Supreme Court Sets Out The Test For Determining Whether A Clause in a Contract Constitutes an Unenforceable Penalty

Under the doctrine of penalties, contractual clauses that impose a disproportionate penalty in response to a parties breach are generally unenforceable as a matter of law.

In the Supreme Court’s recent decision, 127 Hobson Street Ltd v Honey Bees Preschool Ltd [2020] NZSC 53, it provided the appropriate test for how to determine whether a clause constitutes an unenforceable penalty.

Factual background

The case concerned 127 Hobson leasing its commercial property to Honey Bees, who would then operate a preschool out of the premises.  From the outset of the pre-lease negotiations, Honey Bees conveyed to 127 Hobson that it would need to install a second lift in the building to allow Honey Bees to fully utilise the premises for its preschool business. 

Subsequently, in an agreement separate to the lease, the parties agreed that: (1) 127 Hobson would install a second lift in the building by a certain date; and (2) if it failed to do so, it would indemnify Honey Bees for all of its obligations under the lease.

127 Hobson ultimately failed to install the second lift by the set date and Honey Bees thereafter brought proceedings to enforce the indemnity clause.  127 Hobson defended those proceedings, in relevant part, on the basis that the indemnity clause constituted a penalty and was therefore unenforceable.

Both the High Court and the Court of Appeal ruled against 127 Hobson, holding that the indemnity clause was enforceable.  The Supreme Court affirmed the Court of Appeal’s decision, holding that the indemnity clause was not a disproportionate penalty as it protected Honey Bees’ legitimate interest in having the second lift installed, with said lift being necessary to protect Honey Bees’ future business prospects.

Test to be applied

In reaching this decision, the Supreme Court articulated the test to be applied as follows:

  • 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.  A consequence will be out of all proportion if the consequence can fairly be described as exorbitant when compared with those legitimate interests;

 

  • Whether the clause is an unenforceable penalty requires an objective examination of the interests being protected at the time the contract was entered;

 

  • An innocent party’s legitimate interests is not limited to economic losses and may extend to the impact of non-performance on the party’s commercial interest;

 

  • Deterring breach of an agreement can be a legitimate objective of the clause;  and

 

  • The bargaining power of the parties and access to legal representation will be relevant to the Court’s inquiry, but the Court will presume that commercial parties dealing with each other on equal terms are able to properly assess the proportion between the legitimate interests and the consequences of the breach.

Moving forward

The Supreme Court’s decision suggests that New Zealand courts will be less likely to interfere with the contractual arrangements parties reach, even when those bargains result in harsh consequences.

When entering into contractual arrangements with these types of clauses, parties should ensure to record in writing at the time of contracting what interests are being protected by the indemnity and/or liquidated damages clauses.  Further, if the clause is for a quantifiable sum, the parties should also set out how that sum has been calculated.

The full decision can be found here.