In the case of Ahuja Investments Limited v Victorygame Limited [2021] EWHC 2382 (Ch) the court held that a default interest provision in a loan agreement was a penalty clause and therefore unenforceable.
The law of penalties was comprehensively reviewed and restated by the Supreme Court in Cavendish Square Holding BV v Makdessi [2015] UKSC 67, [2016] A.C. 1172. Ahuja v Victorygame provides a clear case study as to how those principles apply to default interest clauses commonly found in finance agreements. The principles are:
- Penalty clauses are secondary obligations.
- Whether a clause imposes a secondary liability upon a breach of contract is a question of substance and not of form.
- Does the clause impose a detriment that is out of all proportion to the legitimate interests of the innocent party or which is exorbitant, extravagant or unconscionable?
- The burden of proof lies on the party alleging that a clause is a penalty to show that the secondary liability is exorbitant, extravagant or unconscionable.
- The courts are slow to interfere with parties freedom to contract.
Ultimately, Judge Hodge QC decided that, despite the fact that
the default interest provision had been freely-negotiated between
two experienced commercial parties both represented by solicitors
at the time, the rate of 12% per month compounded monthly and
representing a 400% increase in the interest rate applicable prior
to default, was properly to be characterised as a penalty.
The Judge went on to say that whilst he would be prepared to
accept, without supporting evidence, an increase of up to 200% in
the applicable rate of interest on default to reflect the greater
credit risk presented by a defaulting borrower, as a rule of thumb,
he would expect the evidential burden to pass to a lender to adduce
evidence to justify any greater increase, at least where the lender
enjoys additional personal and real security for its loan.
Ideally, lenders should keep a detailed note of why the default interest clause was agreed at that particular rate. Evidence of the following matters will help a lender to defend the clause:
- Market interest rates at the time of the loan agreement and at the time of default.
- The rationale for the default interest rate.
- The particular factors affecting the credit risk posed by a defaulting borrower, taking into account any guarantees or security provided for the debt.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
