Penalties and liquidated damages

28 November 2019

A recent decision of the Court of Appeal in 127 Hobson Street Ltd v Honey Bees Preschool Ltd has clarified the law relating to so called ‘penalty clauses’. Sometimes contracts include clauses which state that if a party to the contract fails to fulfil an obligation under the contract, then that party must pay an amount to the other party. Such clauses are unenforceable if they are seen as ‘penalty clauses’, which intend to punish a particular party to the contract. Traditionally, an exception to this rule was if the amount was used to reasonably compensate a party for their loss arising from another party not fulfilling their obligations under the contract.

The Honey Bees case has redefined this area of law, making it easier for parties to ensure others carry out their contractual duties.

The Honey Bees Preschool case

The Honey Bees case involved the lease of the fifth floor of a central Auckland commercial building by a childcare provider, Honey Bees Preschool Ltd. The building only had one lift that serviced the whole building, which included a hotel and apartments.

Part of the agreement between the preschool and the landlord required the landlord to install a second lift in the existing empty lift shaft. The Agreement also stated that if the lift was not installed by a certain date, the landlord would pay the remaining rent and outgoings for three and a half years, until the lease ended. The lift was not installed by the due date and Court proceedings followed.

How have these clauses been interpreted in the past?

Traditionally, these clauses have only been enforceable when the loss claimed was a reasonable estimate of the potential loss when the contract was signed. If the loss claimed was higher than this threshold, the clause risked being considered a penalty and was unenforceable.

What does the Honey Bees case change?

The Honey Bees case created a new approach by looking at whether the loss claimed was out of proportion to the legitimate business interest being protected. The Court found that the preschool relied on the second lift in order to increase the capacity of the preschool to make their business viable, and the preschool therefore had a legitimate interest. The loss claimed by the preschool was not out of proportion to the preschool’s legitimate interest.

The Court also found that commercial parties with equal bargaining power should be free to make their own bargains, except where there is a gross overreach. However, the purpose of the clause should be to compensate for loss, rather than punish the other party.

This ruling provides a greater freedom for parties to enter into contracts that allow compensation when other parties fail to meet their contractual obligations. However, this is provided they are proportionate to the legitimate interest they are trying to protect.

We encourage those seeking to implement effective clauses in their own contracts, or assess whether their existing clauses are valid, to give us a call.

Dan Moore and Aaron Young are part of our Corporate & Commercial team at Norris Ward McKinnon.