In a case a rare example of a clause falling foul of the penalty rule, the High Court rejected a claim for default interest at the rate of 12% compounded monthly on the basis that it was an unlawful penalty.

The rule against penalties is well-known. Here the court was concerned with whether a default interest clause fell foul of this rule. Ahuja had borrowed a sum of money from Victorygame to buy one of Victorygames’s properties, and had subsequently defaulted on a scheduled payment, alleging misrepresentation (among other things). In response, Victorygame sought to enforce a provision of the loan agreement, which stated that interest at the rate of 12% compounded per month was payable on “the amount that may remain outstanding from the Redemption Date”.

The court undertook the penalty rule analysis in two stages. First, it considered whether the clause even imposed a secondary obligation; if the clause only imposed a primary obligation, then it could not be a penalty. Here, Ahuja argued that the clause was simply a primary obligation to repay to Victorygame a certain rate of interest on any outstanding amount on the Redemption Date. Interestingly, the court acknowledged that it might be possible for a penalty clause to be “disguised” as non-penal by reframing it as a primary obligation. Nevertheless, the drafting here was “not sufficiently clever”, and it was clear that the clause was meant to impose an obligation in the event of breach (ie it was a secondary obligation).

In the second stage, the court considered whether the obligation imposed was “out of all proportion to any legitimate interest” or otherwise “exorbitant, extravagant or unconscionable” (Makdessi). The court acknowledged that there were valid reasons for imposing a higher interest rate: the borrower who has defaulted is a higher credit risk. Nevertheless, there was no evidence adduced to the court justifying why the increase in credit risk merited a drastic fourfold increase in interest rate from 3% per month to 12%. Rather bluntly, the court suggested that if the increase had been lower (eg 200% or less), then it might have been prepared to accept the provision as non-penal with no supporting evidence. Ultimately, the court found that the default interest clause was indeed an unlawful penalty.

Judgment: Ahuja v Victorygame