Court Of Appeal Confirms Default Interest Clause In Loan Agreement Is Not Unenforceable Penalty

The Court of Appeal has dismissed an appeal against a High Court decision that a default interest clause in a short-term loan agreement was not extortionate, exorbitant, or unconscionable (and therefore not an unenforceable penalty clause): Houssein & Ors v London Credit Ltd & Anor [2026] EWCA Civ 830. 

As a reminder, in assessing whether a clause amounts to a penalty, the three-stage test drawn from Cavendish Square Holding BV v Talal El Makdessi (Rev 3) [2015] UKSC 67 is applicable. This test provides that a clause will not amount to an unenforceable penalty, unless it creates a secondary obligation triggered by a breach of contract and: (1) the clause is not in furtherance of a "legitimate interest" which the innocent party has in the performance of the primary obligation; and (2) the clause is "extortionate, exorbitant or unconscionable".

The appeal judgment represents the latest in a string of decisions between the same parties and arising out of the same facts. The original trial judge found that the default interest clause was unenforceable as a penalty, but this decision was overturned by the Court of Appeal (see our blog post), which found that the High Court had misapplied the law on penalty clauses and remitted the case back to the trial judge. On remittal, the High Court found that the clause was not an unenforceable penalty (see our blog post), but this decision was appealed to the Court of Appeal, and the present judgment represents the outcome of that appeal.

The Court of Appeal held that: (i) the default interest clause was commercially justifiable in light of the lender’s legitimate interests (in particular, in credit risk management); and (ii) no tender of payment had occurred sufficient to engage the equitable principle that interest should cease to run before repayment. 

The decision will be of interest to financial institutions insofar as it upholds the High Court’s judgment that: (i) a default rate of 4% compounded monthly was considered proportionate to the lender’s legitimate interest; and (ii) the borrowers’ offers of repayment were deemed insufficiently concrete to constitute a tender (and so, absent repayment, were ineffective to stop interest from accruing). It illustrates the margin of discretion afforded to lenders to include provisions to defend their legitimate interest in repayment, and the high bar that must be met for a court to intervene in a commercial bargain providing for interest to be paid.  

We consider the decision in more detail below. 

Background

The borrowers entered into a facility agreement with London Credit Limited (LCL). Following an alleged breach of covenant by the borrowers and consequential event of default under the facility agreement, LCL demanded repayment of: (i) the loan amount; and (ii) default interest at 4% compounding monthly, on the outstanding sums until the breach was remedied under a default interest clause. The borrowers did not pay the full sums demanded by LCL by the repayment date specified in the facility agreement. LCL subsequently appointed receivers to liquidate its security under the facility agreement and proceedings were issued by the borrower.

At first instance, the High Court found that there had been a breach of the facility agreement, but that the default rate under the default interest clause did not apply, because it did not protect any legitimate interest of LCL, and was therefore unenforceable as a penalty (per Makdessi). The High Court held that interest was payable on the standard basis under the standard interest clause, with such entitlement surviving the repayment date.

LCL successfully appealed the penalty finding (see our blog post), and the Court of Appeal remitted the issue for further hearing. At the remitted hearing, the judge also considered a new argument raised by the borrowers, namely that LCL had failed to accept offers of repayment and that interest should therefore have stopped running. The High Court (see our blog post) held that the borrowers had not done enough to stop interest running and that the default rate was not a penalty. The borrowers appealed.

Court of Appeal decision

In dismissing the appeal, the Court of Appeal considered:

1. When does interest stop running under a secured loan (short of repayment)? 
2. Was the default rate under the default interest rate clause a penalty?
3. If so, was LCL nevertheless entitled to statutory interest on the outstanding debt?

(1) When does interest stop running?

The Court of Appeal ruled nothing the borrowers did in this case stopped interest from running. 

The borrowers argued that, in the context of a loan intended to be discharged by a refinancing (and where a new lender will not in practice release funds until the old lender discharges its security), interest should cease to run from the point that the borrowers had an offer of new finance from a new lender which was capable of acceptance (whether or not it had actually been accepted). 

The Court of Appeal observed that the “essential bargain” between a mortgagor and mortgagee is that the mortgagor has use of the mortgagee’s money, and in return agrees to repay the money together with interest for the time that the loan remains outstanding (during which time, interest continues to run). Whilst an equitable principle acts to stop interest running where monies have been tendered but not repaid (which occurs where a mortgagee could have had the monies at a given date; has declined to take them; and they remain available), that had not occurred here. 

