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  NZSC 53, it provided the appropriate test for how to determine whether a clause constitutes an unenforceable penalty.
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:
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.