High Court Finds Default Interest Clause In Loan Agreement Is Not An Unenforceable Penalty

The High Court has found that a default interest clause in a short-term loan agreement was not extortionate, exorbitant or unconscionable and therefore not an unenforceable penalty clause, following remittal from the Court of Appeal and reversing its original decision: Houssein & Ors v London Credit Ltd & Anor [2025] EWHC 2749 (Ch). We considered the previous Court of Appeal decision in this blog post.

As a reminder, in assessing whether a clause amounts to a penalty, the three-stage test drawn from Cavendish Square Holding BV v Talal El Makdessi (Rev 3) [2015] UKSC 67 is applicable. This test provides that a liquidated damages clause will not amount to an unenforceable penalty, provided: (1) it is a secondary obligation triggered by a breach of contract (this is a threshold question); (2) the clause is in furtherance of a "legitimate interest" which the innocent party has in the performance of the primary obligation; (3) and the clause is not "extortionate, exorbitant or unconscionable".

The court held that the clause was commercially justifiable in light of the lender's legitimate interests, which included timely repayment of the loan, protection of security, regulatory compliance and credit risk management. While the default rate of 4% compounded monthly was found to be above market norms (3% compounded monthly being found to be typical), the court ruled that it was not extortionate on the facts of the case, including precarious refinancing prospects, the borrower's credit history and the lender's exposure.

The decision will be of interest to financial institutions for its consideration as to: (i) the legitimate interests of the lender the court will consider when assessing whether a default interest rate clause is a penalty clause; and (ii) whether tenders of repayment made by a borrower are effective to stop interest from accruing.

We consider the decision in more detail below.

Background

In 2020, the lender and borrower entered into an agreement for a short-term bridging loan secured against a number of properties, including the family home. The agreement included a default interest rate clause imposing a higher rate of interest (4% compounded monthly, the Default Rate) in the event of default and was supported by personal guarantees from the directors. The Default Rate applied uniformly to all instances of default.

Shortly after drawdown, the lender alleged breach of a non-residence clause in respect of one of the secured properties, and appointed fixed charge receivers. By the contractual repayment date in August 2021, over half of the balance of the loan remained outstanding. The borrower made offers to repay the outstanding principal, but these were rejected because the lender insisted on payment of interest at the Default Rate. In response, the borrower and its directors issued proceedings challenging the validity of the enforcement action and the enforceability of the Default Rate interest clause.

At first instance, the High Court found that the enforcement steps taken in respect of the breach of the non-residency obligation were void, because the lender permitted drawdown with knowledge of that breach. It held that there had been a breach of the facility agreement but that the default interest clause was unenforceable as a penalty under the Makdessi test (outlined in the introduction). Interest was instead payable under the standard interest clause, even after the repayment date. Both parties appealed.

The Court of Appeal, in a judgment handed down in 2024 (discussed here), found that the High Court erred in its application of the Makdessi test. The Court of Appeal accepted that the first limb of the test was not in issue in these proceedings: it was implicit that the default interest clause was a secondary obligation, engaged on the breach of a primary contractual obligation. In respect of the second limb, the Court of Appeal overturned the High Court's judgment, finding that the lender had a legitimate interest in securing repayment under the loan and all interest and fees thereunder by the repayment date, which the default interest clause was designed to protect. In respect of the third limb, the Court of Appeal concluded that the High Court erred by not considering whether the default interest clause was "extortionate, exorbitant or unconscionable" – whether separately, or at all.

The Court of Appeal remitted the question of whether the Default Rate of interest was a penalty to the trial judge, namely whether:

Decision

The High Court held that the Default Rate was not a penalty and so was enforceable. We consider the key elements of the court's decision, which are likely to be of broader interest to financial services firms.

