Out of All Proportion: Contractual Penalties in New Zealand

A recent decision of the Supreme Court of New Zealand (NZSC) has confirmed the test for contractual penalty clauses in New Zealand and considered whether an indemnity clause amounted to a penalty.

In 127 Hobson Street Limited v Honey Bees Preschool Limited [2020] NZSC 53, Honey Bees preschool (tenant) entered into a lease with 127 Hobson Street Limited (landlord). The parties also entered into a Collateral Deed (contract) pursuant to which the landlord was required to install a lift at the leased premises. Under the contract, the landlord provided an indemnity in respect of the tenant’s obligations under the lease if the landlord failed to install the lift by a specified date.

The landlord failed to install the lift on time and the tenant issued proceedings in the New Zealand High Court (NZHC), claiming under an indemnity for the rent and outgoings due now and in the future, and seeking an order for specific performance.

The landlord resisted the indemnity on the basis that it was disproportionate to the tenant’s legitimate interests and therefore unenforceable as a penalty. The landlord submitted that the indemnity, if enforced on a literal interpretation, would release the tenant from all of its obligations under the lease (payment of rent and outgoings, maintenance, breakages, painting, groundskeeping, rubbish renewal, etc) for the duration of the lease and subsequent renewals.

Whata J rejected the landlord’s interpretation of the indemnity, instead finding that common sense required the indemnity to be confined to the tenant’s obligations to pay rent and outgoings for the initial term of the lease only. His Honour was satisfied that the tenant had good reason to doubt the reliability of the landlord’s commitment to install the lift, and held that the indemnity was not punitive, but rather sought to protect the tenant’s legitimate interest in the landlord’s performance of the lift installation.

The landlord appealed to the New Zealand Court of Appeal (NZCA), arguing that the NZHC had erred in finding that the indemnity did not have a punitive purpose. In dismissing the landlord’s appeal, the NZCA agreed with the NZHC’s finding that the indemnity was not disproportionate to the tenant’s legitimate commercial interests.

Finally, the landlord appealed to the NZSC, which endorsed an approach which captures the essence of the approach taken by the Australian courts, albeit adopting different wording:

A clause stipulating a consequence for breach of a term of the contract will be an unenforceable penalty if the consequences are out of all proportion to the legitimate interests of the innocent party in performance of the primary obligation.

The NZSC also recognised that ‘legitimate interests’ may extend beyond the loss caused by the breach (as assessed by a conventional measure of contractual damages) to include the broader commercial interests of the party seeking to enforce the terms of the contract.

In finding that the indemnity was not ‘out of all proportion’ to the tenant’s legitimate interests and dismissing the landlord’s appeal, the NZSC treated the following matters as relevant:

•   the tenant was a start-up business and had invested approximately $500,000 on hard fit-out costs on the premises, which would be difficult to recoup if the business’ growth was undermined;
•   being deprived of the additional lift was reasonably likely to adversely impact the growth and success of the tenant’s business, given that the preschool was located in a high-rise building with limited access points, and the number of children attending was important to the business’ commercial success.

Consistently with the approach of Whata J at first instance, the NZSC also observed that, when assessing whether consequences for breach are proportionate to a party’s legitimate interests, the court may have regard to the parties’ relative bargaining power. However, power imbalance alone is not determinative. It remains open to the courts to find that the consequences of an impugned clause are disproportionate to the parties’ legitimate interests, even where the parties are on equal footing and have received independent legal advice.

Although Honey Bees did not involve a construction contract, penalty doctrine arguments often arise in the context of liquidated damages clauses for the late delivery of projects. It will be interesting to observe how the meaning of “legitimate interests” is applied in building and construction disputes in New Zealand as the the penalties doctrine continues to evolve.

The full decision can be found here.