Penalty Clauses – Recent Supreme Court View

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 rule against penalties and the unenforceability of penalty clauses originated in courts which sought to prevent exploitation of borrowers during a time when credit was not as easily accessible as it is today and borrowers were particularly vulnerable.

Supreme Court judgment

Launceston Property Finance Limited v Burke [2017] IESC 62 (Burke) involved an appeal by a married couple of a decision and subsequent order of the High Court for the possession of two properties by Anglo Irish Bank. The couple had entered into a number of loan transactions on which they defaulted. The loans were secured against the repossessed properties in question. The borrowers appealed on four grounds. One reason offered was that certain fees charged were excessive and as a result amounted to a penalty. Although the appeal was unsuccessful on all four grounds, Mr Justice McKechnie made some interesting comments on the rules for determining whether a sum stipulated in a contract is a 'penalty' and would, as a result, be unenforceable.

The Traditional Test vs. the New UK Approach

Until recently 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. The Supreme Court in the UK recently decided not to apply this test in Cavendish Square Holding BV v Talal El Makdessi [2015] UKSC 67 (Cavendish). The court 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. In order for the penalty to be enforced, the amount:

is no longer required to be a genuine pre-estimate of loss; must be a primary obligation; must not be exorbitant or unconscionable; must be commercially justifiable having regard to the innocent party's interests The Cavendish test is arguably a less rigid test, which should lead to fewer clauses being struck down as penalties in the UK.

In the recent Irish case of Sheehan v Breccia [2016] IEHC 67 (Breccia), the...

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