Penalty Doctrine update: Honey Bees in the Court of Appeal

23 April 2019

​​​New Zealand has a new leading judgment on the Penalty Doctrine (the rule that prevents disproportionate punishment for contractual breach). 

127 Hobson Street v Honey Bees Preschool [2019] NZCA 122 represents the latest in a series of recent penalties cases, and sets out a clear articulation by the Court of Appeal of how the doctrine applies in New Zealand. That is, sparingly - and only where the clause is out of all proportion to the interests being protected. Though this still requires a careful construction of the contract and interests in each particular case, the decision will no doubt be of general interest to any business seeking to stipulate the consequences for bre​ach of contract.

Background to Appeal

In 2013 a preschool leased fifth-floor premises on Hobson Street, accessible via one lift. The term of the lease was for an initial period of six years (to 2019) with a final expiry date (including any renewed terms) of 2037. In addition to the lease, the preschool and landlord agreed a "collateral deed" under which the landlord agreed to install a second lift (which the preschool required for educational licensing purposes) by 31 July 2016, failing which it agreed to indemnify the preschool for all obligations "to the expiry of the Lease." The landlord missed the deadline and the preschool invoked the indemnity clause. The landlord challenged the indemnity as being an unenforceable penalty, but failed in the High Court (see our previous update). The landlord appealed.

The Court of Appeal's judgment, given by Kós P, summarised the correct approach to the Penalty Doctrine and how it applied to the parties' indemnity clause, ultimately dismissing the appeal.

Correct approach to the Penalty Doctrine

The Court confirmed that the correct test for a penalty, as adjusted by recent authorities in New Zealand and overseas, is whether a stipulated remedy for breach is out of all proportion to the legitimate performance interests of the innocent party. The Court observed that the modern approach "gives greater credence to freedom of contract" than the historic formulation (whether the sum claimed was a genuine pre-estimate of loss), and that the requirement to show a clause is "out of all proportion" sets a "particularly high" bar.

The Court explained that the "proportionality test" may be "cross-checked" against the "punitive purpose test" – i.e. whether the predominant purpose of the secondary obligation is to punish rather than to protect legitimate performance interests. However, the Court described the tests as "two sides of the same coin".

The Court also addressed the question of whether the doctrine applied only to clauses contingent upon breach of contract (as in the UK) or extended to other types of provision (as in Australia). This was not a live question, as both parties had accepted the indemnity was a secondary obligation arising on breach. However, the Court resoundingly agreed with the High Court's preference for the UK approach (even describing the UK Supreme Court's "condemnation" of the Australian approach as "well made"). The New Zealand position is therefore clearly stated: the doctrine does not allow review of contingent obligations other than those operating upon breach.

Was the indemnity clause a penalty?

Applying the above principles to the indemnity clause in issue, the Court found that it was fair, and not penal. It noted various factors, including:

  1. The preschool had a legitimate interest requiring protection (the installation of the second lift being crucial for educational licensing purposes) and it had already expended significant costs on fitting out the premises.

  2. In light of the landlord's questionable conduct during negotiations (including only partial disclosure of parking limitations) the preschool had good reason to seek to impose a deterrent "in strong terms."

  3. Further, because the obligation to install the lift was recorded in the separate collateral deed, the preschool had no right to cancel the lease for breach of that obligation. In those circumstances, the indemnity was a proportionate measure to protect the preschool.

  4. In addition, the risk structure was balanced: the preschool was required to pay full rent pre-31 July 2016 even without the second lift, and was only relieved of its obligations if the landlord failed to install it by that date.

  5. The Court also considered that the duration of the indemnity was proportionately confined. The indemnity was expressed to run "to the expiry of the lease", which the Court construed as referring to the end of the initial term only, i.e. to 2019. It did not consider that the indemnity ran to final expiry of the agreement including renewal periods, i.e. to 2037 (as the landlord had contended in seeking to show the punitive effect of the clause). 

In respect of the last point, the judgment seems to suggest (though it does not say so expressly) that had the indemnity run through to 2037, that ​would h​ave been penal. (At one point the Court acknowledged that the inflexibility of the clause – which applied equally regardless of the length of delay – was the "best point" for the landlord, but that this was "much abated" by its construction of the indemnity as expiring in 2019). However, the judgment does not make clear whether this would have altered its conclusion, or indeed which of the various factors were determinative to its overall assessment.

As such, this judgment does not provide any bright line test for distinguishing unenforceable penalties from enforceable liquidated damages provisions. Rather, it highlights that there can be no bright line – and that whether a sum is "out of all proportion" to a party's "legitimate interests" remains a highly contextual question, measured against a wide range of factors. Therefore, notwithstanding the Court's various reassuring comments about the importance of freedom of contract, it is important to remember that even contracts between commercially sophisticated parties remain potentially susceptible to the doctrine, and will fall to be assessed in their own particular light.

If you need any further information on contract matters covered in this update, please contact your usual Bell Gully advisor.

Disclaimer: This publication is necessarily brief and general in nature. You should seek professional advice before taking any action in relation to the matters dealt with in this publication.