Contractual penalties again
28 Aug 2018
A previous update covered a 2017 Court of Appeal decision on contractual penalties.(1) Although the law applied in that decision was not NZ law, but that of the contract (ie, the law of New South Wales, Australia), the update suggested that the 2016 English and Australian decisions applied in that case could have a similar effect on contractual penalties under New Zealand law. With the High Court's decision in Honey Bees Preschool Limited v 127 Hobson Street Limited, that suggestion is now manifest.(2)
Previously, New Zealand's approach to contractual penalties was governed by the decision in Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd.(3) Dunlop established the following rules for determining whether a term is a penalty: (4)
- A term will be a penalty if the sum stipulated for is extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved to have followed from a breach.
- A term will be a penalty if the breach consists only of not paying a sum of money, and the sum stipulated is a sum greater than that which ought to have been paid.
- There is a presumption that a term is a penalty when a lump sum is made payable by way of compensation, on the occurrence of one or more or all of several events, some of which may occasion serious, and others but trifling, damage.
- It is no obstacle, to the sum stipulated being a genuine pre-estimate of damage, that the consequences of the breach are such as to make precise pre-estimation almost an impossibility. In fact, that is a situation when it is probable that pre-estimated damage was the true bargain between the parties.
In essence, the penalty rules, as conceptualised in Dunlop, sought to distinguish between secondary obligations (a contractual obligation arising upon breach) that represented a genuine pre-estimate of loss caused by breach, and those imposed to punish a breaching party.
Developments in contractual penalties
In 2016 the approach to contractual penalties in both Australia and the United Kingdom underwent a conceptual shift. The focus in both jurisdictions became a comparison of the secondary obligation to the innocent party's performance interest or, in other words, to the value of performance to that party.
The shift of focus in the United Kingdom occurred in Cavendish Square Holdings BC v Makdessi. The decision addressed two appeals to the UK Supreme Court, both of which dealt with the penalty rule. Cavendish was chiefly concerned with the rule's scope, that is, the nature of the clauses to which the penalty rule applies. The other appeal, Beaves v ParkingEye Limited, dealt primarily with the rule's application.
In Beaves, the court held that a secondary obligation to pay an £85 parking ticket was not a penalty, despite finding that the overstaying motorist did not cause ParkingEye loss.(5) The conclusion rested on the court's finding that overstaying motorists caused systemic problems for ParkingEye, which managed car parks for retail landlords, which gave ParkingEye an interest in preventing overstaying motorists, beyond any direct loss that overstaying caused. The court held that the £85 fine was not clearly disproportionate to the performance interest.(6)
Cavendish concerned an agreement for the sale and purchase of shares. The agreement obliged the purchasers to pay the sellers in several instalments, as consideration for both the transfer of shares and adherence to certain restrictive covenants. Clause 5.1 disentitled the sellers from receiving several instalments, if they defaulted on any restrictive covenants. The court held that the clause created a conditional primary obligation, representing an adjustment to the price to reflect the value of the shares following default on the restrictive covenants, rather than a penalty for breach.(7) The court held that, as the penalty rule applied only to secondary obligations, not primary obligations, Clause 5.1 was not a penalty clause.(8)
In Paciocco v Australia and New Zealand Banking Group, the High Court of Australia adopted a largely similar approach to the rule's application but took a broader view of the rule's scope, holding that it is not confined to secondary obligations.(9) In Wilaci Pty Limited v Torchlight Fund No 1 LP (In Receivership), the New Zealand Court of Appeal, applying New South Wales law, applied the wider Paciocco approach to the rule's application (finding it unnecessary to address the difference between Cavendish and Paciocco concerning the rule's scope on the issues arising for determination on the appeal).(10)
Honey Bees decision
Honey Bees Preschool leased premises from 127 Hobson Street Limited to run a childcare facility. The lease was for six years, with three rights of renewal.
Honey Bees and 127 Hobson entered into a collateral deed at the time of the deed of lease, under which 127 Hobson was obliged to install a second lift on the premises. 127 Hobson agreed to
indemnify Honey Bees for all of its obligations under the lease if the lift was not fully operational by 31 July 2016.
