Virtually all loan agreements (and many other commercial agreements) include provisions that place increased obligations on a borrower in the case of a contractual breach and allow a lender to recoup enforcement costs. The Court of Appeal has recently re-considered and re-stated Irish law on these points.
The latest Court of Appeal judgments1 are part of long-running and multi-faceted litigation relating to investments in the Blackrock Clinic, Dublin. Briefly summarised, a group of investors borrowed monies from Anglo Irish Bank and provided security for their loans. As part of the liquidation and deleveraging of the bank, the loans and security were sold to Breccia, being one of the investors. Breccia then proceeded to take enforcement action against the other investors, including separate actions involving Mr. Sheehan and Mr. Flynn. Given the complexity of the litigation it was split into various modular hearings and, where issues of common interest to the Sheehan and Flynn cases arose, the judgments cross-referred to each other.
The Court of Appeal judgments focus on three principal issues:
- Did the application of “surcharge” interest – expressly provided for in the standard terms and conditions incorporated into the Anglo loan agreements – amount to an unenforceable penalty?
- If not, was Breccia estopped from claiming surcharge interest as a result of first Anglo/its successors' actions and then its own actions?
- What “enforcement costs” could be included in the amount required by Breccia to redeem the loans and related security?
Irish law on Penalties – Reform?
As discussed in an earlier briefing (here), the English Supreme Court recently reformulated the criteria to be applied when assessing whether a clause should be declared unenforceable as a penalty. The Irish High Court judgments in this litigation had noted the English law development but declined to consider it further as the court was bound by the precedent of superior Irish courts.
The appeal on this point asked the Court of Appeal to consider (i) whether the Irish law principles could be re-considered in light of the English law developments; and (ii) if not, whether the existing principles had been appropriately applied by the High Court. The Court of Appeal, noting that the principles had been stated by the Irish Supreme Court (and recently re-affirmed in non-binding commentary by the Supreme Court), held that it was also bound to apply existing Irish law when assessing whether a contractual provision constituted a penalty. Consequently, the question of whether Irish law on this point will be reformulated has been left to a further appeal or another case.
Irish law on Penalties – Restatement
The court then moved on to re-state and clarify the existing law on penalties.
First, the court outlined the following principles which were not in dispute:
- the onus of establishing that a clause is a penalty rests on the person making that allegation;
- the question of whether a clause is penal must be assessed by reference to the date that the agreement was made, not the date of breach; and
- as a general rule, the courts are reluctant to interfere with the terms of a contract made between parties with equal bargaining power; holding a penalty clause to be unenforceable is an exception to this rule.
Next, the court outlined the basis on which a clause can be found to constitute an unenforceable penalty. The starting point is to ask whether a clause, which imposes an increased obligation on a party in the event of breach, constitutes an agreement for the payment of liquidated damages caused by such a breach. The court acknowledged that the amount of such damages is not always easy to ascertain. Consequently, the usual question to be determined is whether:
“the clause is a genuine attempt by the parties to estimate in advance the loss which will result from the breach”.
If it is, then the clause is an enforceable agreement to pay liquidated damages. If it is not, then it is a penalty for breach and will not be enforceable.
Irish law on Penalties – Application
The court then considered whether the High Court had been correct in applying the principles and finding that the surcharge interest clause constituted an unenforceable penalty. This decision had caused some concern for lenders and loan purchasers given that the type of surcharge interest clause was relatively typical in its formulation (albeit that the surcharge rate of 4% over the “facility interest rate” was higher than many others).
The Court of Appeal upheld the High Court declaration of unenforceability, citing the following reasons for the decision:
- the surcharge interest clause formed part of the general terms and conditions incorporated into the loan agreement. The fact that it was not tailored to the amount of the loan, the level of security provided or any other aspects of the specific lending arrangement strongly supported the contention that the clause could not have been a genuine attempt to pre-estimate the loss resulting from a default;
- the banking evidence before the High Court (in Sheehan) indicated (i) that any pre-estimate of probable loss in the event of default was already a factor taken into account in the calculation of the ordinary interest rate (Euribor plus a margin); and (ii) a default in itself will not necessarily cause the lender to incur loss;
- the court also attached weight to the breadth of circumstances to which the surcharge interest clause applied equally (eg failure to apply quarterly interest and failure to repay the capital when due) and the fact that the clause did not expressly provide for how or when surcharge interest was payable; and
- while not necessary for the court to reach its decision, the indemnity (included in the terms and conditions) from the borrower to the lender in respect of any costs incurred by the lender as a result of the borrower’s default was further evidence that the surcharge interest clause could not be construed as a liquidated damages clause.
