127 Hobson Street Ltd v Honey Bees Preschool Ltd [2020] NZSC 53, 5 June 2020
- Court
- Supreme Court
- Judgment
- 5 June 2020
- Neutral
- [2020] NZSC 53
Areas of law
Judgment analysis
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Facts
Honey Bees Preschool Ltd leased premises from 127 Hobson Street Ltd to operate a childcare business. Honey Bees' director, Mr James, identified that the single lift servicing the fifth-floor premises would be inadequate for the business. After an initial agreement to lease, lengthy licensing delays, and significant fit-out expenditure by Honey Bees (approx. $500,000), the parties executed a formal Deed of Lease and a separate Collateral Deed. The Collateral Deed, created at the landlord's request to keep the obligation from his bank, required the landlord to install a second lift by 31 July 2016. If this primary obligation was breached, the landlord and its director (Mr Parbhu) were to indemnify the tenant and its director (Mr James) for all their obligations under the lease until its expiry. The landlord failed to install the lift by the specified date. The tenant issued proceedings to enforce the indemnity. The landlord defended the claim, arguing the indemnity clause was an unenforceable penalty. The High Court and Court of Appeal both found the indemnity was enforceable, leading to this appeal to the Supreme Court.
Held
- A clause stipulating a consequence for breach of contract is an unenforceable penalty if the consequence is out of all proportion to the legitimate interests of the innocent party in the performance of the primary obligation. A consequence is out of all proportion if it can be described as exorbitant.
- A party's legitimate interests can extend beyond the direct financial loss from a breach to include broader commercial interests, such as ensuring a business has the necessary facilities (like a second lift) for its operational success and future growth, particularly where significant capital has been invested.
- In this case, the indemnity clause relieved the tenant of its obligation to pay rent and outgoings for the remainder of the initial six-year lease term upon the landlord's failure to install a second lift by the due date. The tenant had a legitimate interest in securing the installation of the lift for the success of its business, in which it had invested heavily. The consequences of the indemnity, while significant, were not out of all proportion to this legitimate interest and therefore the clause was not an unenforceable penalty.
The appeal is dismissed. The appellants must pay costs of $25,000 plus usual disbursements to the respondents.
Key passages9
The classic statement on the law of penalties, from Dunlop, described a dichotomy between a penalty, 'a payment of money stipulated as in terrorem of the offending party', and liquidated damages, 'a genuine covenanted pre-estimate of damage'. The former was unenforceable, the latter enforceable.
“In Dunlop, Lord Dunedin had described a dichotomy between a penalty, 'a payment of money stipulated as in terrorem of the offending party', and liquidated damages – 'a genuine covenanted pre-estimate of damage' by the parties. The former was unenforceable, the latter enforceable.”
The true test is whether 'the impugned provision is a secondary obligation which imposes a detriment on the contract-breaker out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation.'
“… the true test was whether: … the impugned provision is a secondary obligation which imposes a detriment on the contract-breaker out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation.”
The test for a penalty is one of proportionality, allowing for interests beyond an innocent party’s interest in compensation for direct losses to be reflected in such clauses. It is a more flexible and permissive test than the Dunlop test.
“The proportionality test instead allows for interests beyond an innocent party’s interest in compensation for direct losses to be reflected in such clauses. It is a more flexible and permissive test than the Dunlop test as applied, and appropriately so.”
The penalty doctrine interferes with the parties' freedom to contract on public policy grounds.
“The penalty doctrine is an example of where the law interferes in the parties’ freedom to contract on public policy grounds.”
A legitimate interest is an interest in performance of the primary obligation, and this assessment is made at the point of contract formation as a matter of construction.
“A legitimate interest is an interest in performance of the primary obligation... This assessment is to be made at the point of formation of the contract because the question of whether an impugned clause is a penalty is a matter of construction.”
Legitimate interests may extend beyond the harm caused by the breach as measured by a conventional assessment of contractual damages and can include the broader impact of non-performance on commercial interests.
“It is clear that the legitimate interests so described may extend beyond the harm caused by the breach as measured by a conventional assessment of contractual damages. Those interests cannot be measured simply by reference to the loss caused by the particular breach – the parties may agree to consequences for breach which recognise the broader impact of non-performance on the commercial interests the parties seek to achieve through the contract.”
Deterring breach can be a legitimate objective of a contractual clause, as it is the flip side of securing performance.
“While legitimate interests will not include objectives unrelated to the performance interest, such as punishment, what is also plain is that deterring breach can be a legitimate objective of a clause. Deterring breach is simply the flip side of securing performance.”
The doctrinal basis for the penalty rule is not preventing one party from taking advantage of another (unconscionability), but rather that using a contract to punish is against public policy.
“Although the test in cases like Cavendish uses the language of unconscionability, the doctrinal basis for the court’s refusal to enforce a penalty clause is not that one party has taken advantage of another; rather, it is that the use of contract to punish another party has been treated by the law as against public policy.”
The bargaining position of the parties is relevant. Where parties are of comparable bargaining power and advised, there is a 'strong initial presumption' they are the best judges of what is legitimate.
“Nevertheless, they said, the broad bargaining position of the parties is relevant – where a contract is the result of negotiation between advised parties of comparable bargaining power “the strong initial presumption must be that the parties themselves are the best judges of what is legitimate in a provision dealing with the consequences of breach”.”
Cases mentioned in judgment
Legislation mentioned
- Arbitration Act 1996, sch 1 art 34
- Fair Trading Act 1986
- Commerce Act 1986
- Consumer Guarantees Act 1993
- Credit Contracts and Consumer Finance Act 2003