Interest

From Max-EuP 2012

by Tobias Tröger

1. Scope and purpose

Interest is the typical remuneration for providing the scarce resource of capital (money or fungible goods). Forgoing current liquidity incurs opportunity costs that can be offset by an adequate rate of interest on the capital provided. Hence, interest rates are calculated with regard to maturity and default risk but are generally independent of any proceeds the debtor may generate from the funds he received. From the perspective of the law, primarily two issues are of general significance. On the one hand, jurisdictions are concerned with the prerequisites and limits of valid interest agreements between private parties. On the other hand, the unauthorized arrogation of capital calls for adequate sanctions like an ex lege duty to pay interest.

The vital economic significance of the allocation of debt capital for both investment and consumption purposes has induced all market-oriented European legal systems to generally honour private parties’ agreements on interest rates. Only widely drawn limits that rest upon either a need to protect the debtor or more general common welfare considerations are imposed upon private agents’ freedom. However, this finding of largely unrestricted private autonomy is nothing but the current state of a highly varied historical development. In Roman law economic individualism was largely unfettered and thus agreements on interest rates were valid without any restrictions on the merits. However, the Law of the Twelve Tables introduced the fenus unciarium for the nexum, which established a stable interest rate for loans. Charging higher interest rates was considered usury. If such usurious interest rates were stipulated in an agreement, the debtor was not only entitled to reclaim the overpaid amount but could also bring the actio poenalis aiming at the quadruplum, ie at the quadruplicate of the excess payment. To the extent that the nexum was replaced by the informal mutuum over the course of time, the mentioned limitation on interest rates was obliterated. However, this development was rectified to some degree when the centesimae usurae (12 percent p.a.) was implemented for the mutuum as well at the end of the Republic.

As a result of Christian influence, the Corpus Juris Civilis imposed reduced limits on interest rates for the general public and less rigid restrictions in certain areas of business (maritime loans) or for certain agents (merchants, fabricants) to reflect both the specific risks of certain transactions and the superior experience of the parties involved. The increasing power of the Christian Church led to the strict prohibition of interest rates in canon law gaining importance in secular statutes as well. However, as early as in the late Middle Ages, the prohibition was undermined by special arrangements in the trade practices of the time (eg in the form of a ‘purchase of annuities’, an arrangement under which capital was provided against the promise to pay annuities and which could not be terminated by the consignee). It can be observed that the comparably strict prohibition of interest stipulations under Islamic law was bypassed by similar arrangements. It has nevertheless survived as applicable law in some jurisdictions. In contrast, the rigid prohibitions of Christian origin were gradually repealed by territorial statutes that emanated first from the upper Italian cities and knew only prescriptions of maximum interest rates. Due to the influence of political liberalism and classical economics, particularly the writings of Adam Smith and Jeremy Bentham (Defence of Usury, 1789), strict limits on interest rates have been incrementally substituted for more flexible usury provisions in Europe since the middle of the 19th century. While even the latter rules and standards are frequently regarded as undesirably curtailing mutually beneficial lending activities, (behavioural) economists have recently defended the pertinent provisions against the proponents of unfettered lending. Their rationale for usury law rests on the grounds that it prevents limited rational would-be borrowers with poor credit standing from accumulating excessive debt simply because (risk-adequate) high-interest loans are unavailable to them.

With regard to the protection of debtors, interest on interest (anatocism) demands particular attention. The properties of the interest-function involve total interest due rising exponentially if interest that accrued in the past is subject to future interest calculation. Historically, this accumulating effect of compound interest was regarded as a rationale for regulation. The main purpose of these interventions was to protect debtors from snowballing burdens of interest or at least to make the perils originating from compound interest agreements transparent. In this spirit, classical Roman law had already prohibited the stipulation of interest on interest outright in order to make sure that interest would accrue only in a linear rather than in an exponential manner. However, the experience under Roman law in particular also illustrates that parties who see economic reason in compound interest agreements have ample opportunities to contract around blunt prohibitions, eg by periodically entering into new loan agreements and simply adding the previously accrued interest to the new nominal sum borrowed.

Finally, the primary function of interest payments to compensate creditors for temporary forgoing liquid funds is also relevant where defaulting debtors usurp capital that would have been vested in the creditor if performance had occurred in time. Statutory obligations to pay interest as a sanction for the delay in payment can thwart incentives to behave opportunistically.

