A recent High Court decision has shed further light on New Zealand's approach to the "penalty doctrine" - the rule which prevents contractual parties from disproportionately punishing one another for breach.
ACM Removals Ltd v Southern Demolition And Salvage Ltd  NZHC 124 marks a further step in a sequence of cases which have recently reappraised this long-standing doctrine (discussed here) and provides a helpful example of a clause which, though agreed between commercially astute parties with equal bargaining power, was considered nevertheless to be penal.
One important takeaway for businesses is that where a liquidated damages formula seeks to recover unpaid amounts under a contract, the formula should generally be set by reference to the balance unpaid - and not to the overall value of the contract.
Facts of the case
In 2015, Southern Demolition ("Southern") was engaged to demolish a building in Christchurch, and subcontracted with ACM Removals ("ACM") to carry out the removal of asbestos discovered in the walls. ACM submitted an initial quote for the work on terms which provided, at clause 19, for a late payment fee including: "… a daily charge of 0.125 per cent of the contract value."
Following subsequent negotiations, the contract value was agreed at $461,000, and the work commenced in late 2015. By April 2016, invoices had been issued and paid for 75% of the contract value. However, when ACM issued its final invoices in May 2016, the parties disagreed over whether the asbestos removal was complete. Southern refused to pay the invoices, cancelled the contract and engaged a substitute subcontractor to complete the works.
ACM issued proceedings for breach of contract. It claimed payment of the outstanding invoices, and liquidated damages under clause 19. Applying the daily rate (0.125%) to the contract sum ($461,000 plus GST) it claimed a daily rate of $663. Applied to the period of alleged default (685 days) the claim for liquidated damages was $454,000 – i.e. almost as much as the original contract value.
Southern denied liability for breach on the basis that ACM had failed to complete the works. It also argued that, in any event, clause 19 was an unenforceable penalty.
Penalty Doctrine – principles clarified
In a detailed judgment, addressing extensive evidence on the various amendments to the quote, Justice Mander found that ACM had materially failed to complete the asbestos removal and therefore was not entitled to payment of its final two invoices. It followed that ACM's liquidated damages claim failed (as its effect depended on establishing Southern's default). However, the Judge helpfully went on to explain whether he would have found clause 19 to be penal, had a breach by Southern been established.
The judgment provides a helpful summary of the evolution of the penalty doctrine, away from the traditional focus on whether the clause represents "a genuine pre-estimate of damages", towards a modern test based on proportionality. The modern test (adopted by the New Zealand Court of Appeal in Wilaci Pty Ltd v Torchlight Fund No 1 LP (in rec) and the High Court in Honeybees Preschool Ltd v 127 Hobson Street Ltd) looks at whether the sum claimed is out of all proportion with the legitimate performance interest sought to be protected. Importantly, as the Judge highlighted, the former test remains a relevant consideration as part of the assessment of whether a clause is penal in certain cases, including where the performance interest is payment of a contract sum.
Drawing in particular on Justice Whata's analysis in Honeybees, the Judge set out the following principles to guide the application of the penalty doctrine:
The threshold question of whether a clause is an unenforceable penalty is one of construction and context to be decided upon the terms and the circumstances of each contract. The issue is to be judged at the time of the making of the contract, not at the time of breach.
The fundamental issue is whether the impugned secondary obligation is out of all proportion to any legitimate interest in the enforcement of the primary obligation, or is exorbitant or unconscionable, having regard to the interests of the innocent party. The degree of disproportion between the contractually stipulated consequence and the loss likely to be suffered by the innocent party will inform the assessment of disproportionality. The degree to which that factor will be influential or potentially decisive will depend on the circumstances of the case and will remain an important yardstick where the performance interest is a contract sum.
The commercial context of the clause, including the relative bargaining power of the parties and whether they were commercially astute, is a relevant consideration.
Whether the predominant purpose of the impugned clause is to punish rather than deter non-performance will also be a relevant factor.
Application to the case
The Judge considered that the parties had similar bargaining power, and the daily rate of $663 was relatively minor when compared to the contract value. However, he considered that clause 19 was ultimately penal, noting the "lack of relativity between the late payment fee provided by the contractual term and the potential loss or risk arising from non-payment." He noted:
Clause 19 fixed the late fee against the whole of the contract price at a daily rate. It does not allow for any differentiation based on the amount of the balance owing, despite the contract being one for the payment of services rendered. The amount owing on the contract is an essential part of ascertaining the potential loss the plaintiff will suffer in the event of non-payment.
The fact that the fee would apply equally whether $1 was owed or $100,000 indicated that the formula was penal. The Judge considered that such a formula should be drafted so that "its application and effect could, at least in some moderate or broad way, be calibrated to take into account the amount owing on the contract which it is seeking to recover." Conversely, had the formula been based on the balance outstanding, rather than the whole contract sum, it would have been legitimate.
Both parties sought to invoke the finding in Torchlight where a $28 million fee for late payment of a $37 million loan was upheld (see our update on that case here). ACM argued that, as in Torchlight, the size of the ultimate sum was simply a consequence of Southern's choices in delaying and contesting the outstanding payments. However, the Judge agreed with Southern that Torchlight was distinguishable. There, the lender faced demonstrable and significant risks if the loan was not repaid, whereas there was no identified link between ACM's daily rate and the potential commercial effect of any non-payment. (The Judge also noted that, in Torchlight, the default rate was in fact lower than the standard interest rate applicable during the term of the loan, which further suggested it was not penal).
Similarly, the Judge carefully distinguished Honeybees, on the basis that in that case the relevant breach (failure by the landlord to install a lift) jeopardised the tenant's chances of obtaining a critical childcare licence. Again, the evidence in that case showed that fulfilment of the obligation was essential to the tenant.
This case offers important clarification to those drafting contracts containing liquidated damages formulae. On the one hand, the judgment emphasises that the question of whether a clause is an unenforceable penalty is context-specific and turns on the provisions and circumstances of each contract. At the same time, the judgment indicates that for a liquidated damages clause set by reference to payments under a contract, it will generally be safest to ensure that the sum is tied to the unpaid balances due under the contract, rather than its total value.
If you need any further information on contract matters covered in this update, please contact your usual Bell Gully advisor.
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.