Court of Appeal clarifies key issues in loan agreement dispute

In this article, we look at the Houssein and others v London Credit Ltd and another [2024] EWCA Civ 721 case.

In a significant judgment for lenders and their advisors, the Court of Appeal recently addressed important issues surrounding interest rates, default interest, and unenforceable penalties in a case involving a loan dispute between CEK Investments Limited (Borrower) and London Credit Limited (Lender).

Background

• The dispute arose in respect of a £1,881,000 loan agreement (the Agreement) secured by mortgages over five properties, including a family home in Barnet, North London (the Barnet Property).
• A key term of the Agreement prohibited occupation of the Barnet Property during the loan’s term, a condition that the Borrower breached when its directors, members of the Houssein family, continued to live there.
• The Lender argued that this breach triggered the default interest clause in the Agreement, which was set at a rate of 4% per month (Default Interest), which was higher than the standard rate of 1% per month (Standard Interest).
• Initially, the High Court ruled that the Default Interest constituted a penalty and was therefore unenforceable. Both parties then appealed to the Court of Appeal.

What did the Court of Appeal consider in this case?

• Was the Default Interest under the Agreement an unenforceable penalty?

• Should the Standard Interest continue to accrue after the repayment date if the Default Interest was found to be an unenforceable penalty?

What amounts to an unenforceable penalty?

The Court of Appeal applied the leading case of Cavendish Square Holding v Talal Shawar, which established the test for determining whether a contractual provision amounts to an unenforceable penalty.

Under the Cavendish test, a provision constitutes a penalty if:

• the clause is a secondary obligation, only triggered upon a breach of a primary obligation;

• the non-breaching party has a legitimate interest in enforcing that primary obligation; and

• the secondary obligation is disproportionate to the legitimate interest, meaning it is "extravagant", "exorbitant," or "unconscionable".

Default Interest: legitimate interest and proportionality

The Court of Appeal recognised that lenders have a legitimate business interest in securing timely repayment and that higher default rates are common practice to reflect the increased risk. Considering whether the 400% increase between the Standard and Default Interest rates was commercially justified, however, the Court of Appeal found that the Default Interest was excessive and disproportionate to the risk that the Lender faced.  The Judge commented that an increase in an applicable rate of 200% upon default would reflect the increased risk to a lender in those circumstances.

The Default Interest was deemed unenforceable, on the basis that it was exorbitant and unconscionable.

Standard Interest: interpretation of the Agreement

Standard Interest not applicable after repayment date

The Court of Appeal also considered whether Standard Interest continued to accrue after the repayment date if the Default Interest was found unenforceable. The Court of Appeal concluded, closely analysing the wording of the Agreement, that the Standard Interest was expressly limited to the term of the loan. Once the repayment date passed, the Standard Interest ceased to apply.

Standard Interest not a fallback if Default Interest not applicable

The Court of Appeal also considered the meaning of the wording of the default clause of the Agreement which provided that interest should accrue on outstanding payments under the Agreement at either the standard rate, or default rate if applicable.  The Court of Appeal rejected the Lender’s argument that the relevant wording allowed Standard Interest to accrue after the repayment date in the absence of enforceable Default Interest. The Court of Appeal emphasised that Standard Interest and Default Interest were mutually exclusive, with one replacing the other depending on the status of the loan.

Conclusion and implications for lenders

The Court of Appeal’s decision offers key lessons for lenders and their legal teams:

• Default Interest rates and penalties: While higher interest rates after default can be commercially justified, the rate must be proportionate to the lender’s legitimate interest in securing repayment. Default rates that appear excessive, extravagant, or unconscionable are likely to be considered as penalties.

• Clear drafting of interest provisions: The Court of Appeal's emphasis on the clear language of interest provisions highlights the importance of precise drafting. Lenders should ensure that interest provisions clearly outline what happens after the loan term ends and avoid any ambiguities about which rates apply and when.

• Context matters: Courts will interpret contractual provisions within the wider context of the loan agreement, taking into account the ordinary meaning of the words used and the parties’ intentions. This reinforces the need for careful consideration when drafting complex loan documents.

For lenders, this case underscores the importance of balancing commercial interests with legal enforceability. While default interest rates can help manage credit risk, they must be proportionate to avoid being considered as penalties. For advisors, the case highlights that clarity in loan documentation, particularly around post-default and post-repayment interest, is essential in avoiding disputes and ensuring that the terms can withstand judicial scrutiny.

For further guidance in relation to interest provisions or loan documentation, please contact the Banking & Finance team at Foot Anstey.