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Ireland: Contractual penalties ruling

John Breslin

Ireland has a shared legal tradition with the UK. Even though UK decisions are not binding in Ireland (but have persuasive authority), decisions of superior courts in the UK (such as the Supreme Court) merit close attention. This is undoubtedly true for the recent UK Supreme Court decision on contractual penalties in two joined appeals cases: Cavendish Square Holding v El Makdessi/ParkingEye v Beavis ([2015] UKSC 67) (Cavendish decision).

The traditional doctrine of contractual penalties provides that where a contract stipulates for a liquidated sum to be paid on breach of contract, the amount must be a genuine pre-estimate of the non-defaulting party's loss. Contractual deterrents are generally not permissible. In line with UK banking case law, some flexibility is permitted to allow a lender to provide for a modest uplift in interest margin where a borrower defaults on a loan repayment. This is to reflect the increased credit risk associated with lending to a borrower who has defaulted. The precise uplift is unclear – market perception is that in and around three percent appears permissible. There are, however, difficulties with a financial institution identifying a precise loss in terms of the regulatory capital treatment of a single defaulted loan.

To state the doctrine as it has recently developed is to highlight its uncertain and arbitrary nature, particularly in the banking context. The notion of increased credit risk sits uneasily with the concept of actual loss. It is unsatisfactory that the level of permissible interest-rate uplift is unclear.

The Cavendish decision provides, for lawyers throughout the common law world, an opportunity to re-evaluate the purpose of the doctrine in various commercial contexts, including banking and security law. The Cavendish decision concerned (respectively) sophisticated and heavily negotiated clauses in a share sale agreement where the purchaser sought to protect the goodwill of the target company, and a charge levied by a car park operator where a consumer over-stayed. Notwithstanding the different contexts of the appeals, the decision provides an historical analysis of the rationale for the doctrine, a review of key decisions in common law jurisdictions, and an analysis of what the test for contractual penalties should be prospectively.

The following are the key elements of the judgment:

  • The role of the contractual penalties doctrine is not to regulate the core terms of the contract – that is, price, quality, and so on. Rather, it is to control the remedies which arise on a breach.
  • A clause will be permissible if it protects, on a proportionate basis, a legitimate interest of the non-defaulting party. This can extend beyond the payment of damages and can include the protection of goodwill, branding, and even provide a deterrent for breaches (but not punishment for a breach).
  • Exorbitant or unconscionable consequences of a breach of contract will be struck down.
  • The role of the court is not to re-write an offending clause: it stands or falls.
  • Where parties of comparable bargaining power enter into a contract with the benefit of legal advice, there should be a strong presumption that they are the best judges of what is legitimate in providing for consequences of a breach.

In brief, therefore, the Cavendish decision represents a sophisticated recalibration of the penalty doctrine. It is adaptable to different commercial settings and places proper emphasis on freedom of contract, more appropriate for today's commercial world, and places proper emphasis on freedom of contract. In particular, interest rate uplifts fit within the concept of protecting a legitimate interest of the non-defaulting party (protecting against increased credit risk). However, whether the uplift in question will be exorbitant or unconscionable will be fact-sensitive. Therefore, the exact level of permissible interest rate uplift remains unclear.

John Breslin

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