When does contractual default interest amount to a penalty?

The legal principles applicable to contractual default or surcharge interest are particularly relevant to commercial lenders. On 30 July 2018 the Irish Court of Appeal declined to expand the doctrine on penalty interest, and re-affirmed that a demand for surcharge interest will not be upheld where it is penal in nature and does not reflect a genuine pre-estimate of loss.  

 

 

The cases - Flynn v Breccia¹  and Sheehan v Breccia²  - dealt with disputes between the shareholders in Blackrock Hospital Ltd. The shareholders financed the purchase of their shares with loans from Anglo Irish Bank. The loan agreements included a provision for surcharge interest in the event of a borrower default.  The Anglo loans were acquired by a NAMA subsidiary and then sold to Breccia who demanded payment, including surcharge interest. The borrowers claimed that the demand for surcharge interest was a penalty which was unenforceable and also that Breccia was estopped from claiming surcharge interest.

 

Penalty interest
 

The Court held that the surcharge interest provided for in the loan agreements (4% over the contractual rate) was a penalty. It pointed out that the surcharge interest provision could not have been a "genuine" pre-estimate of loss or damage to Anglo in the event of default, noting that the clause was contained in Anglo's standard terms and conditions and was not specific to the loan agreements at issue.

 

The Court had regard to:-

 

(i) the marked difference between the terms of the surcharge interest clause and the very specific provisions applying to the payment of standard interest due and the entitlement of the bank to debit such interest on a quarterly basis;

 

(ii) the absence of any express provision as to when surcharge interest became payable by the borrower; and 

 

(iii) the absence of any provision entitling the bank to debit the account of the borrower with surcharge interest.

 

In the circumstances the Court held that the clause providing for surcharge interest was unenforceable.

 

 

The Court of Appeal declined to follow the recent UK Supreme Court decision in Cavendish Square Holdings v Talal El Makdessi³  where the Court focused on whether there was a penal intent rather than on whether the rate was a genuine pre-estimate of loss. The test now in the UK is whether a default interest clause places an obligation on the contract-breaker which is disproportionate to the loss caused to the innocent party. The commercial justification for this broader approach is the difficulty in calculating interest rates in complex financial dealings.

 

While the Court of Appeal has declined to adopt the broad approach in Cavendish, the door is open for the Irish Supreme Court to expand the doctrine of penalty interest at a future date.

 

 

The cases represent a reminder that if a default interest provision is contained in standard terms and conditions, it will is more likely to be considered to be a penalty where:
 

Where a lender wishes to proceed by way of a facility letter plus standard terms and conditions, and where the standard conditions include a default interest clause, it may (depending on the terms of the standard conditions) be advisable to exclude the default interest provision in the standard terms.  The facility letter can then provide for a bespoke default interest clause which is specifically negotiated between the parties and which reflects the mechanics and terms for calculating and paying the facility's general interest amounts and which has regard to the damage or injury caused by the default.

 

Commercial lenders should also be aware of the differing approaches of the Irish and UK courts in dealing with default interest provisions and tailor their facility letters accordingly.