2. Structures and tendencies of legal development

a) Contractual interest stipulations

Today, in European jurisdictions the general freedom to stipulate interest obligations in contracts is not in question. However, if the parties do not agree upon specific provisions, it remains to be determined whether the respective private law systems treat any allocation of capital as remuneration by default or rather assume that it is free of charge in the absence of any express stipulation to the contrary. The loan as the basic type contract for the allocation of capital does not provide for interest payments as default remuneration for the lender in those jurisdictions that follow the example of Roman law (eg Art 1905 Code civil, Art 1755 Código civil, Art 7A:1804 Burgerlijk Wetboek (BW); Art 313(1) OR; for the English common law see Page v Newman (1829) 9 B & C 378, 381; President of India v La Pintada Compania Navegacion SA [1985] AC 104; for a different default rule see in particular Art 1815(1) Codice civile, § 488 (1)2 Bürgerliches Gesetzbuch (BGB)). However, in commercial law, the opposite often applies, ie interest has to be paid for any allocation of capital by default (eg § 354(2) HGB (UGB); Art 313(2) OR). Moreover, even where specific regulations are lacking, the prevailing case law in line with the typical interests of the parties frequently assumes a tacit agreement on remuneration or a common commercial practice to this end. In these scenarios, statutory interest rates that only serve as a default of ‘last resort’ (eg § 246 BGB, § 352(1) HGB, Art 1284 Codice civile, Art 7A:1805 BW) are usually considered to be tacitly replaced by the customary interest rate.

The harmonized law on consumer credit (regulatory principles) requires strict transparency of agreements on interest rates. Extensive information (in particular on debit interest, annual percentage rate, etc) has to be provided to the consumer both prior to the conclusion of the contract and in the contractual document itself (Arts 4 ff Consumer Credit Directive (Dir 2008/ 48)).

Substantive limits for contractual stipulations of interest rates exist in all European legal systems, in particular as rules and standards prohibiting usury. The terminology can be deduced from its Latin root usura (or in Medieval Latin usuria) not only in the Romance languages but also, for example, in English, Swedish (ocker) and German (Wucher). The comparison of various jurisdictions reveals two different regulatory approaches. In some legal systems, the mere existence of a heavy disproportion between the market value of the allocated capital (ie the customary interest rate) and the agreed interest rate is considered sufficient to trigger the allegation of usury. Other legal systems require additionally that the lending party deliberately took advantage of the other side’s inferior position.

Particularly in the context of consumer credit law, the mere existence of a grave disproportion is usually regarded sufficient to amount to usury, arguably because of the structurally inferior position of the consumer who concedes excessive interest payments. However, regulations are rarely limited to consumer contracts. Special rules for usury exist, for example, in France (Art L-313-5 Code monétaire et financier and Art L-313-3 Code de la consommation), England (ss 137–140 Consumer Credit Act 1974), Spain (Art 1 Ley de la represión de la usura) and Italy (Art 1815(2) Codice civile). These regulations partly contain fixed limits on interest rates (France: usury found above an interest rate of 133 percent of the average global annual percentage rate as calculated by financial institutions during the previous quarter for credits of the pertinent type) which nevertheless leave room for a good share of distinction between various types of credits. Moreover, courts construe blanket provisions in civil law statutes (§ 138(1) BGB, § 879(1) ABGB, Art 178 f Greek Civil Code, Art 36 Nordic contract statutes) in a way that the mere existence of a disproportion amounts to usury (eg the leading case of the German Federal Supreme Court, BGH 24 March 1988, BGHZ 104, 102, 105: overall interest rate of more than 200 percent of the average interest rate is considered usurious and therefore against public policy).

An additional exploitation of the inferior party’s vulnerable position is generally required if the usurious transaction is to be appraised under laws and doctrines that potentially apply not only to the stipulation of disproportionate interest rates but to other disfavoured practices as well. This is true, for example, with regard to the equitable doctrines (equity) of undue influence and unconscionable bargain, but also in the law of the Netherlands (Art 3:44(4) BW).

The general consequence of usury in most jurisdictions lies in the reduction of the agreed rate of interest to the average market interest rate. Yet, significant differences in the doctrinal paths that lead to this uniform result exist. While in some legal systems the contract is adapted either through judicial act or statutory provisions, others partly nullify the interest clause or declare it void in its entirety and secure remuneration in line with the market rate via the principles of unjustified enrichment (eg France, England, Italy, Germany and Scandinavia).

b) Interest on interest

In those jurisdictions where an outright prohibition of anatocism is still in force today (eg § 248(1), § 289(1) BGB; Art 314(3) OR; Art 1154 Code civil) it is usually attenuated by substantive and personal exemptions. Particularly in commercial law, extensive exceptions and opportunities to custom-tailor compound interest arrangements exist (eg § 355(1) HGB, Art 314(3) OR, § 317 Código de commercio). The general theme of the relevant law in action is that an austere prohibition in this context would be regarded as excessive with regard to adequate creditor protection. Hence, the pertinent rules are construed in a rather narrow manner.

