A common question when drafting a commercial contract is whether a “penalty” can be imposed where the other side commits some form of default. For example, failure to adhere to an SLA as part of an IT Service Agreement. The answer to the question often surprises. A penalty clause will not be enforceable at Irish law unless it is a genuine pre-estimate of the loss suffered. Therefore, great care should be exercised to ensure that a contingency clause (eg. provision for what happens should a contingency arise) is not construed as a penalty clause. For example, if Party A fails to deliver X goods to Party B, by 16.00 on 1st January 2021, Party A will be liable to make a payment to Party B for €1,000,000. Where €1,000,000 has no correlation to B’s loss whatsoever and no provision has been made in the contract demonstrating this loss, it’s highly likely that such a clause will be unenforceable at Irish law. This is a significant issue in drafting performance clauses in outsourcing agreements.
The enforceability of penalty clauses was dealt with in the recent linked litigation cases in Irish Court of Appeal case of Flynn v Breccia and Sheehan v Breccia, where the court relied on the traditional test that surcharge interest was not a genuine pre-estimation of loss and consequently the surcharge was a penalty and unenforceable.
The UK Supreme Court in Cavendish Square Holdings v Tala El Makdessi, has taken a broader approach to the issue. It held that a clause will be a penalty clause if it imposes a detriment on the contract breaker out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation under the contract. Although the Irish Court of Appeal did not adopt this broader approach in Flynn the option remains available to the Irish Supreme court to adopt it a later date.
Parties wishing to include such provisions in their commercial contracts should carefully consider and provide workings within the commercial contract demonstrating what their loss would in fact be should the contingency happen. Having language contained in the contract to the effect that the parties agree that the negotiated clause is in fact a genuine pre-estimation of loss, is not a penalty clause and that the defaulting party agrees to abide by its terms on default will go some way towards bringing the clause outside the definition of being a considered a penalty clause.
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