The essence of a tender is not just that a borrower offers to repay the entirety of a debt: it must be able to do so. The court referred to a number of key authorities supporting this proposition, including Rourke v Robinson [1911] 1 Ch 480. At the time the borrowers received offers of refinancing, they were in dispute with LCL about whether the default rate was properly chargeable – and each offer they received was made subject to conditions (eg that the dispute would be settled). In these circumstances, the offer made was conditional and therefore the borrowers had evidenced nothing more than an offer of future settlement – which is different to tender of repayment. 

The borrowers also argued that the Privy Council’s decision in Ҫukurova Finance & Anor v Alfa Telecom Turkey Limited [2013] UKPC 20 meant interest should cease to run not just where a lender receives an offer of repayment that it is obliged to accept as a matter of contract, but also where it receives an offer it should accept as a matter of equity. The Court of Appeal:

• doubted that a lender can be obliged to accept an offer of tender as a matter of contract;
• determined that, even if it can, on the construction of the facility agreement LCL was only obliged to accept an offer of tender in immediately available funds; 
• considered that the concept of a non-contractual offer that a lender “should” accept was too vague and unspecified; and 
• distinguished Ҫukurova on the basis that interest stopped running in that case because the loan had been discharged and the tendered funds set aside (in contrast to here – where there were never any monies set aside nor made immediately available). 

In an obiter comment, Lewison LJ (giving the leading judgment) suggested a binding commitment from a new lender to lend (albeit conditional on the release of security) might be sufficient to effect tender. Newey and Arnold LJJ reserved their position, considering it unnecessary to determine on the facts of the present case. 

(2) Was the default rate a penalty?

The Court of Appeal noted that: (i) the question of whether a default rate is a penalty is a value judgment (per Makdessi); and (ii) applying Re Sprintroom Ltd [2019] EWCA Civ 932, an appellate court should only overturn a first instance decision where persuaded it is wrong by reason of some identifiable flaw undermining the cogency of the conclusion reached (eg a gap in logic; a lack of consistency; or a failure to take account of some material factor). It should not carry out a balancing task afresh. 

At the remitted hearing, the High Court considered whether the default rate was extortionate in relation to each of LCL’s legitimate interests it was designed to protect, concluding it was not. In that assessment, the High Court separated out LCL’s legitimate interests, in particular focusing on the legitimate interest of a lender in the primary obligations that go to preserve a borrower’s ability to repay a debt when due (a Credit Risk Interest). LCL’s Credit Risk Interest was the focus of the borrowers’ appeal.

The Court of Appeal held the borrowers had failed to demonstrate an identifiable flaw in the High Court’s evaluative judgment sufficient to justify overturning the earlier decision. In particular:

• The High Court ruled LCL’s Credit Risk Interest justified an above market default rate as: 
  1. the borrowers’ contemplated exit route from the loan was via a refinancing, which represented LCL’s best chance of repayment; 
  2. this refinancing was precarious and could be derailed by anything that pushed up the interest rate at which a new lender was prepared to lend; and 
  3. the default rate was therefore tied to the borrowers’ refinancing (because several events of default could reasonably be expected to move the interest rate sufficiently to cause the refinancing to collapse).
• Whilst the borrowers argued that the facts could change (and, therefore, the precarious nature of the refinancing could improve), the Court of Appeal accepted the High Court’s reasoning that LCL was entitled to base its rate on the premise that an objective new lender would work on the facts as they were.
• The Court of Appeal also held that the High Court correctly applied Makdessi to determine that the causal analysis must be carried out as at the date the contract was entered into (not at the time of breach). Whilst this meant it could consider (for example) the possibility that part of the borrowers’ property portfolio might be let out during the lifetime of the loan, it was entitled to conclude it lacked the evidence to factor this into the assessment of LCL’s Credit Risk Interest. 
• Whilst the borrowers argued that LCL’s Credit Risk Interest was adequately protected without the default rate (which made the default rate a penalty per se), the Court of Appeal held that this was not the correct test. It restated that the test as whether the default rate is “out of all proportion” to the legitimate interest in question.

(3) Was LCL entitled to statutory interest on the outstanding debt?

The Court of Appeal concluded that the third question only arose if the default rate was a penalty, and therefore did not arise to be determined here. 

Accordingly, the appeal was dismissed.

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.