Doctrine of Penalties: New Zealand Supreme Court Emphasises the Need to Look Beyond Contractual Loss

Brooke Holden and Simon Collier

In the past five years, the doctrine of penalties has come under significant scrutiny in the United Kingdom and Australia. In particular, the courts have expressly moved away from the traditional test in Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co Ltd [1915] AC 79, which was focused significantly on the need to assess whether the sum payable under the impugned clause is a “genuine pre-estimate of loss”.

In 127 Hobson Street Limited v Honey Bees Preschool Limited [2020] NZSC 53 (“Honey Bees”), the New Zealand Supreme Court (“NZSC”) has done likewise reinforcing that a clause will be upheld if it protects broader legitimate interests, which is not limited to a pre-estimate of the loss which would be recoverable in damages.

Background

127 Hobson Street Limited (the “Landlord”) leased premises to a new childcare business, Honey Bees Preschool Limited (the “Tenant”), for six years in a busy high rise building.  The Landlord agreed in a collateral deed to the lease to install a second lift for use of the Tenant within two years and seven months, in order to facilitate students and parents having easier access to the preschool.  If it failed to do so, it agreed to indemnify the Tenant’s repayment obligations for the remainder of the lease (three years and five months).

The lift was not installed in time and the Tenant sought to enforce the indemnity.  The Landlord argued that the indemnity was an unenforceable penalty as it was not proportionate to the Tenant’s potential losses in not having the additional lift.  In particular, the landlord relied on the fact that the penalty was drafted in such way that it was “all or nothing”, meaning one day delay in installing the lift would trigger the full indemnity, which it argued was entirely disproportionate.

Honey Bees presented the New Zealand Supreme Court (“NZSC”) with its first opportunity to re-consider the law of penalties and decide whether to follow recent developments in the United Kingdom Supreme Court (Cavendish Square Holding BV v Makdessi; ParkingEye Ltd v Beavis [2015] UKSC 67 (“Cavendish”)) and in the Australian High Court (Paciocco v Australia & New Zealand Banking Group Ltd [2016] HCA 28, (2016) 258 CLR 525 9 (“Paciocco”)).

Judgment of the NZSC  – New Test Adopted

Overall, the NZSC was persuaded by the reasoning in Cavendish and Paciocco that there was a need to move beyond the traditional test based upon a comparison between what the impugned clause provides and what might have been recoverable as contractual damages ([57]).  The new test to be adopted was helpfully summarised in paragraph 91 of the Judgment:

  • The proper approach is to determine, objectively as at the date of entering into the contract, whether the obligation imposed by the clause is “out of all proportion”, or “exorbitant”, when compared with the innocent party’s “legitimate interests” protected by the clause ([91(a)‑(c)]).
  • While legitimate interests will not include objectives unrelated to the performance interest, such as punishment, a party’s legitimate interests may be broader than the possible loss measured by a conventional assessment of contractual damages. These can include the impact of non-performance on the broader commercial interests that the parties seek to achieve or protect through the contract ([91(d)]).  Indeed, deterring breach in of itself can be a legitimate objective of a clause ([91(e)]).
  • Courts will be slow to intervene where the clause has been negotiated by commercial parties with similar bargaining power. The court will presume that commercial parties dealing with each other on equal terms are able to assess the appropriate proportion between the legitimate interests in performance of the primary obligation and the consequence of breach to which they have agreed.  But where there is evidence of unequal bargaining power, or where one party is not legally advised, a court will scrutinise more closely the innocent party’s claims as to the interests protected, and also the issue of proportionality ([89]).

The NZSC specifically rejected the appellants’ contention that, regardless of the test to be applied, the court was still required to consider the likely damages that would have been available but for the clause.  The Court accepted that sometimes an assessment of contractual damages may be a useful indicator.  For example, an assessment of actual damages may be relevant (if not determinative) where the clause purports to provide a pre-estimate of loss, or where the only legitimate interest in performance can be properly analysed as the monetary loss that directly flows from the breach ([76]-[78], [91(g)]).

However, the Court said that where the impugned clause protects broader legitimate interests (i.e. beyond the interest in compensation for direct loss), or where the loss would have been difficult or impossible to forecast, a notional calculation of damages is unlikely to be of any value ([78]).

A Further Purpose Test?

The NZSC also expressly rejected the New Zealand Court of Appeal’s suggestion that the proportionality test should be cross-checked against a “punitive purpose test” i.e. whether the predominant purpose of the secondary obligation is to punish the promisor rather than protect the legitimate interest of the promisee in performance of the primary obligation.  The NZSC said that such a test was unhelpful.  Requiring the Courts to assess the purpose of inserting the clause invites a separate inquiry into the state of mind of the parties which could lead to a different or conflicting result to that achieved by applying the proportionality test ([58]).

Application

The NZSC ultimately concluded that the indemnity was not a penalty.  The Tenant was a startup business; limited access could reasonably be viewed as likely to adversely impact the number of children that the preschool could accommodate, and therefore the future growth and success of the business ([103]).  It therefore had a legitimate interest in operating a business supported by two lifts, which legitimate interest was not out of proportion to imposition of the indemnity ([116]).

Comment

This decision provides welcome clarification and simplification of the common law test for penalties, which recognises that parties may legitimately protect performance interests that extend beyond the kind of loss recoverable as contractual damages.  The result is greater certainty in the enforceability of penalty clauses, signaling an increased willingness on the court’s behalf to uphold clauses of this nature.

The question as to what will constitute a “legitimate” interest remains, however, uncertain, and it will be interesting to observe how this area of the law develops.  What is clear is that parties wishing to include a penalty clause in their contractual framework, should specifically consider the interests the clause is seeking to protect, and given the objective nature of the test, ensure that these interests are communicated to the other party during negotiations (better still, expressly set out in the agreement).

The decision is a worthwhile step towards clarification of the law, and brings New Zealand in line with developments in Australia and the United Kingdom.  It remains to be seen whether other common law jurisdictions, such as Hong Kong, will follow suit (the issue has yet to be considered by the Court of Final Appeal of Hong Kong but there is some support for the Cavendish test in the Court of Appeal, see Bank of China (Hong Kong) Ltd v Eddy Technology Co Ltd [2019] 2 HKLRD 493).

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