A recent High Court decision marks an important step in the development of the approach to the “Penalty Doctrine” in New Zealand – that is, the principle that contractual provisions which allow parties to punish one another disproportionately are unenforceable. Justice Whata’s judgment in
Honey Bees v 127 Hobson Street1 carefully traverses the recent evolution of the doctrine and provides helpful clarification of its application to contracts in New Zealand.
The judgment will be of particular interest to those considering liquidated damages-type clauses in their contracts. It heralds the end of the old test which asks whether the clause is a “genuine pre-estimate of loss”, and instead asks a much broader question about the interest to be protected.
Facts of the case
The plaintiffs were the operators of the “Honey Bees” preschool. In 2012, they agreed to lease fifth-floor premises on Hobson Street. In a Collateral Deed to the Lease, the landlord agreed to install a second lift and to indemnify Honey Bees for “all obligations they may incur under the Lease” including rent and other expenses, if the second lift was not fully operational by 31 July 2016.
The landlord failed to install the second lift by the deadline (and had failed to do so as at the trial in September 2017). Honey Bees sought to enforce the indemnity under the Collateral Deed, but the landlord argued it was an unenforceable penalty.
Was the penalty doctrine engaged?
The first question was whether the penalty doctrine applied at all in this context, or whether (as argued by Honey Bees) it was confined solely to payments arising upon breach of a contract. The Courts in the UK and Australia are split on that issue. In short:
The UK Supreme Court has held that the doctrine applies only upon breach of contract. That is, only clauses which are “secondary obligations” to compensate for breach of “primary obligations” can be struck out as penalties.2
Conversely, the High Court of Australia has held that a breach of contract is not required, and the doctrine can extend in equity to “primary obligations”3.
Honey Bees, the Judge preferred the former approach – the penalty doctrine affixes only to secondary obligations to compensate or make good on the breach of or failure to discharge primary obligations.
On the present facts, the Judge construed the indemnity as creating (in substance) a liability which was secondary to the breach of the landlord’s primary obligation to install the lift. The indemnity was therefore
capable of being characterised as a penalty (the doctrine was engaged), and the next question was whether it was
in fact a penalty.
A penalty in fact?
In considering whether the indemnity was a penalty, the Judge considered whether the indemnity protected and was proportionate to Honey Bees’ legitimate interests in enforcement. This focus on legitimate interests reflects the recent approach of the courts in the UK and Australia (and also applied by New Zealand Court of Appeal, though in a case decided on New South Wales law - discussed
here). That approach has gradually replaced the longstanding test established by Lord Dunedin in
Dunlop v New Garage4 which examined whether the sum claimed was a genuine pre-estimate of loss.
Applying the legitimate interest test, the Judge considered that the indemnity was not a penalty because it was proportionate to Honey Bees’ legitimate interests in securing installation of the lift and obtaining a fully licensed preschool facility. The reasons included that:5
Liability under the indemnity would only arise some 31 months after the deed was executed. The landlord had had ample opportunity to install the lift;
The landlord was considered commercially astute, and should have known of the importance of the lift;
Honey Bees had incurred significant expenditure in fitting out the premises;
Though the landlord was not independently advised, this was because he was content to rely on his own experience of property matters; and
Based on prior dealings, Honey Bees had “good reason to doubt the reliability” of the landlord’s ability to install the second lift on time, and therefore the indemnity justifiably sought to deter non-performance in strong terms.
Accordingly, Honey Bees was entitled to specific performance of the obligation to indemnify.
The decision offers a welcome clarification that New Zealand will follow the approach of the UK Supreme Court on the law of penalties. In adopting this approach, the New Zealand High Court has narrowed the scope of the penalty doctrine to payments arising upon breach of contract, making it much clearer for those drafting contracts to know when the doctrine might be engaged.
Honey Bees also highlights the importance of considering the purpose of these types of clauses. Parties who wish to insert a clause providing for consequences of contractual non-performance should carefully consider whether there is a bona fide interest that the clause is trying to protect, and whether the consequences of non-performance are proportionate to that interest. That will be a question of fact in each case. However, commercial parties can take some comfort, based on the UK approach, that courts will be reluctant to engage in a weighing of interests and are more likely to assume that commercial parties have agreed a clause that is proportionate rather than penal.
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.