A series of judgments handed down by the Court of Appeal on 30 July 2018 in linked litigation (Sheehan v Breccia/Flynn and Benray v Breccia) deals with important issues arising in loan default scenarios, particularly where the loan has been traded in the secondary market. The implications of these decisions require careful consideration in the context of broader finance and commercial arrangements under Irish law.
The key issues addressed by the court are as follows:
- Whether a borrower's agreement to pay default interest under Irish law was unenforceable because it was not a genuine pre-estimate of loss caused by default (the "Penalty Issue");
- Whether the purchaser of the loan was estopped (by reason of correspondence with the borrower) from claiming default interest (the "Estoppel Issue");
- Whether an express "reservation of rights" clause in the loan purchaser's demand letter preserved its ability to claim default interest (the "Reservation of Rights Issue"); and
- Whether the borrower's agreement to pay the lender's enforcement costs breached public policy (the "Enforcement Costs Issue").
Brief Summary of Factual Context
The facts were complex but may be summarised as follows. The parties were shareholders in a company operating a private medical clinic in Dublin (the "Company"). The key protagonists were two individuals and a corporate entity ("Breccia"). The individuals (the "Borrowers") had financed their investment with borrowings from Anglo Irish Bank plc (the "Bank"). One of the Borrowers structured his investment through a private limited company. The security provided by the Borrowers included a mortgage over their respective shareholdings in the Company. The facility agreements included a provision for additional interest to be paid on a Borrower default, and an agreement that the Borrowers would pay and indemnify the lender against all costs incurred by the Bank in enforcing the loan.
The Bank went into liquidation. One Borrower's loan was put up for sale by the Bank's liquidators, the loan of the other Borrower transferred to a subsidiary of NAMA (Ireland's "bad bank") and was put up for sale by it. Breccia successfully outbid the Borrowers for both of the loans. Breccia's objective was to gain control of the shares pledged by the Borrowers as security for their loans.
Shortly after it acquired the loans, Breccia issued a formal demand for repayment of principal and contractual interest against each of the Borrowers. Breccia subsequently demanded payment of default interest, and a sum of money purportedly representing Breccia's enforcement costs. (In round figures, default interest and enforcement costs increased the repayment amount over and above principal and normal contractual interest by €2.5 million in the case of one Borrower, and €4.5 million for the other). The Borrowers resisted Breccia's claims for default interest and enforcement costs on a number of bases. These included that the default interest was a penalty and was therefore unenforceable, that Breccia was estopped from claiming default interest, and that the clause obliging the Borrower to pay the lender's enforcement costs contravened Irish public policy. The judgments arise from an appeal of a number of earlier decisions handed down by Haughton J on the points in the Irish High Court Commercial Division.
The Penalty Issue
The Court of Appeal adopted a traditional analysis of the penalty issue: a contractual provision requiring a party in breach to make an additional payment will be unenforceable unless it is a "genuine" advance estimate of the loss likely to arise upon breach. The court declined to follow recent precedent from the United Kingdom Supreme Court updating the law on penalties so that a clause providing for payment on breach would only be struck down if it was unconscionable and disproportionate.1
The court held that the default interest (4% over the contractual rate) was a penalty. In doing so, the court held that the default interest provision could not have been a "genuine" pre-estimate by the parties of loss arising from breach: this was primarily because the clause was contained in the Bank's standard terms and conditions.
The court also held that where default involves a failure to pay a defined monetary amount, a contractual obligation requiring the defaulting party to pay extra is very likely a penalty. It is difficult, therefore, to see how normal default provisions in loan agreements and other financial contracts (such as swaps, prime brokerage agreements, repos, and derivatives transactions) can survive the traditional doctrine on penalties, even where such default payments are relatively modest, and are really intended to reflect an increased credit risk arising from default.
The court strongly hinted that the traditional principles may need to be updated but took the view that this is a matter for the Irish Supreme Court.
