Is Your Default Interest Clause Enforceable?

The vast majority of loan agreements will contain a default interest provision which provides a contractual sanction against non-payment of a sum of money. Care must be taken however in the lender's choice of default rate and the manner in which it becomes payable, otherwise such provision may risk being invalid as a penalty. Recent case law has confirmed the new approach which a court will adopt when considering whether a particular provision can be regarded as a penalty (and will consequently be void and unenforceable).

When deciding whether or not a contractual term is penal, the traditional approach of the courts has been that the clause will be enforceable if it does not exceed a genuine attempt to estimate in advance the loss which the claimant would be likely to suffer from a breach of the obligation in question.

However, in relation to default interest clauses, any future "loss" following breach of a loan agreement is likely to be very difficult for a lender to quantify. English law has recognised this and default interest clauses are nevertheless commonly upheld despite not being genuine pre-estimates of the loss, provided that the increased rate of interest is not "commercially unreasonable".

The two usual justifications for a lender charging a higher rate of interest following a borrower's default are:

it reflects the lender's enhanced credit risk by it being effectively forced to lend to a borrower who, by the very fact of its non-payment, has become a questionable credit risk; and a loan which has gone into default involves more time and expense to administer and monitor. The modern approach:

It appears that above attitude in respect of default interest provisions now applies to all contractual terms when analysing if they are penal or not and courts' are now reluctant to strike out a specified amount as penal just because the amount specified is greater than the actual loss.

The recent case of Cavendish Square Holdings BV v Makdessi [2012] EWHC 3582 confirms the modern approach i.e. that when considering whether a term is a penalty, emphasis is not placed on whether or not the term equates to a genuine pre-estimate of loss, but rather to...