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Default interest, in a loan agreement, at a rate of 4% compounded monthly, was not extortionate given the legitimate interests at play and so was not an unenforceable penalty, according to the High Court.
This, third judgment, follows an earlier High Court judgment which had found the converse: the 4% default interest rate was a penalty and unenforceable. That was then reversed by the Court of Appeal which, in doing so, clarified that the correct test for penalty clauses is to ask yourself: (1) is it a secondary obligation; (2) does the clause protect a legitimate interest; and (3) is it extortionate by reference to the legitimate interest?
The question, remitted back to the High Court, was: “having regard to the legitimate interest in the performance of the primary obligation, [is] the default interest provision … extortionate, extravagant or unconscionable in amount or effect”?
The question was to be assessed at the time the contract was signed. On the facts, the trigger for the default rate was a failure to repay on the due date.
What counts as extortionate?
As a helpful starting point, the court confirmed that what is “extortionate, extravagant or unconscionable” is merely “different ways of describing the same approach … [and that using] all three terms repeatedly is somewhat cumbersome and adds nothing to the analysis”.
Most of the analysis in this lengthy decision stems from the fact that the default interest could be triggered by more than one event of default, and, said the court, “[i]f, by reference to any one interest, the provision is extortionate it fails in relation to all of them”. This was said to be unlike other cases where only a failure to pay was at issue.
The court therefore felt compelled to identify the underlying legitimate interests in each of the events of default, and assess if the default interest rate was extortionate by reference to each of those interests. This was especially the case since “there was a presumption that a sum would be penal if it was payable in a number of events of varying gravity”.
The “strong initial” presumption against penalties
The court started from the position that, in “a negotiated contract between properly advised parties of comparable bargaining power”, the parties were the “best judge of what is legitimate”.
In the present circumstances, this presumption applied since:
the borrowers had options throughout the process, indicating they were not forced to take the loan on the terms provided;
experienced solicitors and a mortgage broker advised the borrowers throughout; and,
the borrowers were also “very experienced”.
Market practice as a benchmark?
The court then turned to consider whether “a 4% rate would ever not be extortionate” by considering expert evidence on what rates were commonly imposed in the market. The court found that the 4% default interest rate was “plainly above the range of market rates but not, in itself, unreasonable” in light of the strong initial presumption. It therefore appears that market practice may help to set what is generally seen as extortionate whatever the legitimate interest.
Testing all legitimate interests
The onus was on the borrowers to overcome the presumption that the provision was not penal. As a result, the court examined the relevant events of default and resulting legitimate interests, finding that there were five in play:
Repayment Interest: this was the interest that a lender has in having a loan repaid. It was accepted that this was a “very strong interest” given that it was the “sine qua non of a loan from the lender’s perspective”. Having considered the expert evidence, the court found that while the default rate was on the high end of what was commercially acceptable, it was not extortionate.
Representation Interest: this was the interest in representations made by the borrower being true. Given that these were the “basis of the whole Loan” and went to the “heart of the decision to lend”, the default interest was not extortionate.
Security Interest: this was the interest the lender had in the security being intact and realisable. This interest was accepted to be “highly significant in principle” as it was the “lender’s primary protection if there is default”. The default rate was not extortionate in this regard.
Non-residence Interest: this was the interest that the lender had in the property that the loan was financing not being used for residential purposes (since this would be an unregulated activity for this lender). This was found to be a very significant interest, described in the evidence as having “horrific” consequences including imprisonment. Accordingly, imposing a 4% default rate to protect this interest was not extortionate.
Credit Risk Interest: this interest, the court said, was capable of having two meanings. One was in the predictive sense: given what we know now, what is the likelihood of a borrower like this one defaulting (which requires a causal link). The other was in the descriptive sense: given that the borrower has defaulted, we know they were not good for their debt (which doesn't require a causal link).
The court had most difficulty in analysing the Credit Risk Interest. This was to do with the difference between an individual and a class when it comes to probability, and there not being an “inevitable” causal link between past and future default. Assume, for example, that A, B and C all took identical loans from a lender on similar terms to the Housseins. Imagine then that A has defaulted on an instalment for GBP20,000, B has not missed an instalment but is the subject of an historic GBP20,000 County Court judgment relating to a different loan, and C has received a letter claiming GBP20,000 due under a different loan. All three would be considered defaulters. However, the probability that A would default on the next instalment is likely to be greater than that for B (default in payment to someone else) and C (alleged default in payment to someone else). In other words, “if the probability of future default is lower for some of those present defaults, the interest in enforcing those provisions is on its face weaker”.
The court also found it troubling that the evidence suggested that past defaults (of the B type) would typically merit an increase of 0.3% on the base rate not the 3% increase via the default rate (to 4%) in this case.
Despite these concerns, the court ultimately ruled that the default interest was not extortionate when compared to the Credit Risk Interest. To do so, the court engaged in a technical analysis of the loan to value ratio, the interest cover ratio and the business model common to these types of lenders. In contrast to the first High Court hearing, it became clear to the High Court this time how precarious it was whether the interest cover ratio be achieved.
Post-match analysis
It remains to be seen whether other judges take the same forensic approach. In the meantime, lenders who wish to take a cautious approach may want to consider all legitimate interests that a default interest rate provision seeks to protect and satisfy themselves that the rate is not extortionate in relation to any one of them.
