Enforceability of Penalty Clauses in Contracts
A recent Court of Appeal decision, 127 Hobson Street Ltd v Honey Bees Preschool Ltd, has clarified when penalty clauses in contracts are unenforceable.
Honey Bees entered into a lease with 127 Hobson Street to lease premises for a childcare facility. The term of the lease was for six years starting in 2013. The lease also contained three rights of renewal, providing Honey Bees with an option to extend the lease to 2037 at the latest.
The building had only one lift which was used to access the premises. Honey Bees required a second lift to be built to provide reasonable access to the premises. Accordingly the parties entered into a collateral deed whereby 127 Hobson Street agreed to install a second lift by 31 July 2016. If not installed by that date, 127 Hobson Street agreed to indemnify Honey Bees for all obligations “to the expiry of the Lease” (indemnity clause).
The lift was not built by 31 July 2016 (and at the date of the Court of Appeal hearing was still incomplete). As such, Honey Bees invoked the indemnity clause.
127 Hobson Street claimed the indemnity was an unenforceable penalty. The High Court held in favour of Honey Bees and ordered specific performance of the indemnity clause. 127 Hobson Street appealed.
Court of Appeal
The Court of Appeal dismissed the appeal. In doing so it clarified the approach for determining when a penalty is unenforceable under New Zealand law as involving the following two tests.
The disproportionality test
The Court considered this to be the primary test to determine enforceability of a penalty clause. The disproportionality test considers whether the penalty imposes a detriment “out of all proportion” to any “legitimate interest” in the enforcement of the primary obligation (in this case to install a lift on time). The term “out of all proportion” denotes a particularly high threshold. A “legitimate interest” may include commercial or non-commercial justifications wider than purely financial interests.
The punitive purpose test
The punitive purpose test is used to “cross-check” the disproportionality test. It requires consideration of whether the primary purpose of the penalty is to punish rather than protect the legitimate interest in performance of the primary obligation. If the primary purpose is to punish, rather than to induce performance, the clause is unenforceable.
The Court enforced the indemnity clause until the end of the initial term of the lease in 2019. This was reasoned on the basis that, among other things, running to the end of the initial term of the lease was proportionate to Honey Bee’s legitimate interest in performance of the obligation to install the second lift by 31 July 2016.
The Court interpreted that the term “expiry of the Lease” in the indemnity clause meant expiry of the initial term of the lease, not expiry of the lease if the rights of renewal were enforced. At least in these factual circumstances this suggests that if the indemnity ran with the rights of renewal, it would be penal and unenforceable.
Leave to appeal to the Supreme Court was granted 27 June 2019. It will be interesting to see if the Supreme Court follows the approach taken by the Court of Appeal.
ANDERSON CREAGH LAI LIMITED
Article written by Katie Creagh
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