A feature so common in transactions that its inclusion is rarely contested is a default interest provision, which allows the financier or lessor to claim default interest on unpaid amounts. REN Legal asset finance partner Adam Longney and senior associate Zara Asif write.

A default interest provision is widely perceived as justifiable on the basis that once a borrower or lessee has defaulted, it represents a different – indeed, greater – credit risk to the financier or lessor than at the time of entry into the transaction, and the cost of assuming that greater risk should be compensated.

It is also a well-established tenet of English contract law that parties are free to choose with whom and on what terms to contract; with certain exceptions and limitations, English law will generally uphold the parties’ agreement.

One notable exception to the freedom of contract is the rule against penalties, which renders a contractual provision unenforceable if it is considered to be a penalty. In the recent case of Cargill International Trading Pte Ltd v Uttam Galva Steels Ltd [2019] EWHC 476 (Comm), the High Court considered whether a default compensation provision in a commercial contract fell foul of the rule against penalties.

The brief facts of the case are as follows: Cargill and Uttam, two sophisticated market participants in the Indian steel industry, entered into two Advance Payment and Steel Supply Agreements (APSAs) as they had done previously on similar terms over the course of the previous 10 years.

Under these APSAs, Cargill agreed to make certain advance payments to Uttam in respect of contemplated future sales by Uttam of steel products to Cargill. Uttam agreed to repay these advances within a specified period, either by the sale of the steel products to Cargill or, if such sales were not concluded, in cash. In essence, these arrangements amounted to a form of unsecured financing for Uttam.

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Between February 2015 and July 2015, Cargill made advance payments to Uttam in an amount totalling $61.8m (€55.2m). Uttam suffered from the downturn in the steel market and did not repay the amounts due to Cargill under the APSAs.

The APSAs provided that default compensation would accrue on unpaid amounts at “the rate per annum equal to one month Libor plus an additional margin of 12%”. During subsequent court proceedings brought by Cargill, Uttam argued, among other things, that this default compensation provision amounted to a penalty and is therefore unenforceable.

Two-stage Test

At first glance, a default rate of Libor plus an additional margin of 12% may seem unusually high, hence Uttam’s arguments that it amounted to a penalty. However, applying a two-stage test set out by the Supreme Court in Cavendish Square Holding BV v Makdessi [2015] UKSC 67, the High Court in the Cargill case concluded that the default compensation provision in the APSAs did not amount to a penalty.

The first stage of the test applied in the Cargill case was whether the default compensation provision imposed a detriment on Uttam “out of all proportion to any legitimate interest of Cargill”.

On this point, the court found that Cargill had a legitimate interest in ensuring that Uttam repaid the money advanced by Cargill at a time when Uttam had undertaken to repay it. The court also noted that it is “self-evident that there is a good commercial justification for charging a higher rate of interest on an advance of money after a default in repayment. The person who has defaulted is necessarily a greater credit risk and ‘money is more expensive for a less-good credit risk than for a good credit risk’”.

The first stage of the test having been satisfied, the court went on to consider the second stage: whether, in the circumstances, the default rate agreed between Cargill and Uttam was “exorbitant or unconscionable in its amount or in its effect”.

On this point, the following factors were relevant to the court’s decision:

  1. The financing arrangements were unsecured and so would naturally have attracted a higher rate of interest due to the lack of security and, therefore, increased risk.
  2. The court was provided with evidence that the default rate selected was both (i) the commercial norm for Indian companies comparable to Uttam, particularly since the Indian steel industry was generally experiencing difficulties in 2015, and (ii) generally lower than Uttam’s average cost of financing at the time of default.
  3. Cargill was able to demonstrate that the default rate had been set to reflect Cargill’s genuine assessment of Uttam’s creditworthiness, particularly in the event of default when there would be an increased risk in general that Uttam would be unwilling or unable to repay sums in the future.

Given these facts, the court concluded that there was no basis for finding the default rate to be so exorbitant or oppressive as to constitute a penalty. The judge also pointed out that the courts are, and have consistently been, reluctant to declare a provision to be a penalty where it “has been freely negotiated at arm’s length between commercial parties and there is no indication of oppression”.

This case is a helpful illustration that an ostensibly high default rate will not necessarily be regarded as an unenforceable penalty – although, equally, it does not provide a definitive statement on how high a default rate would need to be for it to be considered a penalty, since this will depend on the specific facts in question.

It also provides useful insight into the courts’ approach to penalties, and factors that a court may consider when assessing whether a provision in a commercial contract falls foul of the rule against penalties.

by Adam Longney and Zara Asif