Extravagant, exorbitant and oppressive: When will interest in a commercial contract fall foul of the rule against penalty clauses?

This question has been revisited by the courts in the recent case of Ahuja Investments Ltd v Victorygame Ltd [2021] EWHC 2382 (Ch). In this case, Judge Hodge QC described the interest rate of 12% per month, compounded monthly, as so obviously extravagant, exorbitant and oppressive as to constitute a penalty.

The basics

A penalty clause is a contractual provision that forces the party in breach of a primary obligation to pay an excessive amount that is out of proportion to any legitimate interest of the innocent party in the performance of that obligation.

The general rule in English law is that a penalty clause will not be enforced by the courts beyond the actual loss of the innocent party.

This rule may appear to contradict the principle of parties' freedom of contract, which recognises that a contract should be enforced in accordance with its terms and allows parties to agree between themselves the consequences of a breach. However, the rule against penalty clauses aims to protect against unconscionable or oppressive provisions in a contract which punish the party in breach, instead of protecting the legitimate interests of the innocent party.

The test

Broadly, the test for determining whether a clause constitutes a penalty is:

“Whether the impugned provision is a secondary obligation which imposes a detriment on the contract-breaker out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation” (Lord Neuberger and Lord Sumption in Cavendish Square Holding BV v El Makdessi and Parking Eye Ltd v Beavis [2015] UKSC 67UIUI). 

Breaking it down into three parts, the Supreme Court test requires the party alleging that a clause is a penalty to satisfy the courts that:

1. The penalty clause operates on breach of contract.  I.e. It is a secondary obligation engaged by breach of a primary contractual obligation.
2. The clause seeks to protect a legitimate interest of the innocent party.
3. The provision is so extravagant or unconscionable that it is disproportionate to the innocent party's legitimate interest in enforcing the other party's obligations.

Applying the test

In Ahuja Investments v Victorygame Ltd, Judge Hodge QC asserted that it was the breach of the loan agreement that triggered the payment of default interest. He accepted that a lender has a legitimate commercial interest in applying a high rate of interest to a borrower who is in default because the borrower represents an increased credit risk, but noted that there was no evidence that this interest rate was fixed to reflect the seller's genuine assessment of the buyer's creditworthiness.

The Court held that the default interest rate in the loan agreement of 12% per month, compounded on a monthly basis, represented a 400% increase in the pre-default rate.  It was therefore so obviously extravagant, exorbitant and oppressive as to constitute a penalty.

The judge commented that he would be prepared to accept, without supporting evidence, a default interest rate that was twice the pre-default rate but would expect the lender to provide evidence to justify any greater increase.

Practical considerations 

When agreeing liquidated damages and interest clauses, the following should be considered:

1. Is the term in question a primary obligation?  This means that the remedy is linked to an external event rather than a breach of contract.   The courts will look at substance rather than form, and will be on the lookout for structuring put in place to convert a secondary obligation into a primary one. 
2. Similarly, express wording describing the relevant clause as a liquidated damages clause may be helpful but will not be conclusive.
3. Can the figure or interest rate be justified as representing a genuine pre-estimate of loss?  Or does it provide for excessive payment on breach?  
4. If the clause is not a pre-estimate of loss, it is otherwise commercially justified?
5. Consider putting in writing the reasons for the figure or interest rate being set at a particular level.

This article has been co-written by Robyn Watson (Senior Associate) and Annie Long (Trainee Solicitor)