A penalty clause is a contractual provision that imposes a financial or other detriment on a party if they breach the contract, which goes beyond compensating the innocent party for actual loss.
Under English law, such clauses are unenforceable if they are deemed penal rather than a genuine and proportionate means of protecting the innocent party’s legitimate interests.
In Houssein v London Credit Ltd [2025] EWHC 2749 (Ch), the Court revisited the legal test that is applied to assess whether a contractual provision is an unenforceable penalty clause, and the Court's decision provides useful guidance to financial lenders who intend to include default interest provisions in their contracts, which are triggered in the event of a breach.
Background
Ali and Nuray Houssein had built a residential property portfolio secured against several properties known as the "Downhills Way" properties and their family home at 71 Hamilton Road.
London Credit Ltd (LCL) advanced a £1.881 million bridging facility to CEK Investments Ltd, a company owned by the Housseins, supported by personal guarantees and charges over the property portfolio but subject to a condition that the Housseins would not live at 71 Hamilton Road.
However, an inspection before drawdown revealed that the Housseins had breached this condition by residing at 71 Hamilton Road. Upon the Housseins refusing to vacate the property, LCL sought to enforce the agreement to recover the full balance of the loan plus interest at a default rate of 4% (compounded monthly) (the Default Interest Provision).
At the first trial in the High Court, the Default Interest Provision was held to be unenforceable as an unlawful penalty clause.
However, this decision was overturned by the Court of Appeal on the grounds that the High Court had incorrectly applied the relevant test for determining whether a contractual provision is a penalty clause (and therefore unenforceable).
The Makdessi Test
The relevant test for penalty clauses was established by the Supreme Court in Cavendish Square Holding BV v Talal El Makdessi [2015] UKSC 67.
There are three stages to the Makdessi Test:
- Is the clause a primary or secondary obligation? The rules on penalty clauses apply only to obligations operating on breach (i.e. secondary obligations), and not primary obligations or clauses triggered by non-breach events.
- Is there a legitimate interest? Legitimate interests may extend beyond compensation (for example, protecting goodwill, ensuring operational systems, or deterring conduct that endangers regulatory status).
- Is the provision proportional? Even where a legitimate interest exists, the provision will be a penalty if the stipulated detriment is extravagant/unconscionable relative to that legitimate interest.
The outcome
Following the Court of Appeal's decision that the High Court had originally failed to properly apply the second and third stages of the Makdessi Test, the High Court went back to undertake a more comprehensive analysis of LCL's legitimate interests, by identifying and then assessing the following five categories:
- The repayment interest – i.e. the lender's basic interest in timely repayment of the loan.
- The non-residence interest: as an unregulated lender barred from providing regulated mortgages, LCL had a strong interest in strict observance of the non-residence covenant to avoid severe regulatory risk.
- The security interest: preserving the security protecting the loan.
- The representation interest: ensuring the truth of representations made at inception which underpinned the decision to lend.
- The credit risk interest: the predictive risk that third-party defaults or enforcement against a borrower would increase the likelihood or cost of default or refinancing.
Taking all of these elements into account, the High Court held that the Default Interest Provision, whilst at the upper extremity, was not extravagant or unconscionable in the circumstances and was therefore proportionate and enforceable.
Summary
Whilst the necessity and proportionality of every proposed contractual provision should be considered on its own specific facts, this case provides reassurance to financial lenders that default interest clauses which are triggered in the event of breach can be enforceable, providing that the applicable interest rate can (a) be justified with reference to clearly identifiable legitimate interests, and (b) is proportionate to the potential risk and losses to the lender.
