Financial Services Update: Penalty Clauses - Court of Appeal Confirms No Change in Irish Position
26 October 2018
Until the recent Court of Appeal decision handed down in the linked cases of Sheehan v Breccia and Flynn v Breccia, it remained to be seen whether the Irish Courts would deviate from the traditional test used to determine whether a clause is a penalty.
What is a penalty clause?
Parties to a contract often agree that, in the event of a breach, the party that has committed the breach must pay the other party a specified sum of money. However, that sum may be deemed a penalty by the courts if it breaks the common law rule on penalties.
The traditional test versus the UK approach
Until 2015, the test applied in Ireland and in the UK had been whether the amount payable was a genuine pre-estimate of the probable loss of the innocent party caused by the breach of a contract. If it was not a genuine pre-estimate, then the clause would be unenforceable.
In 2015, the Supreme Court in the UK decided to diverge from this test in Cavendish Square Holding BV v Talal El Makdessi  (Cavendish). The UK Supreme Court in that case determined that the proper test was whether the clause amounts to an additional secondary obligation which imposes detriment on the party in breach out of all proportion to any legitimate interest of the innocent party. It remained to be seen whether the Irish Courts would also deviate from the traditional test and follow the new test in Cavendish.
Breccia decisions – a brief summary
The plaintiffs were shareholders in Blackrock Hospital Limited (BHL) and had financed the purchase of their shareholding in BHL by way of loans provided by Anglo Irish Bank Plc. The defendant in both cases, Breccia, subsequently purchased both of the plaintiffs’ loans from the Special Liquidators of IBRC. Central to the issue was whether Breccia was entitled to include default surcharge interest and the costs of enforcement in the redemption figure for the loans.
At no time was surcharge interest mentioned in communications between the plaintiffs and Anglo/Special Liquidators of IBRC when the initial demand was made by Breccia. It was only when the plaintiffs sought to redeem their loans from Breccia that the redemption figure also included amounts representing surcharge interest.
Judgment was handed down in the cases by the High Court in February 2016 and more recently by the Court of Appeal in July 2018.
The key points of the decisions were as follows:
- Both the High Court and Court of Appeal declined to follow Cavendish instead stating that they were bound to follow Irish case law which applied the traditional test.
- The surcharge interest rate of 4% was held to be a generic rate, and not a genuine pre-estimate of loss arising from default. It was therefore held to be a penalty charge and hence unenforceable. The fact that the surcharge interest clause formed part of the general conditions (which was not specific to the facilities agreed between the parties and took no account of either the amount of the loan or the level of security) strongly supported the Court of Appeal’s contention that the clause could not be regarded as a genuine attempt by the parties to pre-estimate loss.
- The doctrine of estoppel was also considered by the High Court and it was held that IBRC/the Special Liquidators were at the date of the assignment to Breccia estopped from recovering or seeking to recover default surcharge interest. This was because of the absence of any indication of surcharge interest in the bank statements and correspondence with the Special Liquidators. This amounted to a representation that no surcharge interest would be charged. Consequently, Breccia as acquirer of the loans was also estopped from seeking to recover (or add to the redemption figure) any default surcharge interest that might otherwise be contractually claimed for any period up to the date the loans were transferred to Breccia.
- Breccia, when seeking to apply surcharge interest, should have disclosed this in its initial letter of demand and its silence on this issue amounted to an implied representation that no surcharge interest was payable. The High Court held that it would be unconscionable for them to be permitted to rely on a generic reservation of rights paragraph to overcome their misleading silence on the subject. The Court of Appeal agreed with this.
- The Court of Appeal suggested that a reconsideration of the traditional test for penalty clauses remains a matter for the Irish Supreme Court.
The Court of Appeal decision confirms that until such time as the Supreme Court in Ireland is required to look at the issue of penalty clauses, the traditional test to determine whether a clause is a penalty will apply.
If a loan agreement provides for surcharge interest on default, the rate should reflect a genuine pre-estimate of the likely loss. It should not be a generic rate and it should not be provided for in the general terms and conditions of the loan.
If a lender intends to charge surcharge interest then it should indicate this in correspondence with the borrower and particularly in any letter of demand. Silence on this may be construed as a representation that no surcharge interest will be charged.
For more information on the impact of these decisions, contact a member of our Financial Services team.
The content of this article is provided for information purposes only and does not constitute legal or other advice.
  UKSC 67