A penalty shoot-out? Not for default interest rates

The High Court in Houssein and others v London Credit Limited and others [2025] EWHC 2749 (Ch) decided that a default interest rate of 4% compounding monthly under a facility agreement is not a penalty, reversing its previous decision on the point.

Background

The case concerned a bridging loan of £1.881 million secured over a portfolio of residential properties. There were two interest rates: a standard rate of 1% per month, and a default rate of 4% per month compounding monthly which was triggered by various events of default.

The borrowers challenged the enforceability of the default rate, arguing that it was a penalty. The High Court originally agreed that it was a penalty because the rate applied to events of default which it considered did not increase the lender’s risk. Following an appeal on this issue[1], the High Court was asked by the Court of Appeal to reconsider its decision.

Penalty clauses

Following the Supreme Court’s decision in Cavendish Square Holdings BV v Makdessi [2015] UKSC 67, the court must consider three questions to determine whether a clause is an unenforceable penalty:

• First, whether the operation of the clause is triggered by a breach of contract. The rule prohibiting penalty clauses only applies to secondary obligations, those arising upon breach, not to primary obligations.
• Second, whether the clause protects a legitimate interest in the performance of a primary obligation.
• Third, whether the clause imposes a detriment which is out of all proportion to the legitimate interest being protected by the enforcement of the primary obligation. If the parties to the agreement are properly advised and of equal bargaining power there is a strong initial presumption that what they agreed was appropriate.

If there is more than one primary obligation being protected by the clause, the proportionality of imposing the detriment must be tested by reference to each of them. If the detriment is disproportionate in relation to one obligation, the clause is a penalty and is unenforceable in its entirety.

The court considers the position at the time the contract was made, not when the breach occurs. Its focus is on substance over form; a clause labelled "liquidated damages" may still be a penalty.

The Court's decision in Houssein

Was the obligation to pay the default rate a secondary obligation?

In Houssein, the default rate applied when an event of default arose and so it was a secondary obligation.

Did the default rate protect the lenders' legitimate interests?

The court recognised that there were several legitimate interests the lender was seeking to protect by imposing the default rate when an event of default occurred. The events of default included:

• Non-payment: This protected the lender’s core interest in the timely repayment of its loan.

• Inaccuracy of the borrower's representations and warranties: The lender had advanced the loan on the basis these were correct.

• Events occurring which impact the security for the loan, such as the destruction of secured property: The lender had an interest in ensuring its security was intact and realisable.

• The borrower residing in the secured properties: The regulations governing residential mortgages prohibited the lender from lending to individuals where the security was the borrower's primary residence. Breaches of those regulations carry penalties for the lender including imprisonment, so it was in its interest to ensure that the borrower did not occupy the secured property. Whilst the borrower in this case was a corporate entity, it was argued the lending arrangements were a sham and the loan was effectively made to individuals, so the lender still had an interest in mitigating this risk.
• The borrower's default on other lending or its failure to pay an unappealable judgment debt of over £20,000. The lender had an interest in protecting the borrower's creditworthiness and its ability to repay its debt to the lender when it becomes due.

Was the default rate proportionate?

The presumption that properly advised parties of equal bargaining power could determine whether the rate was reasonable applied. The court noted that the borrower had advice from solicitors and a broker and had various refinancing options open to it; this lending was not "the only show in town".

The court received expert evidence that 4% was above the range of market rates but was not unreasonable. There was also evidence that dynamic rates were available in the market, with breaches of more significant obligations attracting the imposition of higher interest rates. However, the court had not received any evidence explaining the basis and rationale for the imposition of the default rate in this particular facility.

The court decided that the rate was proportionate in so far as it applied on non-payment of the loan, a change to the security portfolio, the inaccuracy of representations and warranties and breach of the non-residence provisions. These provisions all protected the core interests of the lender in ensuring it was repaid, had secured lending, was provided with accurate information at the outset of the lending, and did not face significant penalties by lending in breach of mortgage regulations.

The court had more difficulty with the proportionality of applying the rate in circumstances where the borrower failed to pay an unappealable judgment debt. The court considered that defaulting on unrelated debts did not necessarily increase the risk of the borrower defaulting on the loan. There may be good reason for not paying another debt, for example if the borrower considered it had a defence to the claim. In this case the lender knew that the borrower had an unpaid county court judgment before it agreed to the lending, but that (and other factors) only caused it to increase the standard interest rate on the loan by 0.3%. It therefore appeared incoherent that a judgment arising after the lending had been agreed triggered an event of default and a default rate of 4%.

Before the Court of Appeal's decision, the High Court had decided that the default rate was disproportionate because the lender was already protected from the borrower's credit issues by its security and the standard rate. It therefore decided it was a penalty and unenforceable in its entirety, even in respect of more serious events of default. The Court of Appeal ordered the High Court to reconsider its decision as it had not correctly considered whether the lender had a legitimate interest in applying the default rate or the proportionality of that rate.

Considering the matter again, the High Court decided the rate was proportionate. It heard evidence that the lender's preferred method of exiting the lending, assuming it was not repaid, was through refinancing rather than enforcing its security. It was therefore in the lender's interest that the borrower remained creditworthy and able to refinance on commercial terms. There was evidence that another lender known for being flexible had declined to refinance the portfolio, and that even a minor change to a lender's view of the borrower's creditworthiness could seriously impact the terms of a refinance. The lender therefore had a good reason to impose a default rate which would deter the borrower from taking any action to harm its creditworthiness. Accordingly, the default rate was not a penalty.

Conclusion

Whilst the High Court ultimately decided that the default rate was enforceable, the decision was finely balanced. The court will scrutinise default interest rates where they apply to ostensibly minor or technical breaches, and carefully assess whether they are proportionate to the interest which is being protected. Evidence of the rationale for imposing the rate to the lending in question, as well as market practice, will be critical.