UK: Cavendish Square – How The New Penalties Test Affects Banking Transactions

Last Updated: 7 December 2015
Article by Adam Pierce

In Cavendish Square Holding BV v. Makdessi and ParkingEye Ltd v. Beavis, reported together at [2015] UKSC 67 (Cavendish Square) the Supreme Court reviewed, and significantly recast, the basis on which a contractual term will be treated as an unenforceable penalty. For a detailed review of the judgment and its general implications, see this Dentons client alert: Supreme Court unshackles the rule on penalties. Adam Pierce considers how the new rules are most likely to affect banking transactions.

Default interest

An easier test to apply

Most facility agreements include a "default interest" clause under which the borrower must pay interest on overdue amounts at a higher rate than would otherwise apply on the loan. This is the context in which banking lawyers most commonly consider the penalty test. Other than for very modest uplifts in the rate (e.g. 1 per cent), in the past it has often been difficult to get entirely comfortable that this type of obligation was beyond challenge. This was because, before Cavendish Square, it was widely accepted that an extra obligation arising on a breach risked being a penalty if it was not a "genuine pre-estimate" of the innocent party's likely loss. This was not an easy test to apply to a default interest obligation. Lordsvale Finance plc v. Bank of Zambia [1996] had provided some comfort that a failure to satisfy the "genuine pre-estimate" test might not be fatal if a default interest obligation was "commercially justifiable", but it was only a first instance decision.

In this respect, Cavendish Square is good news for lenders. It is likely to be easier to argue that a default interest obligation is neither:

  • "out of all proportion to the [lender]'s legitimate interest" in the performance of the borrower's payment obligations; nor
  • "extravagant, exorbitant or unconscionable",

than to argue that it represents a genuine pre-estimate of the lender's likely loss.

Islamic finance transactions

Before Cavendish Square, one of the key indicators of an unenforceable penalty clause was that its primary purpose was to deter breach, rather than to compensate for loss. This made "late payment" obligations in Islamic finance transactions (similar to default interest in conventional loans) particularly problematic. For Shari'ah reasons, the financier must usually give all or most of any late payment amounts it receives to charity. So it is difficult to argue that the clause's primary purpose is anything other than to deter breach.

This type of obligation is perhaps still more at risk of challenge than an equivalent clause in a conventional loan. However, Cavendish Square has made clear that clauses with a deterrent effect can still be effective if they have a commercial justification. The Islamic financier is likely to have commercial justification for deterring non-payment (it could suffer losses as a result) even if it cannot keep the amounts it would receive if the deterrent fails. There seems nothing inherently "extravagant, exorbitant or unconscionable" about this type of obligation.

Other additional cost provisions

The Supreme Court confirmed in Cavendish Square that the penalty rule only applies to terms operating on a breach of contract: the non-defaulting party must be trying to enforce an "exorbitant alternative to common law damages". As a result, various other types of fees and other payment obligations commonly arising in banking transactions would, as before, ordinarily fall outside the scope of the penalty rules.

Loan transactions commonly require borrowers to pay prepayment, profit sharing and other similar "exit" fees. The circumstances in which they are payable will always be deal-specific. But it would not be unusual to find that a default under a loan could ultimately lead to these types of fee becoming payable. For example:

  • A prepayment fee that applies whenever a loan is paid before its stated maturity may become payable because the lender accelerated the loan following a breach.
  • A profit sharing fee may become payable on the sale of a secured property. That sale might occur when the lender enforces its security following a breach.

But in neither of those examples is there an intrinsic link between the accrual of the fee and a breach of the agreement. The prepayment fee could equally have become payable because of a voluntary prepayment. The profit sharing fee could have become payable because the borrower had decided to sell the property. So in either case it would be difficult for the borrower to argue that the prepayment fee obligation is an "exorbitant alternative to common law damages". The parties clearly intended the fee to become payable in circumstances that do not involve a breach, where there would obviously be no question of damages.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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