The recent Court of Appeal decision in 127 Hobson Street Limited v Honey Bees Preschool Limited [2019] NZCA 122 confirms the New Zealand position on the penalty doctrine: the rule that prevents disproportionate punishment for breach of contract.

Facts

Honey Bees Preschools Ltd (Honey Bees) operates a childcare centre out of premises leased from 127 Hobson Street Ltd (“127”). At the time of entering the lease, the premises had one lift.

The lease was in two parts. It consisted of a regular deed of lease and a collateral deed, both executed the same day. The collateral deed required 127 to install a second lift by 31 July 2016, some 31 months after the Deed of Lease was executed. In the event that 127 failed to do so, it was required to indemnify Honey Bees against all obligations it may incur under the lease.

The lift was not installed in time. Honey Bees said the collateral deed meant that it was excused from making payments under the lease from breach until expiry of the lease, a period of 3 years and five months. 127 said the clause was an unenforceable penalty.

The Correct Test

The Court of Appeal confirmed that the correct test for a penalty was whether a stipulated remedy for breach is out of all proportion to the legitimate performance interests of the innocent party. This was the approach recently adopted in the UK and Australia. It departs from the historic test, which was whether the sum claimed for breach was a genuine pre-estimate of loss. The Court said that the requirement to show that a clause is “out of all proportion” sets a high threshold.

The Court also explained that the “proportionality test” is to be cross-checked with the “punitive purpose test”, i.e. whether the predominant purpose of remedy is to punish rather than to protect a legitimate performance interest. However, the Court noted that the proportionality test and the punitive purpose test are two sides of the same coin.

Was the Indemnity Out of All Proportion?

The Court decided that the indemnity was proportionate to Honey Bees’ legitimate interest in the installation of the second lift. It therefore was not a penalty. The Court took into account a number of factors including:

• The lift was important to obtaining Ministry of Education licensing to operate a childcare centre out of the premises;
• Honey Bees had already invested heavily in the fit out of the premises and stood to lose this investment if licensing was not obtained or if the business otherwise failed;
• As the obligation to install the lift was recorded in a collateral deed, Honey Bees had no right to cancel the lease for breach of that obligation; and
• 127’s conduct prior to entering into the lease had given Honey Bees reason to believe that strong measures were needed to ensure the lift was installed.

The indemnity was expressed to run “to the expiry of the lease”. If enforceable, 127 argued that it would run not until the end of the initial term, but until the final expiry of the lease including any renewals, potentially to 2037. The Court determined that the indemnity applied only to the end of the initial term. While the Court does not expressly deal with this point, the judgment could be read as suggesting that had the indemnity run to 2037, it would have been an unenforceable penalty.

Significance of decision

127 has appealed the Court of Appeal decision to the Supreme Court. The appeal hearing was held in October 2019 and the Supreme Court’s decision is expected later this year. For the time being, by adopting the “proportionality test” the Court of Appeal has arguably narrowed the circumstances in which clauses will be unenforceable penalties. However, parties entering into contracts ought to remember that they still remain potentially susceptible to the doctrine.

Fortune Manning represented Honey Bees in this proceeding.