The High Court decision of Honey Bees Preschool Limited v 127 Hobson Street Limited altered the New Zealand law on liquidated damages and penalty clauses. That decision was appealed and the Court of Appeal recently released its verdict on this area of law. This is an important case to understand – especially for those in the construction sector.
What are liquidated damages and penalties clauses?
When entering into a contract, the parties may agree on an amount of damages payable if there is a breach of contract. These predetermined damages are called liquidated damages. The advantage of liquidated damages is that the enforcing party does not need to establish the actual loss they have suffered in the event of a contract breach - which can often be a difficult and expensive task. Liquidated damages are often used in construction contracts and are applied where a contractor fails to finish a job on time.
The traditional approach has been that the courts will not enforce a liquidated damages clause if it imposes what amounts to a penalty. If the liquidated damages clause provided for a “genuine pre-estimate of the loss that will be caused”, it would generally be enforceable. If the clause went beyond being a genuine pre-estimate of loss, and its intention was instead to secure performance of the contract through the imposition of a fine or a penalty; the liquidated damages were considered unenforceable. The Honey Bees litigation has seen the New Zealand courts reject this traditional approach.
The Honey Bees facts
Honey Bees Preschool Limited (Honey Bees) leased premises from 127 Hobson Street Limited (127 Hobson). Honey Bees ran a childcare centre at the premises, which was located on the 5th floor of an inner city building. The building was catered for by a single lift. Initially Honey Bees had a licence for 24 children but it had plans to expand to cater for 48 children. Honey Bees considered the installation of a second lift was critical to the smooth operation and viability of its business.
The parties entered into two deeds on the same day: a regular deed of lease and a “collateral deed”. The collateral deed provided for 127 Hobson to install a second lift in the building within two years and seven months. If the lift was not installed by the deadline, 127 Hobson would indemnify Honey Bees for its entire obligations under the remaining term of the lease. Simply put, 127 Hobson would have to repay the rent and outgoings paid by Honey Bees after the expiry of the deadline.
127 Hobson failed to install the second lift by the deadline and Honey Bees sought to enforce the indemnity contained in the collateral deed. 127 Hobson defended the claim on the basis that the indemnity was an unenforceable penalty.
Discussion in the judgment
The Court of Appeal upheld the High Court’s earlier decision. It considered it was appropriate for the New Zealand law on penalties to move into line with the English and Australian jurisdictions. The Court’s decision emphasised a move towards greater freedom of contract where the parties are astute commercial actors. The proliferation of consumer protection legislation meant that there was now less need for consumers to be protected by the nearly century old prohibition against penalties.
The new English “disproportionality test” was adopted. That test is:
The Court of Appeal held the disproportionality test can be cross-checked against the “punitive purpose test”. The clause will not be enforceable if its predominant purpose is to punish the breaching party, rather than to protect a legitimate performance interest of the enforcing party. The disproportionality test and the punitive purpose test are “two side of the same coin”.
Duration of the indemnity
The collateral deed provided that 127 Hobson would indemnify Honey Bees until “the expiry of the Lease” if it did not install the lifts it promised it would.
The duration of the indemnity in Honey Bees was a critical issue, which needed to be determined before the indemnity could be subjected to the disproportionality test. The longer the duration of 127 Hobson’s indemnity, the more burdensome (and potentially disproportionate) the clause would be.
The initial term of the lease was for six years with three rights of renewal of the same duration. The question was whether “the expiry of the Lease” meant the initial term of six years, or all four terms (24 years). The deed of lease defined the term of the lease to include any renewal.
Interestingly, in a case in which the Court emphasised freedom of contract, it held that the definitions contained in the deed of lease were a “distraction” and that the true intention of the parties was for the indemnity to only apply for the remainder of the initial term of the lease. This determination meant that the indemnity was less burdensome on 127 Hobson (roughly 3 years versus 22 years). Therefore it was more likely to pass the disproportionally test.
Applying the disproportionality test to the Honey Bees’ facts
The Court held that the indemnity passed the disproportionality test and identified a number of reasons why:
The Honey Bees case may have a strong impact on the construction sector in particular. Traditionally, parties to a contract have been somewhat constrained by the need to avoid any implication of a “penalty” when considering including a liquidated damages clause. Now, we expect to see parties turn their minds to the question of liquidated damages in more detail. Parties may want to set out their expectations and intentions more clearly, to give weight to their “legitimate performance interests”.
We may see more parties using liquidated damages clauses to protect their interests. If you are considering using liquidated damages, a key takeaway would be to be very clear on what interest you need to protect and why. This should help the other party (and if need be, a court) understand why the liquidated damages are in proportion to your legitimate interest. However, as we saw in Honey Bees, even clearly drafted definitions aren’t always safe from judicial intervention.
This case is also a useful reminder to think through some of the potential scenarios and consequences when drafting certain clauses. It is unclear whether either of the parties expressly recognised the dollar value of 127 Hobson’s potential exposure (as this may have led to more explicit drafting on the issue of the duration of the indemnity).
Please get in touch with our commercial or dispute resolution team if you have any more queries about liquidated damages or penalty clauses.