Interest in Loans
SOURCE: SCOTTISH BANKER, APRIL / MAY 2008
A recent English case has revisited two important points which a bank may face in demanding repayment under a loan agreement. Failure to properly consider these points could adversely affect the ability of the bank to recover its loan and anticipated interest. Although an English case, this will be persuasive in Scotland, and it will have direct effect if the transaction involves some English assets and the loan documentation is governed by English law.
In the case of County Leasing Limited and others v Richard John East, the court had to consider; first, whether the default interest claimed by the lender under the loan agreement would be enforceable, and second, whether the demand for payment was void if an inaccurate amount was detailed.
The obligation to pay default interest is included in most loan agreements, and regardless of what the lender and borrower agree, the rate of interest should constitute a genuine pre-estimate of the loss that the lender would suffer in the event that the borrower defaults.
However, if the purpose of the default interest clause is actually to deter the borrower from committing a breach, then that will constitute a penalty which is unenforceable. Typically, excessively high interest rates would indicate that it could be a penalty (e.g. a default rate of 5% per week was held to be unenforceable). In the County Leasing case, a clause which provided for payment of default interest of 2% a month for the entire 20 year period of the loan was held by the court to be unenforceable; and the court then effectively substituted a lower sum of default interest, which was able to be recovered by the lender.
There is no set guidance of what would be a reasonable default rate, as it would depend on the type of loan, but an increase of about 2% over the interest rate that applies when the borrower is not in default (along with any increased costs) would be usual.
Turning next to the demand for payment. As we have seen, the demand made by the lender in the County Leasing case referred to an amount, which did not end up being the recoverable sum. How does this affect the validity of the demand for payment?
In deciding whether a demand for payment is valid, the true test is whether the demand was validly made at the time it was given, and whether it was properly given having considered the terms of the document under which it is made (i.e. the loan agreement). The validity of the demand is not affected by circumstances occurring after it is made. Therefore, in this case, notwithstanding that the amount was no longer correct, it was ostensibly accurate at the time it was made, and therefore the demand was valid.
It is common for a lender to include in the loan agreement a provision that specifies that in the absence of manifest error, a certificate given by the lender of the amount due shall be conclusive and binding on the borrower. This type of provision is to be recommended as it will reduce the scope for the borrower to dispute the validity of the demand.
Also, it is important to ensure that the demand is in writing and follows the procedures included in the loan agreement for the service of notices.
When negotiating your loan agreements, you should ensure that your default provisions are careful worded to ensure that they can be easily enforced, and on default, that all the procedures are then carefully followed. Remember, it will be at the time of enforcement when you need to rely on these provisions, and they will be carefully scrutinised, and challenged by the borrower if possible.
author: alex innes