Supreme Court on test for penalty clauses

​The Supreme Court has confirmed that the test to determine if a contractual provision is an unenforceable penalty is whether the consequences are “exorbitant" or “out of all proportion to the legitimate interests of the innocent party".

If the consequences are not so disproportionate then the contractual consequence will be enforced.

The case

127 Hobson Street Ltd v Honey Bees Preschool Ltd[1] concerned a commercial lease entered into between 127 Hobson Street Ltd (the landlord) and Honey Bees Preschool Ltd (the tenant) in 2013. 

The parties had agreed an indemnity clause specifying that, if Hobson Street failed to install a second lift within a set period, Honey Bees would be indemnified for “the payment of rent, operating expenses and other payments" until the lease expired. 

Hobson Street did not meet the deadline but, when Honey Bees tried to enforce the indemnity for the remaining three years of the lease, claimed that it was an unenforceable penalty and so should be ignored.  

After failing in the High Court and the Court of Appeal, Hobson Street took the argument to the Supreme Court – and lost again. 

Supreme Court decision

Legal principles

The Supreme Court has confirmed that the traditional approach to determining whether a contractual promise is an unenforceable penalty, of considering whether the penalty is a “reasonable pre-estimate of damages", is no longer determinative. Instead, the enquiry is whether the promise is “out of all proportion to the legitimate interests of the innocent party".

The Court explained that in determining whether the consequences of the indemnity were “out of all proportion to the legitimate interests of the innocent party":

  • the test is objective and does not depend on whether the parties thought that the clause was a penalty
  • the legitimate interests of the innocent party are fixed at the time the contract is entered into
  • those interests extend beyond the damages that would otherwise have been awarded in the event of breach had the contract not contained a liquidated damages clause, and can include wider commercial and business objectives held by the innocent party that would be affected if the contractual obligation was not performed
  • deterring a breach can be a legitimate interest, but punishment cannot
  • because the innocent party's legitimate interests are wider than monetary loss, any pre-estimate of damages, while relevant to the proportionality analysis, will not be determinative
  • the “all or nothing" nature of a liquidated damages clause is relevant to proportionality. If the clause imposes graduated consequences depending on the scale or length of the breach then the courts will often consider the clause is proportionate, and
  • if there was unequal bargaining power between the parties, or one party was not legally advised, the court will be more willing to find the provision lacked proportionality and is a penalty. 
Application to the facts

Applying these principles to the facts, the Court found that Honey Bees had a legitimate interest in ensuring that the second lift was installed. That legitimate interest recognised that the limited access of one lift:

  • could dissuade parents from using the preschool
  • the rent was calculated on a per-head basis, and
  • the preschool had no ability to terminate the lease even if the second lift was not installed. 

While the Court accepted that ordinarily the “all or nothing" nature of the indemnity clause would be relevant, here the landlord had more than two-and-a-half years to get the work done so there could be no complaint that the indemnity applied after that period.   

Chapman Tripp comment

The Supreme Court's decision provides clarity around when a contractual provision, like an indemnity or a liquidated damages clause, will be enforceable and when it will be an unenforceable penalty. The decision shows that there is a high threshold for a party to successfully claim that such a clause is a penalty. 

The Court's decision also removes the complicated approach that the lower courts applied that could give rise to significant costs in analysing the proportionality of the claim. Rather than focus on the purpose of the clause and analysing damages, the Court has confirmed that the proper focus is on the legitimate interests being protected. 

The Supreme Court’s decision is accessible here.

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

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Related topics: Litigation & dispute resolution; Corporate & commercial

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