How Enforceable Are Default Interest Clauses?

A default interest clause forces a party to pay a higher rate of interest under a contract if they were to fail to comply with its terms for whatever reason. These clauses are used to protect legitimate interests of innocent parties and compensate them for the increased risk they’ve assumed due to the other party’s breach.

A penalty clause, which is unenforceable as a matter of law, is a contractual agreement for the recovery of a sum of money on breach of a contract. It is intended to punish the offending party rather than act as a form of compensation to the innocent party. Case law has outlined a test which is used to determine if a default interest clause is a penalty and therefore unenforceable.

The test sets out that a clause will not necessarily be a penalty simply because it is not a genuine pre-estimate of loss or because it is aimed at deterrence rather than compensation. It must, however, have a focus on legitimate interests. This can include an increase in risk taken on by a party as a result of a breach. If there is a legitimate interest, the sum to be paid resulting from the increase in interest must not be extravagant, exorbitant or unconscionable. 

The Court of Appeal has recently overturned a decision made by the High Court that ruled that a 4% default interest rate in a loan agreement was unenforceable.

The case involved a facility agreement with a default interest rate of 4%. It was argued that this was penal as there was an increase of the non-default interest from 0.7% to 1% to take into account the increased risk due to the borrowers’ creditworthiness. It was argued that an increase by a further 3% was disproportionate for a late payment. The High Court had ruled that this was an unenforceable clause.

On appeal it was ruled that the test had not been properly applied, and the commercial justification for charging a higher rate of interest had not been considered (in this case, the default in payment meant the borrower was a greater credit risk).

The Court of Appeal also decided that if the default interest was a penalty, then the interest rate would not revert to the non-default rate if the default rate could not be charged.

This decision provides a reminder of the test to be applied to establish whether a default interest rate or similar clause is unenforceable as a penalty. It will be interesting to see whether the High Court, when it applies the correct test, reaffirms that the default interest rate in this case constitutes a penalty. It also draws attention to the fact that no contractual interest at even the lower non-default rate may be payable on an outstanding loan should the default interest rate be categorised as a penalty, although statutory interest could potentially be claimed.

If you would like any advice on the enforceability of default interest rate clauses, or have any concerns you would like to discuss relating to an agreement you are a party to, please contact BHW on 0116 289 7000.