Could your Default Interest Clause be Unenforceable?

A default interest clause is a provision often found in loan agreements and other lending agreements that generally compensates the lender for the additional risk and administrative costs associated with a default arising from a failure to fulfil an obligation under the contract.

Default interest is usually a higher interest rate than the standard rate of interest charged.

The following are the most common default scenarios that trigger default interest becoming payable:

• non-payment of the debt on the due date;
• non-payment of any accrued interest in relation to the debt;
• breach of any representation (a statement which may induce a party to enter into an agreement), warranty (assurance that a statement of fact is accurate) or covenant (agreement to do or not to do something) under the agreement; and
• a bankruptcy or insolvency event occurs (depending on whether the borrower is an individual or legal entity).

The default interest continues to accrue from the date of default until the default is remedied (if capable of being remedied), the loan is repaid, or the interest is waived.

To determine whether the default interest clause is a penalty clause, the following three principles need to be considered:

1. Is the clause a secondary obligation triggered by a breach of a primary contract obligation?
2. Does the clause protect the lender's legitimate interests regarding the main obligation?
3. Is the clause "extortionate, exorbitant or unconscionable"?

This test requires the court to consider whether there is any legitimate interest to be protected and, if so, whether the default interest rate is proportionate to that interest based on the circumstances.

For instance, the parties' bargaining power will be relevant when considering the legitimate interest test.

When a contract is negotiated between well-advised parties with similar bargaining power, the default interest clause is more likely to be considered by the court to be commercially justifiable due to the presumption that the parties will have factored in fairness and proportionality before agreeing.

To limit the risk of default interest being a penalty clause, lenders should ensure that:

• The borrower received legal advice - this can be achieved by making the entry into the relevant contract conditional upon the borrower receiving independent legal advice evidenced by a certificate;
• The uplift is not excessively high, as judged by the comparison with market rates when the loan agreement is made. This means the increased interest rate should align with or reasonably close to the prevailing market rates when the loan agreement is made.
  
  By doing so, the lender demonstrates that the default interest is a fair and justifiable response to the borrower's default;
• Where possible, a genuine pre-estimate of loss is provided in the contract, and consider where it is not, whether the interest charged is commercially justifiable;
• The higher interest rate only applies while the default is ongoing; and
• The interest reflects the lender's legitimate interest and is proportionate to the same.