to the first instance Judge for reconsideration.
Clause 6.1 - Interest after repayment date
The Court of Appeal noted that if, on remission, the Judge decided that the default rate was "exorbitant, extravagant, or unconscionable", and therefore the clause was nevertheless a penalty, the proper construction of clause 6.1, concerning interest after the repayment date, would again be relevant. Accordingly, they considered this issue, notwithstanding that the matter would need to be remitted.
Construing clause 12.5 in the light of the Facility Letter as a whole, and clause 6 in particular, the Court of Appeal held that the Judge was wrong to decide that Standard Interest applied after the repayment date in the absence of Default Interest. It held that there was no room for an interpretation which allowed either Default Interest to apply, or for Standard Interest to spring back if Default Interest was not applicable. Whether Standard Interest or Default Interest applied depended on the relevant circumstances.
Why the case is significant:
The Court of Appeal's judgment reinforces the two-stage test for determining whether a contractual provision is a penalty.
This test requires a clear separation of stages to ensure that each is addressed individually. The judgment of the Court of Appeal highlights the necessity to carefully consider both (i) the legitimate interest that a contractual penalty seeks to protect (and to distinguish this from the mere deterrence of breach); and (ii) whether the provision seeking to protect this interest is "extravagant, exorbitant, or unconscionable".