Lending agreements and security documents typically contain a clause providing that if a borrower fails to make payment of a sum owing on a due date, default interest becomes payable on the overdue amount from that due date. Default interest is charged at a higher rate to compensate the lender for the additional costs incurred as a result of the borrower's failure to pay on time. Care must be taken to ensure that such clauses do not fall foul of the rule against penalties. In this article, Pat Nyhan looks at this rule and how it has developed in recent years.
Default interest clauses
Default interest clauses are often found in Facility Letters and other loan agreements, Mortgages (and other types of security document) and Guarantees and are also relevant in the case of judgments. A prescribed rate of interest is applied to judgment debts (this had been 8% for many years but was reduced to 2% in 2016) but as the prescribed rate may be lower than the rate that a lender seeks, it is standard to provide in a loan agreement, guarantee or security documents that a default rate will apply both before and after judgment.
Default interest provisions are standard and are not typically negotiated in any loan agreement however whenever a lender seeks to impose default interest then the rule against penalties needs to be considered, as if an interest clause breaches the rule against penalties then it is unenforceable.
The rule against penalties
The law relating to penalty clauses seeks to prevent a party to a contract (the 'innocent party') recovering a sum of money in respect of a breach which bears little or no relationship to the loss actually suffered by the innocent party. In Ireland (and in England and Wales up to 2015) the test applied for approximately the last 100 years is whether or not the relevant clause is a genuine pre-estimate of probable loss caused to the innocent party. If it is not a genuine pre-estimate of loss then it is a penalty (ie intended to punish the contract breaker rather than compensate the innocent party) and is unenforceable. The Court of Appeal looked at this test in 2018 in the cases of Sheehan v Breccia  IECA 286 and Flynn v Breccia  IECA 273 where a surcharge rate of 4% over the facility interest rate (provided for in Anglo Irish Bank Corporation plc Standard Terms & Conditions) was held to be a penalty and thus unenforceable.
The rule against penalties applies to all contracts but it only affects payments triggered by a breach of contract (therefore the penalty clause is often referred to as a 'secondary obligation' rather than a 'primary obligation'). In the context of loan agreements the rule against penalties will apply to default interest payable on overdue sums (a 'secondary obligation') but it will not apply to interest payable on a loan when the borrower is not in breach (ie 'normal interest' which would be a primary obligation).
UK supreme court decision
Many legal commentators have argued for a number of years that the traditional test is difficult for contracting parties and courts to navigate (it is hard to predict the outcome of any particular case where this test is at issue). In England and Wales in 2015 the Supreme Court restated the traditional test in the case of Cavendish Square Holding BV v Talal El Makdessi and Parking Eye Limited v Beavis  UKSC 67 (in which two cases were conjoined). In that case three of the Supreme Court Judges (2 of the 5 judges stated the test in a slightly different way) held that the test to be applied was whether the clause is a secondary obligation which imposes a detriment on the contract-breaker out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation. The courts of England and Wales have identified the size of the uplift as being particularly important when looking at penalty clauses. This is judged when the contract was made, normally by comparison with market rates.
It is thought this test makes it slightly harder than the old test to successfully challenge a clause as an unenforceable penalty. Commentators in England Wales point out that while there has been no obvious industry wide moves by lenders in England and Wales to increase default interest rates (which tend to be between 1% and 3%), some recent cases do suggest that the courts in England and Wales are likely to uphold higher default interest rates when the circumstances and market evidence justify them
An example of the restated England and Wales test being applied in practice is the 2019 case of ICICI Bank UK Plc v Assam Oil Co Ltd  EWHC 750 (a decision of the High Court of England and Wales which concerned an application for summary judgment for a lender under a facility agreement) where it was held that an additional 4% per annum for default was enforceable.
The law on penalties in Ireland has not yet been restated along the lines of the Cavendish decision, although the line of case law emerging in England and Wales is likely to influence future Irish judgments in this area. At present it is probably reasonable to say that in Ireland the market has generally settled on a default rate of 1% to 2% above the ordinary contractual rate.
It is also noteworthy that in some cases parties to contracts are seeking to avoid the potential application of the rule on penalties altogether, by framing the relevant clause as a primary rather than a secondary obligation. This approach may not be effective and in each case the courts will look at the reality of such clauses.