The Estoppel Issue
The court also held that Breccia was estopped from claiming default interest. A full discussion on estoppel and its operation under Irish law is beyond the scope of this briefing note. However, in general, estoppel may operate where a party makes an express or implied representation which is intended to affect the legal rights between the parties, and which is relied on by the other party to its detriment. In the present case, the Borrowers had been in default for some time and until receipt of a letter from Breccia's solicitors they had not been informed that they would have to pay default interest. When they were bidding to buy back their loans the Borrowers were not told that default interest would have to be paid. As the purchaser of the loans, Breccia was bound by these implied representations that default interest would not be claimed. TheBorrowers relied on these implied representations to their detriment. Each of the Borrowers had approached a third party financier to support their bids to buy their respective loans and this involved them incurring expense and contractual commitments.
The Reservation of Rights Issue
Breccia's initial demand for payment did not claim payment of default interest but included a statement that Breccia reserved its rights to claim further sums owed to it. The court considered that it was "fanciful" to consider that this would have alerted the Borrowers to the fact that default interest would be claimed, and was ineffective to negate prior implied representations that it would not. The court went so far as to say that having indicated what was due, Breccia could not resile from that figure.
The Enforcement Costs Issue
Many finance agreements and security documents include a provision requiring a defaulting borrower/ security provider to pay the costs of enforcement in a default or enforcement scenario.
The court distinguished between enforcement costs incurred by a lender outside of litigation (on the one hand), and costs incurred in the course of litigation (on the other). A contractual provision obliging a borrower to pay a lender's enforcement costs outside the context of litigation is effective. However, where a borrower disputes the amount, he can require the amount to be independently adjudicated.
The position regarding litigation costs is more difficult and raises a public policy issue, namely the courts' primacy in determining how costs of litigation are to be paid. This jurisdiction cannot be ousted by contract. More precisely the issue here is the potential conflict between an agreement by a borrower to pay a lender's costs incurred in enforcing payment even if a court has directed the lender to pay the borrower's costs at a specified level (or gives an order in the usual terms that costs be taxed in default of agreement), or has an order that the borrower is to pay no costs.
The court held that a contractual provision requiring a borrower to pay a lender's enforcement costs could not nullify a court's power to direct a lender to pay costs (or a portion of costs, or a portion of costs to be determined by taxation) in court proceedings, or to direct that no costs should be paid by the borrower. The appropriate practice is for the lender, at the end of court proceedings, to draw to the court's attention the existence of the borrower's agreement to pay the lender's enforcement costs: the court would then have to take this into consideration when exercising its jurisdiction to make an order dealing with the question of costs.
These are the key takeaways from the case:
- The court declined the opportunity to update the law on penalties so that it operates sensibly in the context of finance transactions where default invariably involves a failure to pay a definite sum, notwithstanding that default interest may be relatively modest and is designed to reflect an increased credit risk.
- The law in Ireland on default interest in loan agreements and other financial contracts is not on a par with the more liberal position in the UK, and will remain that way unless and until updated by a decision of the Irish Supreme Court. This is not something that will occur in the short term.
- For now, if a default interest provision is contained in standard terms and conditions, it will be considered to be a penalty.
- As a matter of practicality, 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 would be advisable to exclude the default interest provision in the standard terms, and for the facility letter to provide for a bespoke default interest clause.
- Where lenders or other commercial parties are seeking to include default interest provisions, these ought to be bespoke negotiated terms which have regard to the damage or injury caused by any default, in order to give them the best chance of not being considered a penalty. Consideration might also be given to including language that each party to the agreement agrees that the negotiated term is a genuine pre- estimate of the losses which would occur on a default, and a term to the effect that the defaulting party acknowledges that the negotiated provision is not a penalty. The strength of each parties' bargaining position and whether there has been a true negotiation and engagement on the terms of a genuine pre-estimate of losses on default will still likely fall to be considered in any dispute on the issue, but it may be of assistance to lenders, particularly, in non-consumer lending, to include such provisions if they wish to seek default interest.
- Great care needs to be taken in framing letters of demand as they may create an estoppel, and may prevent a lender from changing the basis upon which it has demanded payment. Statements in such correspondence bind not only the original lender but also any purchaser or assignee of the loan.
- Standard reservation of rights language may well be ineffective to counteract any express or implied representation contained in correspondence.
- A clause in a loan agreement or other financial contract which obliges the borrower or bank counterparty to pay the bank's costs where legal proceedings ensue will only be enforceable to the extent expressly permitted by the court.
1 Cavendish Square Holding BV v El Makdessi/Parking Eye Ltd v Beavis  UKSC 67.
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