For more than a century, the common law of England and Wales has prohibited the imposition of any penalty in the event of a breach. This has also been true of Irish common law. Because authorities from England and Wales are persuasive in an Irish Court, the recent UK Supreme Court’s decision in Cavendish Square Holding BV v El Makdessi should also now be considered by anyone analysing the issue of “penalties” in contracts.
Before Cavendish, any clause in a contract governing the consequences of a breach needed to be based on a genuine pre- estimate of the innocent party’s loss, in order to be enforceable. Whether this concept works for or against you, it is at least straightforward to apply where financial loss is the consequence of a breach. However where a breach triggers adverse consequences not easily quantifiable in monetary terms, or where the most appropriate remedy for the breach is not in payment of a sum of money, the test as to whether the remedy in the contract is based on a genuine pre-estimate of the innocent party’s loss, is clearly problematic for everyone.
In Cavendish, the UK Supreme Court reframed the rather narrow focus of the rule as it has developed, by holding that the true test of whether a clause is penal is whether it imposes on the party in breach a detriment that is out of all proportion to any legitimate interest of the innocent party in the enforcement of the main purpose of the contract. The Court has effectively restored the “bigger picture” to its rightful place in the assessment of what constitutes a penalty in a commercial contract.
Importantly, the Court also reinforced the fundamentally important principle that a court will only apply the rule against penalties in assessing whether the remedies set out in a contract for breach of the main obligations offend the rule: the courts do not ordinarily interfere with the main contractual agreement itself, so that no matter how bad the main commercial agreement is for either party, the rule against penalties is irrelevant.
The position set out in Cavendish appears to suggest a fairer and more commercially acceptable application of the rule against penalties in England and Wales. Although not certain, it seems likely that when a suitable case arises, the Irish courts will also look at the bigger picture and adopt the broader analysis of the rule supported by Cavendish. In the meantime, while the law in Ireland hasn’t changed, we are forewarned that change may be coming.