Courts correct course on default interest

Readers will probably know that certain types of provisions in documents can be struck out by the courts if they are deemed to be a penalty. Very occasionally, default interest clauses come under scrutiny.

In our last case law article, we looked at a Court of Appeal judgment concerning whether a very high default rate of interest in a facility letter was unenforceable. The court concluded that the first-instance judge had made a number of errors in law and sent the case back to him to make a determination based on the evidence before him but applying the correct legal principles.

In this article, we look at the sequel, where the judge makes his determination in favour of the lender, who had lost first time round. Much of the very long judgment is given over to the judge explaining how he came to get the law wrong in the original hearing. There is, however, one interesting point of law in the new judgment which highlights an elephant trap that lenders and their lawyers might wish to avoid.

Default interest revisited

It is not uncommon for a lender or its lawyers to justify the imposition of a default rate of interest on the occurrence of an event of default on the basis that “the credit risk has changed”. In the recent case of Houssein v London Credit Ltd [2025] EWHC 2749 (Ch), the court questioned whether this was true for every event of default in a facility document. If not, and if there was no real justification for the imposition of the default rate after the occurrence of a “minor” event of default, would the whole default interest provision fail because it was a penalty? Or put another way: does the occurrence of a minor event of default change the credit risk enough to justify such a high default rate?

Case summary

The case concerned a low-grade bridging facility for a property transaction which, although well secured, involved a high credit risk. As a result, the standard rate of interest was 1% per month and, if an event of default occurred, this jumped to a default rate of 4% per month. When a default occurred and the lender claimed default interest, it was challenged in the High Court and the judge found in favour of the borrower.

In his view, the default rate was a penalty, and he ruled that the standard rate of interest should continue to apply. The case was then heard before the Court of Appeal, who concluded that the judge had asked himself the wrong questions and had therefore failed to apply the correct test.

The Court of Appeal declined to determine for themselves whether the default rate was a penalty: “It would be unreliable and unsafe if we were to do so because it would be based on a limited knowledge of the evidence and cross examination to which we were referred. It is not appropriate for us to decide the point based on the small number of extracts from the expert evidence to which we were taken.” Accordingly, the matter was returned to the High Court judge, who had to decide whether the default rate was extortionate, exorbitant or unconscionable.

The question that exercised the judge’s mind the most, both in the original case and again in this hearing, was how a minor infringement (such as an unpaid judgment debt for a small amount arising from an obligation to a third party) could affect the credit risk in the same way as a major infringement (such as failure to pay principal or interest under the facility on its due date). In his analysis, each event of default constitutes a “primary obligation”.

While it is slightly odd to characterise the occurrence of an event outside the obligor’s control as a primary obligation, it helps with the analysis. It is well established under current law that a primary obligation gives rise to a “legitimate interest” in the enforcement of such primary obligation, which the lender is permitted to protect by the imposition of a default rate of interest. What troubled the judge was whether, in the case of a minor default, a rate of 4% per month might be considered “extortionate, exorbitant or unconscionable”, even if such rate was justifiable in the case of a payment default.

If it was extortionate in the case of a minor default, the whole default rate clause would fall as a penalty. In other words, he was thinking about proportionality.

What saved the day for the lender was the nature of the facility. It was a bridging finance and there was expert evidence that bridging facilities were regularly repaid by being refinanced by a further bridging facility (and would have been in this case). Where the borrower’s financial position was already looking shaky, the occurrence of even a minor event of default might be enough to deter a potential refinancing lender. It followed that any event of default, however minor, created a legitimate interest which needed to be protected by the same heavy default rate.

Conclusion

What are the lessons to be learned for us as practitioners when documenting loan facilities?

• The first thing to note is that the question of penalties is not going to arise in the case of a typical loan where the default rate increases to 1-2% above the standard rate
• It may become an issue in the case of high-risk loans such as this one, where both the standard rate and default rate are much higher
• It is possible that future judgments will contradict or override the nuanced view expressed in this judgment. In the meantime, lenders and their advisers might consider whether they really need to impose a high default rate in respect of all events of default or whether it is sufficient to exempt some of the “minor” events of default, bearing in mind that, if the default rate fails the “extortionate” test for even one event of default, the whole provision will be struck out as a penalty
• It should go without saying that one must avoid words like “penalty” – a common mistake made by non-lawyers
• Finally, in the unfortunate event that a default rate is found to be extortionate, one could include in the drafting a provision spelling out that if the default rate is adjudged not to be enforceable, the standard rate shall continue to apply in lieu thereof.