The Supreme Court decision in 127 Hobson Street Ltd v Honey Bees Preschool Ltd [2020] NZSC 53 (Honey Bees) confirms the law on penalty clauses in New Zealand. This is a highly anticipated decision as it applies to delay liquidated damages in the construction industry.

The Supreme Court has unanimously dismissed 127 Hobson’s appeal and confirmed that the Court of Appeal’s proportionality test is the correct test to apply when determining whether or not a contractual term constitutes an unenforceable penalty.

The Supreme Court reiterated the test as:[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.”

Applying this test, the Supreme Court agreed with both the High Court and Court of Appeal that the consequences for breach stipulated in an indemnity clause under a collateral deed were not out of all proportion to Honey Bees’ legitimate interests in 127 Hobson’s performance of its obligation. For a comprehensive summary of the facts of the case and the High Court and Court of Appeal decisions, please see our previous articles available here and here.

What does this mean in the construction context?

The Supreme Court decision provides clear precedent on penalties in New Zealand. However, time will tell as to how the courts will apply Honey Bees in the construction context, where liquidated damages (LDs) are commonly used as a consequence of a Contractor’s failure to complete the Contract Works by a pre-defined completion date.

The Supreme Court’s affirmation of this “more flexible and permissive” penalty test should give principals / developers comfort that the courts will be slow to interfere with what parties have contractually agreed when it comes to LDs. However, it is important for contracting parties to understand the key principles underlying the penalty test, and what this practically means when drafting contract terms.

We summarise these key principles and how they might practically apply in the context of LDs below:

• The focus of the proportionality test is whether the LDs amount is proportionate to the legitimate interests being protected by the clause (rather than whether the amount is a “genuine pre-estimate of loss”). Legitimate interests go beyond just compensation for breach, and require consideration of a wide array of commercial interests which may extend “beyond the four corners of the contract”.
  • What does this mean? LDs clauses can protect interests beyond merely compensation for breach. For example, if late completion will have a flow on effect on production in other aspects of the business, then this is likely able to be accounted for in the amount of LDs.
• Assessing whether or not something is a penalty is an objective exercise and looks at the circumstances at the time when that contract was formed, with reference to the terms and circumstances of the contract.
  • What does this mean? Given the test assesses the legitimate interests of a party at the time the contract was formed, parties should record at the time of contracting what interests the LDs provision is seeking to protect, and how they have been calculated / measured.
• The “all or nothing” nature of a clause is relevant to the issue of proportionality. If there is no attempt to scale the consequences to the length of the breach (e.g. period of delay), then this will weigh against the innocent party.
  • What does this mean? In an LDs context, it may be useful to consider whether a scaled LDs approach would be appropriate. For example, it is not uncommon for parties to agree to a nominal amount of LDs to apply for an initial period, with the LDs amount ‘scaling up’ to account for the consequences of continued delay.
• The bargaining power of the parties is relevant to assessing whether or not a clause constitutes a penalty. A court will presume that commercial parties dealing with each other on equal terms are able to assess what a ‘proportionate’ consequence for breach should be. While the fact parties sought legal advice when negotiating the contract will weigh in favour of upholding the bargain made, this is not determinative. For example, a party may not receive legal advice, but they may be a sophisticated commercial party who understands the commercial bargain they are making (as was held to be the case in Honey Bees). It remains to be seen how the “similar bargaining power” factor will play out in the construction context, given some of the inherent issues facing the sector.
  • What does this mean? Parties should be careful when negotiating LDs provisions to understand their counterparty and their relative bargaining power. A party may not have a lawyer at the table when negotiating the contract, but in the construction context, parties often have extensive commercial experience, including when it comes to negotiating LDs. Whatever the relative bargaining positions of the parties, the key issue remains whether the consequences for breach are out of all proportion to the innocent party’s legitimate interests in performance.

If you have any questions in relation to this article or penalties in general please contact our experts.

Footnote

[1] 127 Hobson Street Ltd v Honey Bees Preschool Ltd [2020] NZSC 53 at [56].