When is a penalty disallowed?

The case of Ahuja Investments Limited v Victorygame Limited concerned a number of issues arising from the sale of an investment property known as the “Himalaya Shopping Centre” in Southall and a loan agreement entered into by the parties to cover part of the purchase price. Following a lengthy trial, the main claim for damages for misrepresentation failed and the Judge then went on to consider the Defendant’s claim for repayment of a loan of £800,000 and interest.

The rate of interest payable by the Claimant during the term of the loan agreement was already pitched at a relatively high 3% per month. However, when the redemption date had passed and repayment not having been made, the interest rate increased fourfold to 12% per month with a compounding provision.

The Judgment

A number of interesting comments were made by the Judge on the enforceability of an interest rate which increased to this level.

The Judgment explains that the basic principle is that a penalty is a provision which operates on a breach of contract, and the Judge concluded in this case that the increase in the interest rate following the failure to make repayment constituted a penalty. The question the Judge had then to determine was whether the penalty is “exorbitant, extravagant or unconscionable”, and the onus is on the party challenging the penalty provision to show that this is the case.

The Judge accepted that a lender had a legitimate commercial interest in applying a high interest rate to a borrower in default, because it is inevitably the case that the borrower is an increased credit risk. It was noted that the initial rate of 3% per month was itself reflective of the risk in this case, where the Claimant had turned to the Defendant for a loan having been unable to obtain funds elsewhere. Nevertheless, here the Judge concluded that an increase of 400% was an unreasonable penalty and thus was unenforceable. Of particular note is his comment that he would have been prepared to consider an increase up to 200%, but if anything more was contended for, then he would expect a lender to adduce evidence to justify any greater increase.

As the penalty provision was struck down, the Judge was left to rely on the other terms governing interest at the original rate.

What do lenders learn from this?

When preparing loan agreements, it is important to ensure that the liability for interest at the original rate continues, just in case the enhanced rate is struck down as a penalty. Also, if a much higher rate is claimed in default, then the lender seeking to recover that rate will need to be in a position to evidence the basis for it being claimed by reference to the enhanced level of risk.