The standard position is that parties have freedom of contract, i.e. they can set and rely on whatever provisions they wish to include in their contracts. Nonetheless, there is a risk that certain provisions may be considered punitive and are therefore a penalty and unenforceable on grounds of public policy. This is referred to as the rule against penalties. 

The rule against penalties interferes with freedom of contract which otherwise gives the parties certainty about their legal obligations. Accordingly, courts will not easily declare provisions as penalties. In assessing if a provision is a penalty, the court will apply the following standard principles developed in case law: 

1. Breach – the provision in question must be a secondary obligation triggered by a breach of a primary obligation, for example, where an obligation to pay default interest (the secondary obligation) is triggered by the non payment (breach) of amounts when due (the primary obligation). In other words, the rule against penalties can only apply in relation to obligations arising out of a default.
2. Legitimate interest – the relevant clause must seek to protect the legitimate interest of the innocent party, for example a lender will wish to protect its position, as a defaulting borrower constitutes increased credit risk. 
3. Extravagant and unconscionable – the provision must not impose a detriment on the breaching party out of all proportion to any legitimate interest of the innocent party in enforcing the primary obligation. In other words, the interest of the innocent party cannot be to simply punish the breaching party. This means that the default rate of interest must reflect the greater credit risk to the lender and must not be exorbitant or unconscionable. 

The onus lies on the party alleging that the clause is a penalty to show that the secondary liability is exorbitant, extravagant or unconscionable. 

Courts have accepted that there is legitimate interest in charging a higher rate of interest where the borrower is in default due to the increased credit risk of a borrower whose covenant strength has come into question. 

The market appears to have settled on a default interest rate of 1-2% above the standard rate of interest chargeable under the loan agreement. However, whether a rate is exorbitant, extravagant or unconscionable must be assessed objectively and will depend on the facts and circumstances of the particular case.

For example, the same rate of default interest has been deemed an unenforceable penalty in one instance but an enforceable position in another. In Ahuja Investments Ltd v Victorygame Ltd and another [2021] EWHC 2382 (Ch) a default interest rate of 12% (being a 400% increase) was considered obviously extravagant, exorbitant and oppressive. However in Cargill International Trading PTE Limited v Uttam Galva Steels Limited [2019] EWHC 476 (Comm) a default rate of LIBOR plus 12% was held not to be a penalty. 

In Cargill, the judge relied on market rate evidence that was comparable to the default rate of LIBOR plus 12% and had the comfort of additional evidence showing that the defendant’s other borrowings at the relevant time were also at higher pre-default rates. The loan from Cargill was also unsecured and therefore presented a higher credit risk which would attract higher rates. 

Conversely, in the Ahuja case, there was no evidence of market rates at the time of the loan agreement or that the rate was genuinely assessed against borrower creditworthiness. Additionally, the loan was secured and there was no evidence to support the rate in the context of the covenant strength of personal guarantors or the second legal charge granted to the lender.

Accordingly, a default rate that is “too high”, in the context of available market rates at the time of contract formation, the risks involved, the nature of the parties (and whether they are commercial parties or consumers) and the security available is likely to be deemed penal and unenforceable.

If the default rate is considered penal, it is unenforceable and the lender cannot rely on it. Instead, a lender would have to bring a claim for damages which courts would assess in line with established common law principles. Depending on the drafting, even the standard rate of interest in the loan agreement may  not provide a fall back if the default rate has been found to be a penalty and therefore unenforceable. 

Higher default interest rates are commercially justifiable due to the increase in credit risk of a defaulting borrower, however the rate cannot be arbitrary and must be proportionate to the lender’s interest in the timely repayment of the loan. A default interest rate that is so high that it is deemed extortionate, exorbitant or unconscionable, will be an unenforceable penalty. Interest rates must be set carefully and should be assessed against and proportionate to the increased credit risk. The drafting of interest provisions must be accurate and unambiguous to ensure it is clear what interest rate is payable and when.