127 Hobson failed to install the second lift by the stipulated date. Honey Bees sought to enforce the indemnity; 127 Hobson resisted, arguing that the clause was an unenforceable penalty.
After reviewing earlier NZ authorities, the recent developments in England and Australia and the Court of Appeal decision in Torchlight, the High Court adopted the recast penalties rule adopted in Cavendish and Paciocco, as summarised in Torchlight, holding that the "central issue is whether a stipulated remedy for breach is out of all proportion to the legitimate performance interests of the
innocent party, or otherwise exorbitant or unconscionable, having regard to those interests".(11)
The High Court also considered the scope of the recast rule, adopting the approach in Cavendish that the rule applied, not to primary obligations, but to secondary obligations arising on breach,
illustrating the difference between such obligations by reference to the two appeals which produced the Cavendish decision. The court went on to hold that the obligation was secondary in nature (and thus subject to the recast penalties rule), considering that the assessment of nature rests on substance, rather than form.(12)
Analysis of the extent of the obligation to indemnify (rent and outgoings only for the period from breach to first renewal) and the interests involved led the High Court to conclude that the indemnity
was not out of all proportion to Honey Bees legitimate performance interest and that the term was not a penalty.(13)
The court held that Honey Bees had sought to protect two related performance interests through the bargain, namely:
- the installation of a second lift by a specified time; and
- leasehold premises that were fit for a fully-licensed preschool facility for the full leasehold period (including renewals).(14)
When the deed was executed, Honey Bees had only a probationary licence for 24 children but the related lease fixed the rental after 14 months by reference to the expectation that it would be
licensed for 50 children (regardless of the actual level of occupancy) and a second lift was important for the effective operation of a fully licensed facility of that size.(15) The plaintiff was legitimately seeking to protect itself from the commercial risk associated with premises that were not fully fit for purpose.(16)
In addition, because the likely losses were not quantifiable at the time of execution, the obligation fell within the fourth class of obligation identified in Dunlop.(17)
The court was also influenced by the fact that the contract involved commercial parties (the breaching party was operated by a very experienced property developer, managing 12 commercial
properties)(18) and the fact that the plaintiff had cause to doubt the reliability of the defendants in light of past events.(19) While acknowledging that the costs to the defendants were substantial (60% of the rental to expiry), the performance interests justified a strong deterrence clause. The High Court concluded that it was not the function of the penalties rule "to protect commercially
sophisticated property investors from their commercial decisions".(20)
The High Court adopted the new perspective taken in the United Kingdom and Australia on the penalties rule, shifting focus from a comparison between secondary obligations and genuine preestimates of damage caused by breach, to a comparison between secondary obligations and the innocent party's performance interest. The decision confirmed the continued relevance of Dunlop
but not the rigour of its application in earlier cases.
Adoption of the recast rule prior to its confirmation by an appellate court is seen by some as controversial and the NZ position may not be regarded as truly settled until that occurs. The
decision has been appealed.
(1) For further information please see "Court of Appeal sheds light on new approach to penalties in Torchlight decision".
(2) Honey Bees Preschool Limited v 127 Hobson Street Limited  NZHC 32.
(3) Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd  AC 79 (HL).
(4) Ibid at .
(5) Cavendish Square Holdings BC v Makdessi  UKSC 67,  AC 1172 at .
(7) Cavendish Square Holdings BC v Makdessi, above n 5, at .
(8) Ibid at  and .
(9) Paciocco v Australia and New Zealand Banking Group  HCA 28; (2016) 333 ALR 569.
(10) Wilaci Pty Limited v Torchlight Fund No 1 LP (In Receivership)  NZCA 152.
(11) Honey Bees Preschool Limited v 127 Hobson Street Limited, above 2, at .
(12) At .
(13) At  and .
(14) At .
(15) At .
(16) At .
(17) At .
(18) At .
(19) At .
(20) At .