Default interest clauses, although standard and rarely negotiated, can constitute a penalty if they are extravagant, exorbitant and oppressive. If a default interest clause amounts to a penalty, then the lender will not be able to recover the default interest.
The High Court, in Ahuja Investments Ltd v Victorygame Ltd and another  EWHC 2382 (Ch), found that the default interest rate in a loan agreement of 12% per month, compounded monthly, was in fact a penalty, as it represented a fourfold increase in the pre-default rate. Therefore, the interest was not recoverable by the lender.
In Ahuja, the claimant company alleged that it was induced to buy a commercial investment property, based on fraudulent or negligent misrepresentation of the length of the underlying tenancy agreements. A clause in a facility letter connected with the sale documentation set out a default interest rate of 12% per month, compounded monthly, representing a 400% increase in the interest rate applicable prior to default.
Was the default interest rate a fair reflection of the risk?
Default interest should represent an accurate reflection of possible risks and losses. For example, a lender can be justified to impose higher rate of interest when the borrower represents a high credit risk and had previously defaulted in repayment. There was no evidence in this case that the default interest rate was fixed to reflect the defendants' genuine assessment of Ahuja's creditworthiness in the event of default.
Therefore the question was whether the borrower had demonstrated (on the balance of probabilities) that the rate charged was “in all the circumstances, extravagant, exorbitant, or unconscionable”. The court found that the rate constituted a penalty. The court considered that Ahuja had discharged the burden of demonstrating that a 400% increase in the primary interest rate on default, when combined with the provision for monthly capitalisation of interest, was so obviously extravagant as to constitute a penalty.
Evidential issues and which rate should apply
No evidence was presented to the court detailing market interest rates at the time of the loan agreement, the risk factors involved, or the rationale for the default interest rate being set at a rate four times that of the interest rate applicable prior to the redemption date.
It was held that some interest should be recoverable, possibly at the rate applicable prior to default, therefore invited to further submissions on that point.
Interestingly, the court stated that they would accept, without supporting evidence, an increase of up to 200% in the applicable rate of interest on default to reflect the greater credit risk presented by a defaulting borrower.
Jonathan Porteous, Head of Banking and Finance at Stevens & Bolton, comments:
“Courts are traditionally reluctant to strike down clauses as penalties, especially in negotiated contracts. We typically advise that default interest rates can be justified if they correspond to a notional market rate for continuing to lend on an unsecured basis to a borrower who has just failed to pay when due. On that basis, one can expect pretty high interest rates to be defensible.
This case is an interesting example of a lender being too greedy – demanding a rate of approaching 300% on an annual basis. Notably the court may have been willing to accept a rate of half this amount, and an increase of 75% per annum on the original rate. So if anything, the case should be seen as an affirmation of more modest and appropriate default interest clauses.”