Default interest provisions as penalty clauses: recent lessons from Houssein v London Credit

In recent years, we have seen the enforceability of default interest clauses become a renewed focus for both lender and borrower clients. In this article, we discuss how the Supreme Court’s landmark decision in Cavendish Square Holding BV v Talal El Makdessi [2015] UKSC 67 (Makdessi), which fundamentally reshaped the “penalty rule”, shifting the focus from a genuine pre-estimate of loss to the protection of legitimate commercial interests, has been applied more recently in the case of Houssein v London Credit Ltd [2025] EWHC 2749 (Ch).

Background: the penalty rule and the Makdessi Test

Before we unpick the case of Houssein v London Credit Ltd, it is important to understand the penalty rule which was redefined in the case of Makdessi. The Supreme Court said that a provision would be a penalty if it was a secondary obligation which imposed 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 (the Makdessi Test). Prior to Makdessi, the Court would consider whether a breach of the primary obligation resulted in a “genuine pre-estimate of loss”. If the sum payable upon breach exceeded the highest pre-estimate of loss, it would be considered a penalty.

The Makdessi decision was then applied in another case, Vivienne Westwood v Conduit Street [2017] EWHC 350 (Ch), in which the Court set out a three-stage approach to determine whether a contractual provision is or is not unenforceable as a penalty. Put simply:

1. Primary/ secondary obligations: is a stipulation in substance a secondary obligation engaged upon breach of a primary contractual obligation?
2. Legitimate interest: identify the extent and nature of the legitimate interest of the person seeking to enforce the primary obligation in having that obligation performed.
3. Proportionality: determine whether or not, having regard to that legitimate interest, the secondary obligation is exorbitant or unconscionable in amount or in its effect.

Application in Houssein v London Credit Ltd

The case of Houssein v London Credit Ltd offers a helpful example of the Makdessi Test in practice.

The facts of the case

Mr and Mrs Houssein held residential properties as investments, and they granted security over certain of those properties to obtain finance. On the termination of a loan, they refinanced with an unregulated lender, London Credit Ltd (LCL). As an unregulated lender LCL was not authorised to make loans to individuals secured by way of mortgage over property where they resided. To address this, two steps were taken:

1. The loan of £1.881m was to be provided to a company owned by Mr and Mrs Houssein, called CEK Investments Ltd (CEK) (rather than to Mr and Mrs Houssein personally) and they provided personal guarantees and charges over residential properties in favour of LCL.
2. The loan agreement specified that the borrower was not to reside at any of the secured property, which included the family home of 71 Hamilton Road.

Shortly before drawdown of the facility, LCL inspected the properties and became aware that Mr and Mrs Houssein were residing at 71 Hamilton Road. The employee at LCL who undertook the inspection neglected to notify LCL of this fact, and drawdown later took place irrespective of the breach. Subsequently, LCL was made aware of the couple’s residency at 71 Hamilton Road and requested they vacate the property; however, Mr and Mrs Houssein refused.

LCL took enforcement action by relying on an alleged breach of the non-residency obligation in the loan agreement.

Original High Court trial

By the time of the original trial sums remained outstanding under the loan agreement. Repayment had been due by August 2021. £1.2m had been repaid in May 2021 and no further attempts to repay were made. Consequently, interest continued to accrue and there were two rates of interest under the loan agreement: the standard rate of 1% per month (the Standard Rate) and the default rate of 4% compounded monthly (the Default Rate).

Ultimately, the Judge in the original High Court trial found that the Default Rate was a penalty and so unenforceable because it did not pass the Makdessi Test of protecting the legitimate interest of LCL. The Judge considered the following factors as relevant to this finding:

• any credit risk relating to the borrower was mitigated by the strength of the assets securing the loan – for example, the Loan to Value (LTV) being 54% in circumstances where internal guidelines would have permitted a much higher LTV; and
• if the same default rate applied to breaches of all primary obligations (irrespective of their seriousness) then the lender would need identical protection for each of those obligations which could not be right.

The Judge also held that the Standard Rate continued to apply if the loan was not repaid by the repayment date stipulated in the loan agreement.

Court of Appeal

In 2024, both LCL and CEK appealed this decision. LCL claimed the Default Rate was payable on the amounts remaining unpaid after the repayment date and CEK claimed that the Standard Rate did not apply following the repayment date.

The Court of Appeal found that the High Court had failed to correctly apply the Makdessi Test on the following basis:

• Legitimate interest: it was inevitable that the lender had a legitimate interest in the enforcement of the primary obligation to repay sums due on the repayment date. There was evidently a good commercial justification for charging a higher rate of interest on a loan after a default in repayment, because a person who has defaulted is a greater credit risk. The Judge had incorrectly taken a subjective approach to this and focused on what it seemed to him that the lender was seeking to protect.
• Proportionality: the Court found that the High Court had failed to consider proportionality (i.e. was the Default Rate high enough to be considered extortionate, extravagant or unconscionable).

Having given judgment, the Court of Appeal returned the case to the High Court for the Judge to consider whether the Default Rate was high enough to be considered “extortionate, extravagant or unconscionable”. The Court of Appeal also held that if the Default Rate was disallowed the Standard Rate would not apply in its place.

Second High Court hearing

On reconsidering the question, the High Court Judge found that the Default Rate was not in fact a penalty. The Judge said that the Court of Appeal’s question required him to consider whether the Default Rate was extortionate not only by reference to the lender’s legitimate interest in repayment, but also by reference to the lender’s legitimate interest in all the primary obligations protected by the default interest provisions. If the Default Rate was extortionate by reference to any of those primary obligations, then it would be unenforceable in all circumstances.

The Judge grouped the events of default into categories of primary obligations and ultimately found that the lender had a legitimate interest in enforcing each category. The Judge’s reasoning can be summarised as follows:

• Failure to pay: the Judge said that the lender obviously had a legitimate interest in ensuring repayment of the loan.
• Representations and warranties untrue: the Judge was clear that the lender had a legitimate interest in enforcing representations given at the outset of the loan because the obligation to lend would not arise if these were not true. However, the Judge said the position was less certain where those representations became incorrect or incomplete as a result of circumstances arising later down the line.
• Security events of default: these included the security becoming unenforceable, damage or destruction of security property, and death or incapacity of a guarantor. The Judge said that a secured lender must have a legitimate interest in enforcing obligations for the protection of the security.
• Breach of non-residence requirement: given the lender’s unregulated status, the lender was prohibited from lending to individuals where the security was their primary residence, and it was therefore a legitimate interest of the lender to ensure any non-residence provisions were complied with.
• Credit risk events of default: these were events that relate to the borrower’s ability to repay the debt when due, such as the borrower defaulting on other borrowing or enforcement against the borrower’s property. The Judge described the lender’s interest in the credit risk of the borrower as weaker than the other interests identified, but ultimately accepted that past payment default was likely to correlate with future payment default and accepted this as a legitimate interest of the lender.

The Judge then considered whether the Default Rate was extortionate, and said that given that the borrower was experienced in this market it was capable of judging whether the Default Rate was legitimate and proportionate in the context (and Mr and Mrs Houssein had also received independent legal advice on the documentation and been advised by a mortgage broker).

Expert evidence had previously shown that while the Default Rate was at the “upper extremity”, it was not extortionate in the circumstances. Even a small shift in the borrower’s credit risk would impact the ability to refinance the loan, which would have been necessary for the lender to be repaid here. Therefore, it was not extortionate for the lender to apply an above market default rate where the borrower’s credit risk was affected.