Liquidated damages vs penalties in English law contracts
This area of English law is still a moving area, but one Supreme Court judgment has provided some clarity on this issue, at least how the rules apply to modern commercial contracts (see Cavendish Square Holding BV v El Makdessi; ParkingEye Ltd v Beavis [2015] UKSC 67). That said, there is no one-size-fit-all rule in terms of what default interest percentage would be appropriate in all circumstances, and a lot will depend on the type of contract in question, the commercial practice in the relevant industry, and the facts of each case (should there be a legal challenge of the provision).
As a general rule, if a clause is a liquidated damages clause, it is enforceable and the sum set out in the clause is recoverable as a debt (and there is no need to prove causation or actual losses). However, if it is a penalty, it will not be enforced beyond the actual loss of the claimant recoverable as damages (following the normal breach of contract rules, including remoteness, mitigations, etc.). It is always a matter of contractual interpretation and the relevant facts as to whether a provision is considered a penalty or not. The burden of proof lies with the party that challenges enforceability of the clause.
The relevant test (following the Cavendish case) is whether (a) the clause in question is designed to protect one party's 'legitimate interests' and (b) the fixed amount being paid is not exorbitant or out of all proportion to what the party is trying to protect. In terms of the “legitimate interests” limb, a contractual party can argue that a default interest clause recognises time value of money and that it is to be expected that they would require compensation for not having the use of the money they are owed. In terms of the amount agreed by the parties, the question is whether the sanction is way beyond a ‘norm’ and therefore potentially ‘unconscionable’ or ‘extravagant’. Consideration should be given to what is currently charged as an ‘industry norm’ (where there is one available) and, for example, what others charge in similar circumstances.
The court could also consider the relative bargaining positions of the parties. Where a contract is negotiated between properly advised parties of comparable bargaining power, there is a strong presumption that the parties are the best judges of what should be in the contract and the courts should not interfere. However, in situations where the contract is standard form and not negotiable, this presumption is unlikely to apply and the clause may be more difficult to enforce.
It is probably not a surprise that most case law in this area relates to lending arrangements, and therefore may not be very useful when determining what rate of interest would be considered acceptable by the courts in provision of services agreements. As a matter of practice, before the Cavendish case, lenders would commonly ask for a small uplift (of between 1% and 3%) to the contractual interest rate. In facility agreements, this would normally be in respect of an annual interest rate. Since that judgment, despite the reformulation of the penalties test, there does not appear to have been any obvious industry wide moves by lenders to increase the modest pre-Cavendish default interest rates. However, some recent cases do suggest that the courts are likely to uphold higher default rates when the circumstances and market evidence justify them.
In Cargill International Trading Pte Ltd v Uttam Galva Steels Ltd [2019] EWHC 476 (Comm), the parties entered into two advance payment and steel supply agreements, which were effectively financing facilities. The default interest rate for past due payments was agreed as the rate per annum equal to one month LIBOR plus an additional margin of 12%. The court was convinced by Cargill’s evidence that LIBOR plus 12% was comparable to the commercially available rate for comparable companies, especially given that this was unsecured lending in uncertain industry conditions. Indeed, Cargill produced evidence to the effect that LIBOR plus 12% represented a slightly lower rate in comparison to Uttam Galva’s other financing costs. The court also found that the disputed provision protected Cargill’s legitimate interest on the basis that charging a higher rate of interest on an advance of money after default was commercially justifiable due to the greater credit risk posed by defaulters.
In ICICI Bank UK Plc v Assam Oil Co Ltd [2019] EWHC 750 (Comm), the court held that a default rate of 4% per annum (on top of the agreed rate of interest comprising the margin and the LIBOR rate) was not a sum which was out of all proportion to ICICI's interest in the contract being performed and therefore was not a penalty.
In ZCCM Investment Holdings plc v Konkola Copper Mines Plc [2017] EWHC 3288 (Comm), a default rate of LIBOR plus 10% per annum in respect of unpaid amounts under a Settlement Agreement was held not to be a penalty. The judge observed that it was reasonable for ZCCM to require increased rates of interest upon default, on the basis that a borrower in default is not the same credit risk as a prospective borrower.
By contrast, in a later case to be reported on this issue (Ahuja Investments Ltd v Victorygame Ltd and another [2021] EWHC 2382 (Ch)), again dealing with a loan agreement, the court found a four-fold increase in the monthly interest rate from 3% to 12% (compounded monthly) in case of default to be an unenforceable penalty. 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 presented to the court justifying why the increase in credit risk merited a drastic fourfold increase in interest rate. Interestingly, the court suggested that if the increase had been lower (e.g. 200% or less), then it might have been prepared to accept the provision as non-penal with no supporting evidence.