Reed Smith Client Alerts

Key takeaways

  • The Court of Appeal in Houssein v London Credit Limited ("LCL") [2024] has recently reiterated the test for determining whether default interest should be construed as a penalty clause. The threefold test is:

First, as a threshold question, is the default rate of interest in substance a secondary obligation engaged upon breach of a primary obligation?

Second, if it is, what is the extent and nature of the legitimate interest of the promisee in having the primary obligation performed?

Third, is the default interest clause extortionate, exorbitant, or unconscionable in light of the nature and extent of the legitimate interest?

  • Lenders have a legitimate interest in charging default interest, but care must still be taken to ensure that the interest charged is not extortionate.
  • If there is any concern that a default interest rate clause may amount to a penalty clause, care must be taken to ensure that the standard rate position applies in the alternative.

Authors: George Hoare James Stockman Natalie Hendy Aishwarya Karunakaran

Facts

Mr and Mrs Houssein had a portfolio of residential properties, which were either held in their sole names or in their joint names, with all being subject to mortgages. In June 2020, the Housseins sought to refinance one of their secured loans through their company, CEK Investments Limited (“CEK”), of which they were both directors.

That loan was financed by LCL for a period of 12 months, with a standard interest rate of 1% per month and a default rate of 4% per month. The loan was secured by, among other things, a mortgage on the Housseins’ family home.

The facility agreement included a provision prohibiting CEK or its “Related Person”, which included the spouses and relatives of the “Borrower” from occupying the family home. Shortly after the loan had been drawn down, LCL alleged that CEK was in breach of the facility agreement because the Housseins occupied the family home and demanded repayment of the loan plus default interest.

First instance decision

A key question considered at first instance was whether the default interest provision amounted to an unenforceable penalty clause. The leading authority of an unenforceable penalty is El Makdessi v Cavendish Square Holdings BV [2015] WLUK 78. In that case, the Supreme Court held that, in determining whether the provision is an unenforceable penalty clause, it is necessary to consider:

  1. whether the “impugned provision” is a secondary obligation that imposes a detriment on the breaching party, that is out of proportion to any “legitimate interest” of the innocent party in enforcing the primary obligation;
  2. whether any (and if so what) legitimate business interest is served and protected by that clause; and
  3. whether, assuming such an interest does exist, the provision made for the interest is nevertheless in the circumstances “extravagant, exorbitant or unconscionable”.