Penalty or Promotion of Legitimate Interest?

The English Court of Appeal has recently considered the legal effect of a default interest provision in a financing agreement. In doing so, it had to determine whether the clause involved constituted an irrecoverable penalty or whether it served to protect a legitimate interest of the non-defaulting party. Our Commercial Disputes team examines this decision.

As a matter of Irish law, the general principle is that a clause which provides for particular financial consequences in the event of a breach or default will be an unenforceable penalty clause. This is true unless the quantum, or amount to be charged, reflects a genuine pre-estimate of loss. English law has relatively recently moved to a different position. This position involves consideration of whether the relevant clause can be said to be commercially justifiable. The English Court of Appeal has recently dealt with a case involving a default interest provision in a financing agreement and whether it was a penalty.[1] Specifically, it had to considered whether, on the facts of the case, the application of a higher interest rate in the event of default by the borrower constituted an unlawful penalty. Here, the court found that there was a legitimate interest in the enforcement of the primary obligation to repay the loan, interest, fees and commissions. As a consequence, it was the trial judge’s duty to consider whether the provision was extortionate, exorbitant or unconscionable. Although the test for penalty interest in Irish law is different, the decision importantly highlights the key point that there is a legitimate interest in deterring late payment and ensuring compliance with primary obligations. This may ultimately be something which is adopted as part of Irish law when considering if a default interest provision is an unenforceable penalty.

Background

Under the relevant facility, interest accrued at the rate of 1% compounded per month. However, in the event of default the rate would rise to 4% compounded per month. In the English High Court,[2] it had been declared that the default interest rate was an unenforceable penalty. This was on the basis that it constituted an unenforceable penalty as the quadrupling of interest, plus the effect of compounding the interest, constituted a substantial increase. The High Court judge did not believe that the imposition of such an interest rate protected any legitimate interest of the lender.

The English Court of Appeal noted that the UK Supreme Court in Cavendish had determined[3] that the common law rule that a term in a contract which constituted a penalty was unenforceable, whilst not to be abolished, should not be extended:

“there was no reason in principle why a contractual provision, the effect of which was to increase the consideration payable under an executory contract upon the happening of a default should be struck down as a penalty if the increase could in the circumstances be explained as commercially justifiable, provided always that its dominant purpose was not deter the other party from breach.”

Instead:

“the true test is whether the impugned provision is a secondary obligation which imposes a detriment on the contract breaker out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation. The innocent party can have no proper interest in simply punishing the defaulter. His interest is in performance or in some appropriate alternative to performance…”

The decision

Here, the Court of Appeal accepted that the proper approach to adopt in considering whether a provision was or was not a penalty, a threshold issue first had to be considered. Specifically, did it constitute a secondary obligation which was triggered by breach of a primary obligation?

If so, it was necessary to identify the extent and nature of the legitimate interest of the non-defaulting party in having the primary obligation performed. Then, having regard to that legitimate interest, the court had to consider if the secondary obligation was exorbitant or unconscionable in amount or effect. In considering the second element, the Court of Appeal felt the High Court judge had not taken any real account that it was self-evident that “there is a good commercial justification for charging a higher rate of interest on an advance of money after a default in repayment because a person who has defaulted is, inevitably, a greater credit risk.” Consequently, the Court of Appeal ruled it was “inevitable” here that there was “a legitimate interest in the enforcement of the primary obligation to repay the loan”. Further, the High Court judge had not addressed the question of whether the provision was extortionate, exorbitant or unconscionable. In addition, the High Court judge had failed to consider the extent and nature of the non-defaulter’s interest after default. Accordingly, the question of whether the default interest was “extortionate, extravagant or unconscionable” was to be remitted to the trial judge to consider “having regard to the legitimate interest in the legitimate interest in the performance of the primary obligation.”

Conclusion

The decision reflects a broad conception of the legitimate interest a lender may have in providing for default interest. It would further appear that the greater the legitimate interest, the less likely it is that the default provisions can be said to be extortionate or extravagant. To an extent, therefore, there is an argument to be made that the decision reflects a greater willingness to hold parties to their bargain and accommodate contractual freedom.

However, as mentioned briefly, Irish law relating to penalties is somewhat different. It remains the case[4] that unless the amount sanctioned by the default provision involved reflects a genuine pre-estimate of loss then it is likely to constitute an unenforceable penalty clause. This is especially so by reference to the question of whether the consequence can be said to be “extravagant and unconscionable” compared to the maximum loss caused by breach. It remains to be seen if the developing approach in English law will inform how Irish law addresses default provisions. However, there appears to be a hesitation to date on the part of Irish courts to adopt Cavendish.[5]

For more information and expert advice on commercial disputes, contact a member of our Commercial Disputes team.

The content of this article is provided for information purposes only and does not constitute legal or other advice.

[1] Hussein & Ors v London Credit Ltd & Ors [2024] EWCA Civ 721

[2] [2023] EWHC 1428 (Ch)

[3] Cavendish Square Holdings BV v. Makdesi [2015] UKSC 67

[4] Pat O’Donnell v Truck Machinery Sales [1998] 4 IR 191

[5] McKechnie J. in the Supreme Court in Launceston Property Finance Ltd v Burke [2017] IESC 62 commented, albeit obiter, that he was not convinced that a change to the test was necessary or that the English approach was a superior one.