Penalising default interest: a spotlight on the bridging loan market

Earlier this year, the High Court ruled that a clause in a loan agreement which imposed a default interest rate of 4% per month constituted a penalty and was thus unenforceable.

The case of Houssein vs London Credit Limited (Houssein) has shone a spotlight on default interest clauses and clarified that

1. such provisions should be tailored on a transaction by transaction basis to protect the "legitimate interest" of the lender; and
2. rates of default interest must be proportionate to the risks faced by the lender in a default scenario.

Tangentially, Houssein also highlights regulatory issues about lending arrangements involving individual borrowers, considered below.

Non-residency covenant and implications of default

Houssein featured an unregulated lender who provided a 12-month bridging loan of £1.9m to a borrower company owned by two individuals (the Owners). The loan was secured over a group of five buy-to-let properties and a house that was the former residence of the Owners. The house was reported to be vacant when the loan was made.

It was a term of the loan agreement that neither the Owners nor any related persons should reside in any of the properties. However, less than a month after advancing the loan, the lender claimed a default on the basis that the Owners were living in the house.

The loan agreement provided that, in the event of a material breach, the lender would be entitled to appoint a receiver to sell the properties and apply default interest at the rate of 4% per month. The default interest rate was quadruple the standard interest rate payable under the loan agreement. The borrower claimed that the lender was aware that the Owners were living at the property in question at the time when the loan was made, but also argued, as a secondary defence, that the default interest was unenforceable as a penalty.

The judge found in the borrower’s favour on both points, determining that:

1. there had been no default under the loan agreement as the lender had actual knowledge that the owners were residing in one of the properties and therefore had waived the non-residence requirement; and
2. in any event, the default interest provisions were unenforceable as they amounted to a penalty.

Unenforceable default interest 

Houssein affirmed the test in Cavendish vs Makdessi, which questioned whether the default interest rate protected the "legitimate interest" of the lender. In other words, did the underlying breach (in this case, of the non-residency covenant) impose a liability on the borrower that was disproportionate to any legitimate interest of the lender in the commercial context of the loan agreement.

The court accepted that charging a higher rate of interest on a default could be commercially justified to compensate for an enhanced credit risk of a borrower. However, in this instance the default interest rate was set centrally by the lender and applied to:

•  all defaults regardless of the nature of the breach; and
• all borrowers across the lender’s loan book. Therefore, it had not been set by reference to the specific risks of the particular borrower or loan.

Regulatory concerns – lending to individuals

It is likely that the non-residence requirement was to ensure the loan was excluded from the definition of a "regulated mortgage contract" for the purposes of the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (RAO).

Lenders should exercise caution when considering providing a loan to an individual or trustee and structuring the loan as an unregulated mortgage contract, as the consequences that flow from non-compliance with the RAO are severe.

Specifically, regulated loans entered into contrary to relevant rules are unenforceable against the other party. The lender may also be guilty of a criminal offence, punishable by up to two years imprisonment and, or, an unlimited fine. 

From a commercial perspective, the risk of reputational damage cannot be understated. Additionally, failure to properly consider the regulatory aspects when structuring the arrangements could lead to a protracted and costly legal dispute, diverting crucial time and resources from other commercial activities.

Conclusions 

Charging a higher rate of default interest on the basis of an enhanced credit risk for a borrower is an acceptable principle. However, lenders should:

1. give default interest provisions, particularly in template documents, proper consideration and not adopt a one-size-fits-all policy where "standard" rates apply;
2. consider keeping records of the decision making process when determining the default interest provisions for each loan;
3. review their standard terms and seek to ensure that default provisions protect the lender’s legitimate interests. For example, seeking to apply default interest rates to only material breaches of the loan agreement which genuinely enhance the borrower’s credit risk such as non-payment defaults or, potentially, financial covenant breaches (noting that the Loan Market Association precedent facility wording applies default interest to unpaid amounts only, in which case the lender’s credit risk can easily be said to be increased); and
4. obtain specialist legal advice in the early stages of the transaction to ensure the arrangements are structured correctly to benefit from any available exemption in the RAO. The UK’s financial regulatory regime is complex and often difficult to navigate and the penalties that can arise can be severe.