Court of Appeal confirms law on penalty clauses in New Zealand
The recent Court of Appeal decision in 127 Hobson Street Ltd v Honey Bees Preschool Ltd  confirms the scope of the rule against unenforceable penalties and the application of the reasoning in Wilaci  in New Zealand.
The Court dismissed the appeal and upheld Whata J’s decision in the High Court . We have previously addressed the High Court decision which considered the re-casting of the penalty test in the United Kingdom  and Australia . A copy of our commentary is available here.
Honey Bees Preschool (Honey Bees) entered into a lease with 127 Hobson Street (127 Hobson) for the purposes of operating a childcare centre. It also entered into a collateral deed (Deed) which required 127 Hobson to install a second lift at the premises. If 127 Hobson did not install the lift on or before 31 July 2016, it had to indemnify Honey Bees for all obligations it may incur to 127 Hobson to the expiry of the lease (the Clause) including rent and operating expenses. 127 Hobson failed to install the lift on time and Honey Bees sought to enforce the indemnity. 127 Hobson denied liability on the basis that the Clause was an unenforceable penalty.
Under traditional legal principles, a fee is an unenforceable penalty if it is payable on breach of a term of a contract and the payment is extravagant in comparison to the genuine pre-estimate of loss. If a clause had the purpose of deterring a party from breaching, then it was likely to be a penalty. However, recent overseas cases in the UK and Australia have broadened the traditional test as follows:
- there may be other broader legitimate interests (apart from loss suffered) that are relevant to whether a clause is a penalty; and
- the fact that a clause is designed to deter a party from breaching, does not mean that it is necessarily a penalty.
In addition, the Australian and UK cases disagree on whether the penalty doctrine only applies where a sum is payable on breach of contract. The Supreme Court in the UK decision of Cavendish  has said that a breach of contract is necessary and that a penalty only exists where a secondary obligation is imposed to compensate for breach of a primary obligation. In contrast, the High Court of Australia has said that a breach is not necessary and that a primary obligation can be a penalty. These matters were discussed by the New Zealand Court of Appeal in Wilaci – see our case summary here.
In Honey Bees, the High Court was asked to consider whether the new UK and Australian approaches should apply in New Zealand. The High Court found in favour of Honey Bees, concluding that although the penalty rule was engaged, the indemnity was not an unenforceable penalty as it was not out of proportion to Honey Bees’ legitimate interests in the performance of the obligation. The High Court preferred the UK approach to the rule against penalties, taking the view that the rule affixes only to secondary obligations which are imposed to compensate for a breach of a primary obligation.
Confirmation of the law relating to unenforceable penalties
127 Hobson appealed the High Court’s finding that Honey Bees was entitled to specific performance of the obligation to indemnify. The Court of Appeal helpfully confirmed that the primary test for a penalty in New Zealand is the ‘disproportionality test’. The essential question is whether the secondary obligation imposes a detriment on a promisor out of all proportion to any legitimate interest of the promisee in the enforcement of the primary obligation. The Court noted that damages are not necessarily the only legitimate interest that the innocent party may have in the performance of the obligation. There may be other commercial justifications which represent legitimate interests.
The bar to meeting the test – “out of all proportion” – was described by the Court as being a “particularly high one”. The Court referred to its decision in Wilaci noting that imbalance in bargaining power and unconscientious conduct are relevant factors.
By way of a cross-check, the Court considered the associated ‘punitive purpose test’. That is, whether the predominant purpose of the secondary obligation is to punish the promisor rather than protect the promisee’s legitimate interest in performance of the primary obligation. The Court held that the test focuses on whether the predominant purpose of the clause is to deter. However, the Court noted that the proportionality test and the punitive purpose test are two sides of the same coin.
The Court noted that the disproportionality test gives greater credence to freedom of contract and the enforcement of bargains made by free agreement. It recognises that contracting parties, particularly those who are commercial entities, are likely to be the best judges of their own interests.
The Court of Appeal also clearly preferred the UK approach to penalties and found that the UK Supreme Court’s comments were “well made” – that the penalty doctrine should be restricted to secondary obligations which apply on breach. However, the Court acknowledged this view was not binding as this was not an issue they were required to decide in the Honey Bees case.
Having held that the penalties doctrine was engaged, the Court of Appeal considered three issues:
- What is the proper construction of the Clause?
- Is the Clause a penalty?
- What relief should be ordered?
The Court held that on a proper construction of the Clause, the indemnity could not be said to run beyond the initial term of the lease (being six years, after which Honey Bees was entitled to exercise a right of renewal).
The burden lay on 127 Hobson to establish that the indemnity was out of all proportion to Honey Bees’ legitimate interest in performance of the obligation to install the second lift by the due date. The Court held 127 Hobson had not discharged its burden having regard to the following key considerations (amongst others):
The nature of Honey Bees’ legitimate interests requiring protection:
- The lift was of considerable importance to Honey Bees in terms in terms of usability of the premises and was crucial to Ministry of Education licensing. The second lift had been the subject of representation by 127 Hobson prior to entry into the lease.
- The landlord’s conduct prior to entry into the lease may well have given Honey Bees reason to consider that strong measures were justified to ensure the lift was installed.
Whether the protection in the Clause is out of all proportion to those interests:
- The agreement to lease contained no right to cancel if the lift was not installed. Instead, 127 Hobson insisted that the obligation be contained in the collateral Deed. This was disadvantageous to Honey Bees. It meant Honey Bees would not be entitled to either cancel the lease or withhold payment of rent. If Honey Bees withheld rent, it would be exposed to cancellation by 127 Hobson, loss of its sunk costs in fitting out the premises and liability to 127 Hobson until the premises were re-let.
- The indemnity was proportionate in that it only applied until the end of the initial term of the lease and would not apply on renewal. Had the indemnity remained in place for the entire contract, the indications are that the Court may have found it was a penalty.
Ultimately, the Court of Appeal held that 127 Hobson is required to indemnify Honey Bees for all obligations in the nature of payments (including rent and operating expenses) down to expiry of the initial term of the lease, being 19 December 2019. An order for specific performance to that effect was also made.
The Court of Appeal’s decision provides helpful clarity on the law of penalties in New Zealand and the applicable test.
The Court’s preference that the penalty doctrine should only apply to secondary obligations shows a preference to narrow the scope of the penalty doctrine to sums payable on breach of a contractual term.
The acceptance of the broader legitimate interests test from the UK will allow commercial parties to rely on broader reasons to justify clauses which impose an obligation on breach. We recommend that where possible, commercial parties embed the justification for such clauses into their contract so that courts are left in no doubt as to the legitimate interests the parties are seeking to protect. The multi-faceted approach which the Court of Appeal has taken means that predicting whether a clause will be penal and therefore unenforceable remains a complex task and one depending on the particular circumstances of each case.
  NZCA 122.
 Wilaci Pty Ltd v Torchlight Fund No 1 LP (in rec)  NZCA 152,  3 NZLR 293.
 Honey Bees Preschool Ltd v 127 Hobson Street Ltd  NZHC 32,  3 NZLR 330.
 Cavendish Square Holding BV v Makdessi  UKSC 67,  AC 1172.
 Paciocco v Australia and New Zealand Banking Group Ltd  HCA 28, (2016) 258 CLR 525.
 Cavendish, above n 4.