The Supreme Court has its say on the rule against penalties
The possibility that a party to a contract will breach the contract is often considered at the time the contract is entered into. The parties may prefer to agree the consequences of a breach in advance, rather than leaving those consequences to be determined by the courts (through application of the law of damages). A common example is in construction contracts, where the contract stipulates the ‘liquidated damages’ payable by the contractor if the contractor fails to complete the works by the due date for completion.
However, the courts have declined to enforce such clauses where the clause is determined to be penal, rather than compensatory, in nature.
The recent decision of the Supreme Court in 127 Hobson Street Limited v Honey Bees Preschool Limited [2020] NZSC 53 sets out the principles to be applied in determining whether a clause in a contract is an unenforceable penalty.
Background
The background is briefly set out below.
Honey Bees Preschool Limited (Honey Bees) is a childcare business located on the fifth floor of a central Auckland high rise.
127 Hobson Street Limited (127 Hobson) leases the premises to Honey Bees. In a collateral deed (i.e. a separate document to the deed of lease), 127 Hobson agreed to install a second lift in the building, providing additional access for Honey Bees’ business.
127 Hobson also agreed that if the lift was not installed by a certain date, they would indemnify Honey Bees for rent and outgoings under the lease until its expiry.
127 Hobson failed to install the lift by the agreed date.
Honey Bees issued proceedings in the High Court to enforce the indemnity. 127 Hobson defended the claim on several grounds, including that the indemnity breached the common law rule against contractual penalties.
The High Court, and then the Court of Appeal, found the indemnity lawful and enforceable (i.e. it did not breach the rule against penalties).
The Court of Appeal said that the test to be applied in determining whether the indemnity was an unenforceable penalty was whether the indemnity imposed a detriment on 127 Hobson out of all proportion to any legitimate interest Honey Bees had in enforcement of the primary obligation to construct the second lift.
127 Hobson was granted leave to appeal to the Supreme Court.
Supreme Court decision
The appeal to the Supreme Court involved two issues.
Issue 1: What is the content of the penalty rule in New Zealand?
The Supreme Court held that the test to be applied for a contractual penalty was as follows (being an extract from the media release):
A clause providing that 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 it can fairly be described as exorbitant when compared with those legitimate interests. The legitimate interests may extend beyond the direct loss caused by the breach. The parties may agree to consequences for breach which recognise the broader impact of non-performance of the obligation on the commercial interests the parties seek to achieve or protect through the contract.
The test is described in more detail at paragraph 91 of the judgment.
Issue 2: Was the indemnity an unenforceable penalty?
The Supreme Court unanimously dismissed the appeal on the basis that the indemnity did not breach the rule against penalties. The Supreme Court held that the consequences were not out of all proportion to the legitimate interests of Honey Bees. Operating a business on the premises which was supported by two lifts and the protection of the future growth prospects of the business were legitimate interests of Honey Bees.
The “all or nothing” nature of the obligation to install the second lift was relevant to the assessment of whether the consequence contracted for was out of proportion to Honey Bees’ interest in performance. But, the consequences were not exorbitant in the overall circumstances.
More information
You can obtain a full copy of the Supreme Court’s decision here.
If you have any questions or would like advice in respect of how the Supreme Court’s decision may impact you, please contact your usual point of contact at Kemps Weir or contact us here.
Disclaimer: This publication should not be construed or acted on as legal advice. It is brief and general in nature. Specific advice should be sought.