The new test sets a higher threshold, which will make it harder for commercial parties successfully to raise penalty arguments, particularly in circumstances where the terms of a contract were negotiated between sophisticated commercial parties of roughly equal bargaining power, who have been legally advised.
When dealing with simple default interest clauses, the bank’s legitimate interest will rarely extend far beyond compensation for the breach – in the form of additional interest compensating for any increase in the bank’s costs of funding the shortfall - and therefore (as recognised by the Supreme Court) the Dunlop principles (as outlined above) are still ‘good law’ as to whether a clause is penal. That said, the Supreme Court’s recognition that “compensation is not necessarily the only legitimate interest that the innocent party may have in the performance of the defaulter’s primary obligations” may provide a means by which a slightly higher rate of default interest may be found to be permissible – if it can be said, for example, that the rate protects the legitimate interest of the bank in ensuring payments are made on time in order to manage its own internal funding arrangements.
Of course, there is a wide spectrum of Clauses other than default interest provisions that potentially fall within the penalty rule. In recent years, the English Courts have considered the application of the penalty rule to clauses ranging from alternative default interest structures (such as a “facility fee” which resulted in enhanced interest being payable if the borrower was in arrears or otherwise in breach of the loan or security terms – see Aodhcon LLP v Bridgeco Ltd  EWHC 535 (Ch)), to a provision in an “Upside Fee Agreement” entitling a bank to receive a large fee upon default of a loan in a sale and lease back property financing (see Edgeworth Capital (Luxembourg) SARL v Ramblas Investments BV  EWHC 150 (Comm)) and, in the recent decision of Hayfin Opal Luxco 3 SARL v Windermere VII CMBS Plc  EWHC 782 (Ch) (“Hayfin”), provisions relating to application of a “Class X Interest Rate” to alleged historical underpayments of interest under a commercial mortgage-backed securitisation structure.
In Hayfin, Snowden J – although he did not decide the point – tended to the view that the relevant interest provision did constitute a penalty. As the holder of Class X notes in a commercial mortage-backed securitisation, Hayfin was essentially entitled to the excess monies in the hands of the issuer generated by the structure. The Class X interest rate was then calculated as the relationship between this amount and the principal value of the Class X notes on the relevant interest payment date. In other words, the interest rate bore no connection to contractual interest on monies invested in what the Court termed as the “conventional sense”. It was not consideration payable for use of the monies borrowed at a stated rate by reference to the principal amount borrowed and the period of the loan but a sum that was entirely independent of the principal value of the notes. Between 2006 and 2009, the Class X rate varied between 2,700% and 6,001%.
At the time of contracting, the parties could have foreseen that the Class X rate would have no relationship to the level of damage that would be suffered by the Class X holder in the event of underpayment of interest. Further, the parties also could have foreseen that the application of the Class X rate to any shortfall would be a very large multiple of the unpaid amount every quarter, consequently amounting to a sum that was “many times the amount that would adequately compensate the innocent party for being kept out of its money”. The Court consequently found that the Class X rate was potentially so exorbitant that it could have been out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation.
On the facts of the case, the Court ruled as a matter of construction that Class X interest had not been payable. Also, the Court did not decide whether the accrual and payment of the Class X rate was properly categorised as a conditional primary or secondary obligation so as to bring the penalty doctrine into play. However, if it had been applicable, the Court’s findings strongly suggest that the interest provision would have been deemed to be a penalty.
At this more complex end of the spectrum, Courts (and therefore parties) may take into greater account ancillary commercial factors (such as reputational damage and loss of goodwill, back-to-back contractual obligations, and possibly even incentive payments) in determining the scope of the innocent party’s legitimate interest in performance of the primary obligation.
However, whilst the El Makdessi and ParkingEye judgments are significant, in practical terms the decision is likely to have a limited impact on how secondary obligation clauses in financing contracts governed by English law will be drafted.