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One of the most basic principles of the common law of contract is that contracting parties are free to determine, for themselves, what primary obligations they will accept. The importance of freedom of contract is highly valued in English law; and is one of the core reasons why many sophisticated parties all over the world select English law to govern their commercial relationships. As a consequence, there are only very limited circumstances in which the English courts will interfere with the parties’ express choices.

Perhaps the best-known reason for the English courts to interfere with the parties’ freedom of contract is the longstanding rule against penalties. However, even this is very limited in scope, as confirmed by a number of recent decisions (see, for example, ICICI Bank UK Plc v Assam Oil Co Ltd [2019] EWHC 750 (Comm), Longulf Trading (UK) Ltd v Niyazi Onen Gida San AS [2019] EWHC 1573 (Comm), and Biosol Renewables UK Ltd v Lovering [2021] EWHC 71 (Comm)).

As a general principle, a penalty clause is a provision which operates on a breach of contract, requiring a debtor to pay an excessive amount that is completely out of proportion to any legitimate interest that the other party might have in performance of the primary obligation. The rule against penalties applies to all contracts but whether any given interest clause is actually penal depends on the facts of the case. Very broadly speaking, case law has established that, to avoid the risk of being classified as a penalty: (1) default interest rate should not be too high; and (2) interest should run only while the default continues.

In that context, a significant judgment handed down by the High Court last year really stands out. The court found that a default interest rate in a loan agreement of 12% per month, compounded monthly, was properly to be characterised as a penalty.

The loan agreement considered in Ahuja Investments Ltd v Victorygame Ltd and another [2021] EWHC 2382 (Ch) (26 August 2021) contained a 12% default interest rate that represented a 400% increase in the interest rate applicable prior to default (3% per month): an increase that the court considered to be “so obviously extravagant, exorbitant and oppressive” as to be unenforceable. Accordingly, default interest at that higher rate was not recoverable by the lender. The underlying dispute involved claims for breach of contract and fraudulent or negligent misrepresentation (the claimant, Ahuja, having purported to rescind the loan agreement for misrepresentation). The court ultimately held that the representation relied upon by Ahuja was not actionable because it had not induced it to contract and, having reached that decision, the court then had to consider whether a default interest provision in the loan agreement was enforceable. The decision is also noteworthy for the court’s drawing of adverse inferences from the parties’ failures to call relevant witnesses.

Ahuja had agreed to buy a shopping centre from Victorygame for over £17 million. However, Ahuja did not have the funds required to complete the purchase so, on the day fixed for completion, Victorygame agreed to lend it £800,000 to assist with the purchase. The loan agreement recognised two types of interest payments: (1) four contractually agreed “interest” payments of 3% per month (£24,000 each) during the term of the loan; and (2) interest at a rate of 12% per month payable on “the amount that may remain outstanding from the Redemption Date”. The first three interest payments were paid as expected, however, later, Ahuja alleged that it was induced to enter into the sale contract and loan agreement by misrepresentation and purported to rescind the loan agreement on that basis. It did not pay the fourth interest payment due under the loan and brought a parallel claim for damages for breach of contract. The defendants counterclaimed for, among others, the recovery of monies due under the loan agreement. It was in this context that the court was asked to consider the enforceability of the loan agreement’s 12% default interest rate.

Victorygame submitted that the 12% default interest rate was not a penalty as the provision did not operate on breach of contract. Its case was that the provision was simply a primary obligation to pay the lender interest at 12% per month on the amount outstanding at the redemption date. The Judge rejected this argument without hesitation on the basis of the Supreme Court’s ruling in Cavendish Square Holding BV v El Makdessi and ParkingEye Ltd v Beavis [2015] UKSC 67, holding that whether or not a clause imposes a secondary liability upon a breach of contract is a question of substance and not of form: “If the substance of the contract is the imposition of a punishment for a breach of contract, the concept of a disguised penalty may enable a court to intervene” (although the Judge went on to note that is may be possible to circumvent the rule by “clever drafting”). In this case, the Judge did not consider the drafting to have been sufficiently “clever” and held that the obligation to pay default interest was in fact a provision which operated upon any breach of the borrower’s primary obligation to repay the loan. It therefore fell within the scope of the rule against penalties.

The Judge went on to consider Ahuja’s argument that the default interest rate was excessive in nature; in particular, to assess whether it was “exorbitant, extravagant or unconscionable”, in comparison with the lender’s legitimate interest, such that it was penal in nature and unenforceable. The Judge observed that the best illustration of this was that, if the provisions did not constitute a penalty (and were therefore enforceable), Ahuja would owe over £80 million in interest on an initial loan of £800,000 taken out just 30 months prior. In the circumstances, the court was satisfied that a default rate equivalent to a 400% increase in the primary interest rate was, when combined with a provision for monthly capitalisation of interest, “so obviously extravagant, exorbitant and oppressive” that it should properly be characterised as a penalty. In reaching that decision, the court had regard to the fact that the lender had provided either no or insufficient evidence detailing: (i) market interest rates at the time of the loan agreement; (ii) the risk factors involved; (iii) the rationale for the default interest being set at such a high rate compared to the interest rate applicable prior to the redemption date; or (v) any genuine assessment of Ahuja’s creditworthiness in the event of default.

In its judgment, the court accepted that a lender has a legitimate commercial interest in applying a higher rate of interest to a borrower who is in default because that borrower then represents an increased credit risk (a position established as “self-evident” in Cargill International Trading PTE Ltd v Uttam Galva Steels Ltd [2019] EWHC 476 (Comm) where the court observed that “money is more expensive for a less good credit risk than for a good credit risk”). Nevertheless, there are limitations to this principle. In any given case, whether the default interest rate applied is penal will depend on whether, in all the circumstances, it is “exorbitant, extravagant or unconscionable”. The burden of proof falls on the party alleging the penalty (usually the borrower) and it must make its case on the balance of probabilities in order to succeed.

Interestingly, the Judge also commented that he would be prepared to accept, as a rule of thumb and 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. He would, however, expect a lender to adduce evidence justifying any greater increase, particularly where the lender benefits from additional personal and real security for the loan.

Comment

Although the judgment in Ahuja provides insight into the grounds upon which such provisions may be challenged – and when they may be struck out – the judgment does not necessarily herald a new era of ready challenges to such clauses.

As the Judge himself observed, “clever” drafting is key and Ahuja provides a stark reminder to practitioners of this fact. When drafting contractual default interest clauses, it pays to be mindful of the key rules discernible from recent authority on the topic: (1) the rate and, particularly, the uplift should not be excessively high, judged by comparison with market rates at the time the loan agreement is made; (2) interest should run only while the default continues and provisions should not purport to operate retrospectively or for an indefinite or arbitrary future period; and (3) any secondary liability imposed upon a defaulting party must be in proportion to the legitimate interest of the innocent party, specifically the objective value of that legitimate interest. In all cases, parties should be mindful that even the most careful drafting will not prevent an extortionately high default interest rate from being scrutinised by the courts and struck out where it amounts to a penalty in disguise.