The Supreme Court's judgment in
127 Hobson Street Ltd v Honey Bees Preschool Ltd
 NZSC 53 is now New Zealand's leading authority on the application of the penalty doctrine (the rule that contractual parties should not be permitted to excessively punish one another for breach).
The Supreme Court, endorsing the approach in the Court of Appeal, found that whether a clause is a “penalty" turns on whether it imposes a consequence out of all proportion to the innocent party's “legitimate interests" in performance.
The case relates to the lease by Honey Bees Preschool of fifth-floor premises owned by 127 Hobson Street Limited as landlord. The premises were accessible via a single lift. As part of the lease negotiations, the parties agreed, under a deed of lease and a separate collateral deed, that the landlord would install a second lift. The collateral deed provided that if the second lift was not operational by a certain date, the landlord would indemnify the tenant “for all the obligations they may incur… under the lease". The landlord failed to install the second lift by the deadline and the tenant sought to enforce the indemnity. The landlord argued it was penal and unenforceable.
High Court and
Court of Appeal found that the indemnity clause was lawful and enforceable. The landlord appealed.
New Zealand's approach to the penalty doctrine
The Supreme Court rejected the landlord's appeal. In doing so, it confirmed that New Zealand's approach to applying the penalties doctrine is as follows:1
A clause stipulating a consequence for breach of a term of the contract will be an unenforceable penalty if the consequence is out of all proportion to the legitimate interests of the innocent party in performance of the primary obligation… A consequence will be out of all proportion if the consequence can fairly be described as exorbitant when compared with those legitimate interests.
This crystallises New Zealand's adoption of a recent trend (which started in the UK Supreme Court in 20152) away from the historic focus of whether a liquidated damages clause represented a “genuine pre-estimate of loss", towards a more commercial, flexible approach which recognises that some performance interests may extend beyond a purely compensable measure.
How that test should apply:
(a) What constitutes “legitimate interests" is to be judged at the time the clause was agreed between the parties and by reference to both the terms and the circumstances of the contract. Legitimate interests can include some element of deterrence (as the Court put it, “deterring breach is simply the flip side of securing performance"), as well as “protecting a way or system of conducting business of which the contract forms a part." On the facts of the case, the legitimate interests of Honey Bees in securing a second lift included the need for greater access to the preschool and the development of a new business.
(b) As in the earlier decisions, the Court indicated that the parties' conduct and bargaining power may be relevant to the proportionality assessment (the assessment of whether the clause is out of all proportion to the legitimate interests). On the facts, the Court found that Honey Bees had not taken advantage of an unequal bargaining position as the landlord was a sophisticated commercial party who had made a conscious decision not to obtain legal advice before entering into the collateral deed.
(c) Interestingly, the Court rejected the Court of Appeal's suggested “cross check" of looking at whether the clause was intended to be punitive, considering it superfluous to the proportionality test.
The Supreme Court was not required to decide the vexed question of whether a breach of contract is an essential prerequisite to engaging the rule against penalties (as in the UK) or whether it applies to other situations beyond breach (as in Australia3) – because it was not disputed that the indemnity arose on breach. Therefore the Court of Appeal's preference for the UK approach remains the leading authority on that point.4
This decision will be welcomed by many commercial parties as a further endorsement of freedom of contract, or in other words the ability for commercial parties to freely decide between themselves terms which appropriately secure performance. That said, it will be important for all parties to remember that the application of the doctrine will vary from case to case, and to take particular care when drafting liquidated damages clauses that are carefully structured and defensible by reference to legitimate performance interests.
If you have any questions about the matters raised in this article please get in touch with the contacts listed, or your usual Bell Gully adviser.
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.