Penalty clauses in contracts: New Zealand adopts the disproportionality test
Frequently commercial contracts, particularly building contracts, include a clause specifying what amount will be payable by one party to the other in the event of a breach of the contract. This could be a lump sum, or a specified amount for each day of default. These clauses are known as liquidated damages clauses. They have proved popular, because they ensure that the parties are aware of the financial consequences of breaching the contract, and they can help to avoid litigation over the actual loss that eventuated.
The courts have always kept close watch on these clauses, ensuring they do not amount to a penalty. In the Court of Appeal’s recent decision in 127 Hobson Street v Honey Bees Preschool, the Court said that:
“The doctrine of penalties arose because it has always been the courts’ function to resolve the consequences of breach. A grossly extravagant penalty with the predominant effect of punishment, rather than protection of a legitimate interest, offended the court’s conscience in its remedial jurisdiction.”
For this reason, courts have long determined penalty clauses to be unenforceable. However, the test for whether a liquidated damages clause amounts to a penalty clause has evolved over time.
Under the previous approach, set out in a House of Lords case dating from 1915, a clause claiming liquidated damages must be for an amount that was a “genuine pre-estimate of loss” that would be caused by the breach of the contract. If not, it would be considered to be a penalty clause, and unenforceable.
Although the “genuine pre-estimate of loss” test was in place for almost a century, the United Kingdom and Australia have in recent years adopted a broader test, which provides greater freedom to the contracting parties. Honey Bees confirms that New Zealand is following suit, and that a damages clause is a penalty only if it is a secondary obligation that imposes a detriment out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation.
Facts of the Honey Bees case
Honey Bees operated a child care facility in premises leased from 127 Hobson. Under a collateral deed, 127 Hobson promised to install a second lift in the building. Honey Bees considered the second lift to be vital to the operation of its business, to ensure that there were no significant delays for parents dropping off and picking up their children.
The collateral deed provided that, if the second lift was not fully operational before a certain date (almost half-way through the term of the lease), 127 Hobson would indemnify Honey Bees for all obligations they might incur to 127 Hobson or another landlord until the expiry of the lease. This included the payment of all rent for the remainder of the lease.
The lift was not installed by the due date and Honey Bees sought to enforce the indemnity clause.
The High Court decision
The High Court, applying the new test for a penalty clause, found that the indemnity protected Honey Bees’ legitimate interest in the second lift being installed. Honey Bees had invested significantly in the premises and the absence of the second lift could impact its commercial viability.
The Court of Appeal decision
On appeal, the Court of Appeal confirmed that the primary test for a penalty clause is the “disproportionality test”. The question is:
“whether the secondary obligation challenged as a penalty imposes a detriment on a promisor out of all proportion to any legitimate interest of the promisee in the enforcement of the primary obligation.”
This is a high bar. It also recognises that a party to a contract might have a number of interests, commercial or non-commercial, in the contract being performed which cannot be adequately protected by a payment of damages.
The Court of Appeal also noted that the “disproportionality test” can be cross-checked against the “punitive purpose” test. That is, whether the predominant purpose of the clause is to punish the party in breach rather than protect the innocent party. If that is the case, the clause will be a penalty.
In this case, the Court of Appeal recognised that Honey Bees had invested in the premises, considered lift access of considerable importance, and its business would suffer if the lift was not installed. The indemnity protected its legitimate interests and was not a penalty.
Another example of a legitimate interest can be found in the United Kingdom Supreme Court decision in ParkingEye Ltd v Beavis. A shopping mall offered free parking for two hours, charging over-stayers £85. This could not be a genuine pre-estimate of the loss that ParkingEye would suffer, but the Supreme Court recognised the mall operator’s legitimate interest in ensuring the turnover of parking spaces.
What does this mean?
Honey Bees confirms that New Zealand has adopted the new test, resolving any uncertainty left following the earlier Court of Appeal decision in Wilaci v Torchlight, which endorsed the new test but was decided under the law of New South Wales, Australia, due to a provision of the contract.
In adopting this test, the Court of Appeal emphasised the importance of freedom of contract, and the enforcement of remedies agreed by the parties. It noted that commercial parties should be left to the bargains they have struck, with less interference from the courts.
As a result of this decision, the courts will be slower to hold that clauses are unenforceable penalties, and more likely to uphold a liquidated damages clause agreed by the parties. A more detailed and extensive factual assessment may be required to identify and assess the parties’ legitimate interests (beyond the loss suffered) and whether the clause is a proportionate protection of those interests. The new test is more flexible and may take into account not just a likely loss from a breach but broader considerations like reputation risk and the public interest in providing a service.
When drafting contracts, parties should keep all of their interests in mind and avoid clauses which are punitive rather than protective of those interests. A party should also ensure that the other parties to the contract are aware of the importance of any key provisions, for example, that the agreed completion date for the construction of a new building is also the commencement date for a lease of those premises.
If you have any questions about this decision, or concerns about the enforceability of clauses in your contracts, please contact a member of our litigation and dispute resolution team.
 127 Hobson Street Ltd v Honey Bees Preschool Ltd  NZCA 122
 Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd  AC 79 (HL)
 Honey Bees Preschool Ltd v 127 Hobson Street Ltd  NZHC 32,  3 NZLR 330
 ParkingEye Ltd v Beavis  UKSC 67
 Wilaci Pty Ltd v Torchlight Fund No 1 LP  NZCA 152,  3 NZLR 293
Disclaimer: the content of this article is general in nature and not intended as a substitute for specific professional advice on any matter and should not be relied upon for that purpose.