Bold reality check: even high default interest rates can be enforceable if they’re commercially justified and properly evidenced. A London High Court ruling has clarified how the penalty clause test applies to default interest in lending, marking a meaningful shift for lenders evaluating risk and enforceability.
The court rejected CEK Investment’s claim that a 4% per month default rate (compounded) charged by London Credit amounted to a penalty clause. Deputy High Court Judge Richard Farnhill found that while 4% is above typical market rates, it is not inherently unreasonable. The rate represents the lender’s protection in a high-risk, short-term lending model, which is a legitimate objective when adequately justified.
Eilidh Smith, a financial services disputes expert at Pinsent Masons, notes that the decision clarifies how the penalty clause test from the UK Supreme Court’s Cavendish Square Holdings v Makdessi (2015) should be applied to default interest. The Makdessi ruling established that a clause is an unenforceable penalty if it’s a secondary obligation that imposes a detriment disproportionate to the legitimate interests of the non-breaching party in enforcing the primary obligation.
This judgment signals how courts will approach Makdessi in relation to default interest rates, a development lenders will want to monitor. It shows that above-market rates can still be enforceable if the justification is strong and demonstrable. This outcome is particularly encouraging for lenders involved in high-risk financing, such as bridging loans.
The case centers on a £1.88 million bridging loan CEK took from London Credit, secured on multiple properties including the directors’ family home. The loan carried a 1% monthly interest rate plus a 4% per month default rate. London Credit claimed CEK breached the agreement and moved to enforce, including seeking default interest.
CEK’s defense hinged on a default event—the Housseins’ residence at the family home—breaching a non-residence clause. After London Credit appointed fixed charge receivers to liquidate the properties securing the loan, CEK and the Houssein family challenged the default rate as a penalty.
In June 2023, the High Court ruled the default rate to be an unenforceable penalty. That ruling was overturned on appeal in 2024, which held the High Court had applied the wrong test and remitted the matter for reconsideration.
Emilie Jones of Pinsent Masons explains that while lenders may welcome the decision, it underscores the need to assess any proposal to set a single, static default rate across multiple primary obligations—such as non-payment on the due date and a breach of a non-residence condition. The court emphasized evaluating the legitimate interests behind each primary obligation individually. If the default rate is extortionate under any one interest, it fails overall.
The judgment identified several legitimate lender interests protected by the default rate, including a strong interest in loan repayment and a strong interest in safeguarding the non-residence requirement due to potential catastrophic consequences when lending against a borrower’s primary residence, particularly for an unregulated lender like London Credit.
Ultimately, the court found the default rate not extortionate with respect to these interests or others labeled as security, credit risk, and representations. However, it highlights a crucial practice: lenders considering a single default rate across diverse primary obligations must demonstrate justification grounded in the legitimate interests of each obligation and document the rationale.
Key takeaway for lenders: when drafting or enforcing default interest provisions, it is vital to tie the rate to clearly articulated, evidence-backed interests tied to each breached obligation, and to be prepared to explain how the rate remains proportionate across all linked primary duties.
