A default interest clause in loan agreements imposes a higher interest rate when a borrower defaults, compensating lenders for increased risks and costs. However, if this clause is seen as punitive rather than compensatory, it may be considered a penalty clause and become unenforceable.
Our Banking Lawyers explain how to ensure enforceability by setting a proportionate interest rate, aligning it with legitimate interests, and ensuring borrowers receive legal advice before agreeing to the terms.
What is a Default Interest Clause?
A default interest clause is a provision often found in loan agreements and other lending agreements that generally compensates the lender for the additional risk and administrative costs associated with a default arising from a failure to fulfil an obligation under the contract.
Default interest is usually a higher interest rate than the standard rate of interest charged.
The following are the most common default scenarios that trigger default interest becoming payable:
- non-payment of the debt on the due date;
- non-payment of any accrued interest in relation to the debt;
- breach of any representation (a statement which may induce a party to enter into an agreement), warranty (assurance that a statement of fact is accurate) or covenant (agreement to do or not to do something) under the agreement; and
- a bankruptcy or insolvency event occurs (depending on whether the borrower is an individual or legal entity).
The default interest continues to accrue from the date of default until the default is remedied (if capable of being remedied), the loan is repaid, or the interest is waived.
What is a Penalty Clause?
A penalty clause is a provision in an agreement that aims to punish a party for breaching the terms of the agreement and acts as a deterrent.
If a court determines that a default interest clause serves a punitive rather than compensatory purpose, the default interest will be deemed a penalty clause and will, therefore, not be enforceable.
As such, the court will delete the clause from the agreement, but the default interest rate will not be replaced with an alternative one.
However, to conclude, the court must assess each case based on its specific circumstances, as an interest rate may be deemed a penalty in one case but not in another.
Three-Stage Test
To determine whether the default interest clause is a penalty clause, the following three principles need to be considered:
- Is the clause a secondary obligation triggered by a breach of a primary contract obligation?
- Does the clause protect the lender's legitimate interests regarding the main obligation?
- Is the clause "extortionate, exorbitant or unconscionable"?
This test requires the court to consider whether there is any legitimate interest to be protected and, if so, whether the default interest rate is proportionate to that interest based on the circumstances.
For instance, the parties' bargaining power will be relevant when considering the legitimate interest test.
When a contract is negotiated between well-advised parties with similar bargaining power, the default interest clause is more likely to be considered by the court to be commercially justifiable due to the presumption that the parties will have factored in fairness and proportionality before agreeing.
How to Limit the Risk of Default Interest Being Classed as Penalty?
To limit the risk of default interest being a penalty clause, lenders should ensure that:
- The borrower received legal advice - this can be achieved by making the entry into the relevant contract conditional upon the borrower receiving independent legal advice evidenced by a certificate;
- The uplift is not excessively high, as judged by the comparison with market rates when the loan agreement is made. This means the increased interest rate should align with or reasonably close to the prevailing market rates when the loan agreement is made.
By doing so, the lender demonstrates that the default interest is a fair and justifiable response to the borrower's default; - Where possible, a genuine pre-estimate of loss is provided in the contract, and consider where it is not, whether the interest charged is commercially justifiable;
- The higher interest rate only applies while the default is ongoing; and
- The interest reflects the lender's legitimate interest and is proportionate to the same.
Contact Our Banking Lawyers
Whilst default interest clauses are likely enforceable, provided the amount of increased interest payable is proportionate to the risks faced in a default scenario, lenders and borrowers should be aware of the importance of striking a balance between the extent of the uplift and the legitimate interest criteria.
For more advice regarding Default Interest Clauses, contact our Banking Lawyers on:
01619414000
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Palma Percze
Associate
Palma is an Associate in our Corporate Commercial Team. Palma has experience assisting with various corporate matters including M&As, disposals, reorganisations and drafting shareholders’ agreements and articles.
About Palma Percze