Gerard Kelly and Gearoid Carey

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.

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, involved 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 — Hussein & Ors v London Credit Ltd & Ors [2024] EWCA Civ 721 — involving a default interest provision in a financing agreement and whether it was a penalty. Specifically, it had to consider 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 one per cent compounded per month. However, in the event of default the rate would rise to four per cent compounded per month.

In the English High Court — [2023] EWHC 1428 (Ch) — 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 Square Holdings BV v. Makdesi [2015] UKSC 67 had determined 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:

Instead:

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 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 make 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 — see Pat O’Donnell v Truck Machinery Sales [1998] 4 IR 191 — 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.

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.

• Gearoid Carey and Gerard Kelly are commercial disputes partners at Mason Hayes & Curran LLP.