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Default interest provision breaches penalty rule (obiter)

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Jason Rix

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17 May 2016

Following the Supreme Court's new test for penalties in Cavendish v Makdessi, Snowden J found (obiter) in Hayfin Opal Luxco 3 SARL & anr v Windermere VII Cmbs Plc & ors [2016] EWHC 782 (Ch) that a default interest provision (which provided for interest to be paid on unpaid interest) in a commercial mortgage- backed securitisation structure was extortionate and fell foul of the penalty doctrine. The fact that the issuer's liability was on a limited recourse basis was not relevant as the penalty doctrine does not depend upon whether it is subjectively intended to, or does, provide a deterrent to the particular contract-breaker.

This case relates to the rights attaching to a certain class of notes in a commercial mortgage-backed securitisation structure called "Windermere VII", which had been arranged by Lehman Brothers International (Europe) in 2006. A subsidiary issue was whether certain interest provisions were void as a penalty. Snowden J deliberately chose not to express any view on whether the provision in question was a conditional primary obligation (so that the penalty rule did not apply) or a secondary obligation (so that it did) as discussed in Cavendish. However, assuming the penalty rule applied, and acknowledging that he did not have to decide the point, Snowden J observed that if, contrary to his primary position, the provision under scrutiny meant that in the event of non-payment of interest on a payment date, further interest would accrue and be payable on that amount, "the almost inevitable result that could be anticipated at the time of contract would be a multiplication of the unpaid amount by a very sizeable factor to arrive at a sum many times the amount that would adequately compensate the innocent party for being kept out of its money. In any conventional terms, the imposition of such interest rates for breach in failing to make payment of a sum due would be regarded as exorbitant (if not extortionate)".

Snowden J went on to say that he did not think that the fact that the obligations of the issuer of the notes were imposed on a limited recourse basis provided any exception or defence to the application of the penalty doctrine, "As Lords Neuberger and Sumption indicated in Cavendish, the penalty doctrine does not depend upon whether it is subjectively intended to, or does, provide a deterrent to the particular contract-breaker, but must be founded upon objective reference to some norm". Accordingly, as Snowden J put it, "the penalty doctrine focuses on the lack of proportionality between the amount of the secondary liability imposed and the innocent party's legitimate interest in performance of the primary obligation". As a result, whether a clause is a penalty could not therefore depend upon the ability of the particular contract-breaker to pay the specified amount, or the source from which he is to pay: "An innocent party cannot save a clause from being a penalty by claiming that even though it provides for payment of a wholly disproportionate amount to the interest which he (the innocent party) has in performance, the contract-breaker is so rich that he will not notice the difference. Nor can he do so by promising to limit his claim to specified funds in the hands of the contract-breaker, if the available amount of those funds would still be capable of paying a wholly disproportionate amount, and payment might deprive the contract-breaker of the ability to pay debts due to other creditors with lower priority". 

Interestingly in Credit Suisse Asset Management LLC v Titan Europe 2006-1 Plc and others [2016] EWHC 969 (Ch) the Chancellor of the High Court noted that the parties had referred to Snowden J's various obiter comments made in Hayfin and sought to rely on them or to distinguish them. The Chancellor, accordingly declined to follow this example, fearing that any obiter views, like those of Snowden J, might be deployed in an argument in future cases where, almost inevitably, the wording of the relevant instruments and the surrounding matrix of fact will not be identical. If that happened, he thought, it would be likely to create more rather than fewer difficulties for a judge in such a case.

Further Information 

This case summary is part of the Allen& Overy Litigation and Dispute Resolution Review, a monthly publication.  For more information please contact Sarah Garvey, or tel +44 20 3088 3710.