Enforceability of the Default Rate

The court found that the Default Rate was not extortionate, extravagant or unconscionable and therefore not a penalty under the Makdessi test, holding that:

1. although a Default Rate of 4% compounded monthly was "at the upper extremity of the band of commercially acceptable rates", it was not in itself extortionate if the primary obligation gave rise to a sufficiently strong legitimate interest; and
2. the claimants were experienced, well advised and had other lending options available to them – accordingly there was a "strong initial presumption" that the parties themselves were the best judges of what was legitimate (per Makdessi).

In coming to this decision, the court considered not only the legitimate interest that had been identified by the Court of Appeal (being the enforcement of the primary obligation to repay the loan and fees on the specified date), but all of the primary obligations (and legitimate interests underpinning them) that were subject to the Default Rate, following the test in Makdessi.

The court was careful to explain that the application of the same Default Rate to the breach of multiple different primary obligations and legitimate interests resulted in a presumption (although no more than a presumption) of a penalty clause (according to Lord Dunedin's four tests in Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd [1915] AC 79). It also emphasised that, in order for the clause to be enforceable, it must not to be extortionate, extravagant or unconscionable in respect of any of the legitimate interests.

Based on the events of default clause, the court identified five legitimate interests and analysed whether the Default Rate was extortionate in respect of each of them, in each case finding that the interests were sufficiently strong that the rate of 4% compounded monthly was not extortionate.

1. The timely repayment of the loaned amount (the Repayment Interest). The court held that this was a self-evidently very strong interest given the purpose and nature of a loan.
2. The truth and accuracy of the representations and warranties given in the facility letter, being the basis on which the loan was provided (the Representations Interest). The court held that this was a strong interest as it forms the basis on which the lender assessed risk and decided on which terms it would lend.
3. Protecting the properties provided as security to the loan, in order that the security could be realised if needed (the Security Interest). The court held that this was a significant interest because the security formed the lender's primary protection if there was a default in respect of the Repayment Interest.
4. As an unregulated lender that was prohibited by law from lending to individuals where the security is their primary residence, the non-residence of the borrowers (the Non-Residence Interest). The court held that this was a strong interest, given that failure to comply could result in significant fines and two years' imprisonment for the person carrying on regulated activities without authorisation.
5. Protecting itself against the risk that the borrower's ability to repay the loan would deteriorate, especially due to defaults on other obligations (the Credit Risk Interest). The court held that this was a very strong interest based on the additional evidence heard at the second hearing (following the Court of Appeal's judgment). Notably, the court reached a different conclusion on this point to the first trial, focusing on the fact that the only realistic way for the borrower to repay the loan was through refinancing. The court recognised that it was reasonable for the lender to make a link between defaults relating to the Credit Risk Interest and the impact on a potential refinancing. The court heard evidence that the borrower's ability to refinance their portfolio was "far from straightforward" and "finely balanced", such that even small changes in creditworthiness or interest rates could make refinancing impossible and force the lender to enforce its security (with which there were some concerns about value, particularly given one of the properties was owner-occupied).

Accordingly, while the Default Rate applied to different primary obligations and different legitimate interests (and treated them all the same way), the court was satisfied that each of the lender's interests was sufficiently strong so that the Default Rate did not amount to a penalty.

Tenders / offers of repayment

The court found that the express provisions of the agreement did not require the lender to accept an offer of repayment that sought to impose conditions, delay the receipt of funds beyond the defined repayment date or in some other way departed from the obligation to repay in the agreement.

In its view, the agreement plainly contemplated actual payment of the sum due by no later than the repayment date. A tender by the borrower and its director (in which the specific set of funds were set aside for the purposes of repayment) in accordance with those terms would stop interest from running on the loan. However, an offer of payment at some point in the future did not have the same effect, nor did such an offer conditional on funding being secured.

With the exception of one repayment, the borrower and its directors did not make an effective tender of or otherwise repay any sums due under the terms of the agreement. And where they had made offers, those were not offers of repayment but were, at most, contractual offers intended to vary the parties' existing rights and obligations to create new rights and obligations.

Accordingly, the balance of the loan due on the repayment date provided in the agreement remained outstanding and nothing the borrower and its directors had done had stopped interest from accruing.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.