c) Duty to pay interest as a remedy for late payment

Continental European jurisdictions generally prescribe a duty for the debtor of a monetary obligation to pay interest to the creditor by law if he is in delay of payment. Contrary to this, the common law does not acknowledge such obligations and denies, for example, the lender a claim for interest payments for the time after the due date of the loan, even if the debtor is in delay with the redemption (London, Chatham & Dover Ry v South Easter Ry [1893] AC 429, President of India v La Pintada Compania Navegacion SA [1985] AC 104). This general observation remains valid even though the rule has been alleviated in certain cases, particularly where creditors are entitled to claim damages for actual and foreseeable losses of interest yields (Trans Trust SPRL v Danubian Trading Co [1952] QB 297, 306, 307; Wadsworth v Lydell [1952] 1 WLR 598). Only statutory law provides for true exceptions from the common law rule. The directive on late payment (Dir 2000/35) is of critical importance in this respect. It prescribes a duty to pay interest on monetary obligations from the 30th day after the due date in all commercial transactions (Art 3 Late Payment Directive). The directive goes beyond the traditional state of the law not only in the United Kingdom as it features an obviously penalizing character unknown to many jurisdictions. The (default) level of interest for late payment is determined at a margin of at least seven percentage points above the reference interest rate (base lending rate of the European Central Bank or national central bank). This margin cannot generally be justified with considerations of a necessary compensation for higher default-risks. It rather serves as a tool to create strong incentives for punctual payments.

3. Regulatory structures in uniform law and unification projects

The academic projects aimed at a unified European private law generally grant parties the freedom to enter into agreements on interest obligations and set interest rates freely. However, they do not contain any general rule on whether transactions leading to a capital commitment generally carry an implicit remuneration clause or not. Even though gratuity is a conceivable option for such agreements, as is the default rule in many jurisdictions, rules like Art 6:104 PECL (or its substantive equivalents in Art II.-9:104 DCFR, Art 5.1.7 UNIDROIT PICC) that provide for the ‘reasonable’ or ‘normal’ price as the agreed compensation may be understood in light of economic realities in a way that, in the absence of an express agreement, any commitment of capital is instituted at the typical market rate. Yet, it militates against such an interpretation that the decision on the pertinent question should not be made in general contract law but rather be left to the provisions dealing with the specific types of contracts that aim at an allocation of capital (cf the respective rule for loan contracts in Art IV.F.-1:104 DCFR).

The academic projects do not comprise prohibitions of compound interest agreements. Usury, on the other hand, is captured by provisions that pertain not only to interest agreements. Hence, it is no surprise that a finding of usury requires not only the stipulation of a disproportionate interest rate but also the deliberate exploitation of the other party’s vulnerable position (Art 4:109(1) PECL, Art II.-7:207(1) DCFR, Art 3.10 UNIDROIT PICC).

Finally, uniform laws (Art 48(2) Geneva Convention on Bills of Exchange, Art 45(1) Geneva Convention on Cheques, Arts 78, 84(1) CISG) as well as the academic projects (Art 9:508 PECL, Art III.-3:708 DCFR, Art 7.4.9 UNIDROIT PICC) contain numerous provisions that prescribe a legal duty to pay interest in the case of delayed payments. It is noteworthy in this context that the relevant statutory interest rates—the CISG does not contain a specification due to insurmountable differences in opinion among participants at the Vienna congress—do not exhibit any penalizing character. The relevant statutory interest rates that determine interest obligations arising in case of delayed payment are set at the common interest rates commercial banks charge short-term borrowers with first-class credit-worthiness (Art 9:508(1) PECL, Art III-3:708(1) DCFR, Art 7.4.9(2) UNIDROIT PICC). As a consequence, for some debtors of bad standing, some leeway for opportunistic arbitrage remains. This holds particularly true if the debtor does not pay his liabilities from deposits—that carry a low interest yield—but from credit lines that were granted only at the price of a high interest-burden.

Literature

Winfried A Hetger, Sittenwidrigkeit von Ratenkrediten und Kreditwucher (1989); Eric Posner, ‘Contract Law in the Welfare State: A Defense of Usury Laws, the Unconscionability Doctrine, and Related Limitations on the Freedom to Contract’ (1995) 24 JLS 283; Eric Kerridge, Usury, Interest and the Reformation (2002); Jochen Dilcher, Die Zins-Wucher-Gesetzgebung in Deutschland im 19. Jahr­hun­dert (2002); John M Houkes, An Annotated Bibliography on the History of Usury and Interest from the Earliest Times through the Eighteenth Century (2004); Diego Quaglioni, Giacomo Todeschini and Gian Maria Varanini (eds), Credito e usura fra teologia, diritto e amministrazione (2005); Cass Sunstein, ‘Boundedly Rational Borrowing: A Consumer’s Guide’ (2006) 73 University of Chicago Law Review 271; Franz Dorn, ‘§§ 246–248. Zinsen’ in Mathias Schmoeckel, Joachim Rückert and Reinhard Zimmermann (eds), Historisch-kritischer Kommentar zum BGB, vol II/1 (2007); Sieg Eiselen, ‘Interest on Sums in Arrears’ in John Felemegas (ed), An International Approach to the Interpretation of the United Nations Convention on Contracts for the International Sale of Goods (1980) as Uniform Sales Law (2007).

Retrieved from Interest – Max-EuP 2012 on 02 October 2022.

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