Loan agreements and security documents usually contain a clause stating that if a borrower fails to pay an amount due on a due date, interest on the overdue amount will be due from that due date. In order to compensate for the additional costs resulting from the borrower’s late payment, the lender will be charged interest on arrears at a higher rate. Care must be taken to ensure that such clauses do not violate the rule against penalties. In this article, Pat Nyhan examines this rule and how it has evolved over the past few years.
Interest on arrears clauses
Interest on arrears clauses are often found in facility letters and other loan agreements, mortgages (and other types of security documents) and guarantees, and are also relevant in judgments. A mandatory interest rate is applied to enforcement debts (this was 8% for many years but was lowered to 2% in 2016), but since the mandatory interest rate may be lower than a lender’s target rate, a loan agreement, guarantee or security document that a default interest rate applies both before and after the judgment.
Interest rate provisions are standard and are usually not negotiated in a loan agreement. However, whenever a lender tries to impose default interest, the sanction rule must be considered because if an interest clause violates the sanction rule, it is unenforceable.
The rule against punishment
The Penalty Clause Act is designed to prevent a contracting party (the “innocent party”) from reclaiming an amount of money for an infringement that has little or no relation to the actual harm suffered by the innocent party. Ireland (and England and Wales by 2015) has been testing for around 100 years whether the clause in question is a genuine estimate of the likely harm that will be done to the innocent party. If it is not a true loss estimate, then it is a penalty (i.e., to punish the contract breaker rather than compensate the innocent party) and is unenforceable. The appeals court approved this test in 2018 in the cases of Sheehan versus Breccia  IECA 286 and Flynn versus Breccia  IECA 273 a surcharge of 4% above the facility interest rate (provided for in the Anglo Irish Bank Corporation plc Terms and Conditions) was deemed a penalty and therefore unenforceable.
The sanction rule applies to all contracts, but only affects payments that are triggered by a breach of contract (this is why the sanction clause is often referred to as a “secondary obligation” rather than a “primary obligation”). In the context of loan agreements, the penalty rule applies to late payment interest payable on amounts overdue (a “secondary obligation”), but not to interest payable on a loan when the borrower does not breach the contract (i.e., “normal interest “Which would be a main obligation).
UK Supreme Court decision
Many legal commentators have argued for a number of years that the traditional test is difficult for parties and courts to use (it is difficult to predict the outcome of any particular case involving this test). In England and Wales, the 2015 Supreme Court passed the traditional test in the case of Cavendish Square Holding BV v Talal El Makdessi and Parking Eye Limited v Beavis  UKSC 67 (in which two cases were linked). In this case, three Supreme Court judges (two of the five judges presented the test slightly differently) were the test to be used to determine whether the clause was an ancillary obligation that would place the breach of contract at a disadvantage in any proportion to a legitimate interest of the innocent party in the enforcement of the primary obligation. The courts of England and Wales have identified the amount of uplift as particularly important when considering penal clauses. This is assessed when the contract is concluded, usually by comparing it with market prices.
This test is believed to make it a little more difficult than the old test to successfully challenge a clause as an unenforceable penalty. Commentators in England and Wales note that while there has been no obvious industry-wide move by lenders to increase late payment rates (which typically range from 1% to 3%) in England and Wales, some recent cases suggest that the courts in England and Wales are likely to maintain higher default interest rates when circumstances and market data warrant it
An example of the application of the reformulated England and Wales Test in practice is the 2019 case of ICICI Bank UK Plc v Assam Oil Co Ltd  EWHC 750 (a decision by the High Court of England and Wales pertaining to a petition for a court ruling on behalf of a lender under a facility agreement) which found that an additional 4% per year was enforceable for late payment.
The penal code in Ireland has not yet been enacted within the meaning of Cavendish Decision, although emerging case law in England and Wales is likely to affect future Irish judgments in this area. At this point it is probably reasonable to say that the market in Ireland has generally settled on a default rate of 1% to 2% above the usual contract rate.
It is also noteworthy that in some cases contracting parties seek to avoid the potential application of the sanction rule entirely by making the relevant clause a primary rather than a secondary obligation. This approach may not be effective and in any event the courts will examine the reality of such clauses.