Estoppel – Consistency Required
In a separate judgment, the court took the opportunity to consider whether Breccia would have been estopped from claiming surcharge interest, if enforceable. Applying existing law, the court came to the following conclusions:
- on the evidence, Anglo/its successors had made an implied representation (through bank statements and a letter saying that the debt could be redeemed “at par”) that surcharge interest would not be applied;
- Breccia, following its purchase of the debt, had also made a similar implied representation through service of a demand for payment of the debt which did not include surcharge interest. The fact that the demand letter included a typical reservation of rights/no waiver statement was not sufficient to displace the implied representation on the facts;
- as the borrower had relied on the representations (eg incurring costs in seeking to purchase and/or refinance the debt) the relevant requirements for estoppel to apply were in place. As a result, Breccia was estopped from claiming surcharge interest (i) because it purchased the loan from Anglo’s successor “subject to equities” and (ii) because of its own implied representation;
- the estoppel would not, however, extend indefinitely and Breccia would have been able to charge surcharge interest (if not unenforceable as a penalty) from the date that it had clearly stated that it would apply surcharge interest and outlined the basis on which it arose.
A third important concept considered in the Court of Appeal’s judgments was the interaction between a contractual provision which allows a secured lender to recoup enforcement costs and the absolute jurisdiction afforded to the courts to award litigation costs. The relevant aspects of the judgments can be summarised as follows:
- Non-litigation costs: Where there is no court litigation, a court order is not required before costs can be recovered in accordance with the relevant contractual provision. However, if the amount of the costs is disputed it can be adjudicated through the usual “taxation” process. The basis for the taxation may depend upon the terms of the document pursuant to which the claim is made.
- Litigation costs: The court has jurisdiction (pursuant to the rules of the superior courts) to decide how litigation costs are awarded. Where a contract provides that one party will pay the litigation costs of another, this will not oust the jurisdiction of the court as this would be contrary to public policy. Rather, if pleaded by a party, the court can take the contractual provision into account when deciding how costs should be awarded. While providing the foregoing as guidance, the Court of Appeal explicitly refrained from expressing a definitive view on how any conflict between a contractual costs provision and the court’s jurisdiction should generally be resolved. The court did, however, uphold the High Court’s decision that Breccia could not claim repayment of litigation costs where the court had made an order of “no costs” or awarding costs to the other party.
- Contingent costs: where there is a mere possibility of future costs which a mortgagor would, pursuant to the relevant contractual provision, be required to pay, this cannot be taken into account when calculating the amount payable by the mortgagor to redeem the mortgage. This is to protect the mortgagor’s right of redemption (ie right to repay the secured monies and have the secured asset returned) as a matter of policy. However, where costs are already incurred and there is a contractual right to the recovery of those costs from the secured assets, then an estimate of those incurred costs can be added to the redemption amount. The mortgagor has the option of paying the estimated amount or providing alternative security. This protects both the mortgagor’s right of redemption and the secured party against the risk of not being able to recover incurred costs simply because the amount remains to be finalised.
What to Take-Away?
The key points to take away from these decisions are:
- Penalties – status quo: Irish law on whether a provision will be construed as a penalty has not changed. It may yet be considered by the Supreme Court but even if it is, it is not clear whether the Irish Supreme Court would follow the approach taken by the English courts.
- Penalties – genuine estimate: A clause which has the effect of placing an increased obligation on a party as a result of a breach of contract needs to be carefully considered to determine whether it can be construed as an estimate of probable loss. If not, it is likely to be considered to be an unenforceable penalty. While this concept applies broadly, it will be of particular interest to lenders and to the purchasers of debt (especially where the applicable loan agreements are on Anglo standard terms and conditions).
- Penalties – T&Cs: The Court of Appeal judgments raise two interesting questions for lenders with regard to their documentation. The first is whether there is any justification for charging surcharge interest at all? If the risk is already reflected in the margin applied as part of the ordinary interest rate, it is possible that there is none. The second is how a lender would calculate surcharge interest on a case-by-case basis. In any event, a surcharge interest provision would be better included in a part of the agreement that is negotiated rather than in standard-form terms and conditions.
- Costs: Parties need to carefully consider the scope of their costs provisions and what those provisions are likely to enable them to recoup. While the provision should be broad, it should not be so broad that it could be seen as seeking to oust the jurisdiction of the court with regard to litigation costs. Parties need to be conscious also when assessing likely recoveries that the costs of litigation are primarily a matter for the court, albeit that the court may take into account a contractual costs provision when making its order.
While Irish law has not been changed by these Court of Appeal decisions, they do provide a challenge to some assumptions, particularly regarding the application of surcharge interest, which may be common in the market. As such, lenders, loan book purchasers and others involved in managing debt should consider whether these decisions may require a review of documentation or other practices within their business.