Are Surcharge Interest Clauses Enforceable?

Are surcharge interest rates enforceable in Ireland? The High Court recently reaffirmed that they will only be enforceable if they are a “genuine pre-estimate” of the potential loss that a lender may suffer. They also must not be intended to deter default by a borrower. This is an important confirmation of the position in Ireland that all lenders need to consider.

What you need to know

• The High Court has recently reaffirmed the approach of the Irish courts to surcharge interest clauses.
• The Court reiterated that a surcharge interest clause must be a “genuine pre-estimate” of potential loss and not intended to deter default to be enforceable.
• The Irish approach differs from the approach of the UK courts, and any change in this jurisdiction will be a matter for the Supreme Court.
• For surcharge interest clauses to be enforceable, lenders must show:
  • The objectives in setting the surcharge interest rate did not include discouraging default, and
  • The surcharge interest rate was calculated as a genuine pre-estimate of the increased costs that the lender would incur.

The High Court recently reaffirmed the approach in Ireland to surcharge interest clauses. Surcharge interest clauses will be unenforceable unless they are a “genuine pre-estimate” of potential loss and are not intended to deter a breach. The decision is important for any lender considering the enforceability of standard surcharge interest provisions.

The case

Mr O’Boyle (the Borrower) entered into a loan agreement with the Governor and Company of the Bank of Ireland in 2004 to develop properties on his land. The Borrower defaulted in repaying this loan. In 2017, the Bank offered the Borrower a new facility allowing surcharge interest to be charged at 0.75% per month. The Bank commenced charging surcharge interest in August 2018 and continued to do so until May 2020. At that point, the Bank concluded that it was unlikely the Borrower would repay any of his debt.

The Bank began debt recovery proceedings against the Borrower’s estate in May 2022. Judgment was granted in the Bank’s favour. However, the extra interest charged between August 2018 and May 2020 was not included in that judgment.This aspect of the Bank’s claim was adjourned to plenary hearing.

The law on surcharge interest clauses

Surcharge interest clauses have been interpreted in Ireland as penalty clauses that are unenforceable. A penalty clause is intended to deter breaches rather than act as a genuine pre-estimate of a loss likely to accrue following a breach. The established test to determine a penalty clause was set out in Dunlop[1]. Key to the test is a consideration of whether the amount set out is “extravagant and unconscionable” when compared to the greatest loss that could result from a breach.

This was also the position in the UK, however that was revised by the UK Supreme Court in Cavendish[2] . In the Cavendish decision, the Court indicated that referring to “deterrent” and “genuine pre-estimate” was unhelpful when deciding if a clause is penal in nature. Instead, the court developed a test that considered whether the clause was a secondary obligation which imposes a detriment on the contract-breaker out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation. The UK Supreme Court also indicated courts should be reluctant to interfere in contracts negotiated by parties of similar bargaining power. The Irish courts have not followed the Cavendish decision and reiterated that Dunlop continues to apply in Ireland[3].

Submissions

The Bank argued that the surcharge interest rate of 0.75% per month was a genuine pre-estimate of the probable loss that would be caused by failure of the Borrower to repay the loan. The Bank’s expert argued that there was genuine uncertainty, at the time the loan was advanced, as to the loss the Bank would suffer. Therefore, the Bank claimed that the surcharge interest clause aligned with the long-established Dunlop principles. At the same time, the Bank also urged the Court to revisit the approach to surcharge interest clauses and to favour what it described as a “recalibrated” Cavendish approach.

In contrast, the defendant argued that the purpose of the surcharge interest clause was to deter customers from defaulting on their repayment obligations. They argued it was meant to penalise those who had defaulted, breaching the Dunlop principles and were supported in this argument as the Bank applied the same surcharge rate generally across its loan book. The defendant argued that the Bank could have crafted a surcharge interest rate that reflected actual costs by tracking the work done following default rather than using a “one size fits all approach”.

Findings

The Court found that the surcharge interest clause was unenforceable as it offended the rule against penalty clauses for the following reasons:

• There was no validated, empirical basis for the rate of 0.75% per month. Therefore, it could not be a genuine pre-estimate of the Bank’s potential loss. The Court also noted that the Bank had not changed its rate of surcharge interest since 2008 despite its own expert’s view that the rate would be expected to change depending on the Bank’s experience of having overcharged or undercharged surcharge interest in the past, and
• The motivation for the surcharge interest clause was to discourage breaches and therefore acted as a deterrent. As support for this the Court referred to a letter the Bank sent to the CBI in 1993 when setting the surcharge rate of 0.75% per month, which noted that “The Bank sees this as necessary … to discourage breach of agreed limits”.

Conclusion

The Court’s decision has confirmed that the Supreme Court will need to be the arbiter of any change in approach to penalty clauses in Ireland. It seems likely that the decision will be appealed, and the Bank may seek leave for a leapfrog appeal to the Supreme Court. In the meantime, in order for surcharge provisions to be enforceable, lenders should consider whether:

• The purpose of the surcharge interest rate is to discourage default, and
• The surcharge interest rate is calculated as a genuine pre-estimate of the increased costs that the lender would incur as a result of a default.

For more information and expert financing advice, contact a member of our Banking team.

The content of this article is provided for information purposes only and does not constitute legal or other advice.

[1] Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co Ltd [1914] UKHL 1

[2] Cavendish Square Holdings BV v. Makdesi [2015] UKSC 67

[3] Flynn & Anor v Breccia [2018] IECA 273; Sheehan v Breccia & Ors [2018] IECA 286