Court of Appeal considers the law on penalty clauses, contractual interpretation and costs orders

In Houssein & Ors v London Credit Ltd & Anor [2024] EWCA Civ 721, the Court of Appeal overturned a first instance decision that a default interest rate of 4% per month in a facility agreement was a penalty.

The decision is a helpful reminder of the correct test to determine whether a contractual term is an unenforceable penalty. As the Supreme Court in Cavendish Square Holdings BV v Makdessi [2015] UKSC 67 set out, the court must consider whether the term is a secondary obligation engaged by breach of a primary obligation, whether (and if so what) legitimate interest is protected and, if such an interest exists, whether the sum required to be paid is nevertheless, exorbitant or unconscionable in its amount or in its effect.

The Court of Appeal also considered the correct approach to contractual interpretation and costs orders.

Background

The First Respondent, London Credit Limited (LCL), agreed to loan £1,881,000 to the Third Appellant, CEK Investments Limited (CEK). Under the terms of the facility agreement (the Facility Letter), the standard rate of interest was 1% per month (the Standard Interest Rate) and the default rate of interest was 4% per month (the Default Interest Rate). The loan was secured by a third-party mortgage over the family home of the directors of CEK (the Property).

The Facility Letter prohibited CEK, or any “Related Person”, from occupying the Property. LCL inspected the Property before the loan was drawn down to verify that it was not occupied; however CEK and the other Appellants alleged that the photographs taken during the inspection had been staged to make it appear that the Property was vacant.

One month after the loan was drawn down, LCL declared an event of default by reason of the occupation of the Property and subsequently demanded immediate repayment of the loan, plus interest at the Default Interest Rate. LCL’s demand for repayment was not met and LCL subsequently appointed joint receivers to sell the Property. Proceedings were issued shortly before the Property was due to be sold, and soon after the Appellants were granted an interim injunction temporarily restraining LCL / the joint receivers from dealing with the Property.

First instance decision

At first instance, the Judge held that the photographs taken during the inspection had been staged, thereby waiving the non-occupation requirement, and that dishonest evidence had been given in this regard on behalf of both the Appellants and LCL.

Having referred to Cavendish Square Holdings BV v Makdessi [2015] UKSC 67, the Judge also held that the Default Interest Rate under the Facility Letter was an unenforceable penalty, and that the Standard Interest Rate applied to any outstanding amounts. The Judge stated that “[t]he question is whether the default rate protects a legitimate interest of LCL”, and that while “[c]harging a higher rate on default can be commercially justified on the basis of the enhanced credit risk of the borrower”, this did not appear to be the interest that LCL sought to protect by applying the Default Interest Rate. A number of factors led the Judge to this conclusion, including:

1. On the evidence available to the Judge, historical credit risk factors had already been baked into the Standard Interest Rate;
2. The Default Interest Rate was a generic rate which was not tailored to CEK’s credit risk and applied to all breaches, regardless of their perceived risk level;
3. The parties’ experts agreed that a typical default rate was 3% per month, and the Judge found no reason why an additional 1% per month was needed in the circumstances.

The Judge at first instance also held that because the Default Interest Rate was unenforceable as a penalty clause, the Standard Interest Rate applied instead (including in the period after the contractual repayment date).

The Appellants appealed, submitting that the Judge erred in his construction of the Facility Letter and that on the correct interpretation, LCL’s entitlement to any interest – including the Standard Interest Rate – had come to an end.

The Appellants also argued that the Judge’s decision to make an issues-based costs order was wrong, and that the Appellants should have been awarded their costs on an indemnity basis.

LCL cross-appealed on the basis that the Judge had failed to apply the correct test on penalties and that the Default Interest Rate was not a penalty and was enforceable.

Court of Appeal

The Default Interest Rate may not be an unenforceable penalty

The Court of Appeal held that the Judge at first instance incorrectly addressed the question of whether the Default Interest Rate was a penalty:

1. The Judge did not consider the question whether the Default Interest Rate was in effect a secondary obligation engaged upon breach of the primary obligation, i.e. repayment of the loan.
2. The Judge failed to take proper account of previous case law which concluded that it is self-evident that there is a good commercial justification for charging a higher rate of interest following default as the defaulting party is inevitably a greater credit risk.
3. The Judge conflated the question of a legitimate interest with the effect of the clause in question and viewed the question of whether the clause was penal subjectively, i.e. what LCL were seeking to achieve with the clause. This should be an objective test; whether a clause was penal depended on its purpose, and determining that issue was a matter of construction.
4. The Judge did not address the crucial question of whether the impugned provision was extortionate, exorbitant or unconscionable.

The Court of Appeal remitted the question of whether the Default Interest Rate was a penalty back to the first instance judge on the basis that the Court had limited knowledge of the evidence and cross examination.

LCL’s entitlement to the Standard Interest Rate had come to an end

The Court of Appeal proceeded to consider the Appellants’ primary ground of appeal, that on the correct interpretation of the Facility Letter, LCL’s entitlement to any interest – including the Standard Interest Rate – had come to an end.

The Court of Appeal held that while there was no dispute about the principles to be applied in relation to the proper construction of the Facility Letter, the Judge at first instance had misinterpreted those principles in the context of the interest provisions by equating “applicable” with “enforceable”. The Court held that the Standard Interest Rate and the Default Interest Rate were mutually exclusive and that, as such, LCL’s entitlement to the Standard Interest Rate had come to an end as at the contractual repayment date. LCL would therefore have to seek equitable or statutory interest if so inclined in respect of any interest claimed after that date (and assuming the Default Interest Rate was found to be an unenforceable penalty upon being remitted to the first instance judge).

The Judge at first instance erred on the question of costs

The Court of Appeal determined that the high hurdle for appealing against a costs order had been crossed and that while the Judge at first instance should have sought to determine the “overall winner” of the case, he instead attempted to determine the “outright winner” when deciding which costs order to make, which was a different approach. The Judge also failed properly to consider LCL’s conduct, and did not fully engage with the question of whether it was more appropriate to make an order on a proportional basis rather than an issue-based order.

The Court of Appeal therefore held that the question of the correct costs order should be remitted to the first instance Judge to determine once the penalty question had been addressed.

Key takeaways

The Court of Appeal’s reiteration of the test for determining whether a contractual provision is a penalty provides a helpful reminder of the relevant principles emanating from the Supreme Court’s decision in Cavendish Square Holdings BV v Makdessi [2015] UKSC 67. This decision is also a useful confirmation that commercial lenders have a legitimate interest in an increased interest rate on default, which the courts should be reluctant to interfere with unless such a default rate is “exorbitant or unconscionable”.

The Court’s guidance may be welcomed in particular by short-term lenders alarmed by the first instance decision, especially as 4% per month is not an unusual default rate.

With thanks to Alex Mann for his assistance in preparing this post.