At first instance and then on appeal, the High Court and the Court of Appeal adopted a recast rule against contractual penalties, reflecting developments in England and Australia (for further details please see "Contractual penalties again" and "Contractual penalties: Court of Appeal upholds High Court's decision in Honey Bees" in which it was noted that 127 Hobson Street had been granted leave to appeal to the Supreme Court). The Supreme Court has now delivered its judgment, confirming New Zealand's adoption of the recast rule.(1)

While the Supreme Court upheld the Court of Appeal's judgment, it expressly rejected the punitive purpose cross-check advocated for by the Court of Appeal.(2) It offered further guidance on the relationship between the penalty rule and the concept of unconscionability, and clarified the relevance of the relative bargaining power of the parties to application of the recast penalty rule.

The Supreme Court did not comment on the sorts of clause which are subject to the recast penalty rule. The Court of Appeal had preferred the English approach to the rule's scope, stating that it should be limited to secondary obligations arising on breach, while expressly noting that the expression of view was obiter.(3) Therefore, while the application of the recast rule is now settled in New Zealand, its scope remains to be finally decided.

Prior to the High Court decision, the NZ courts followed the approach set out in Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd,(4) an English case which distinguished between secondary obligations representing a genuine pre-estimate of loss and obligations imposed to punish a breaching party. It did so by applying the following general rules(5):

• A term will be a penalty if the sum stipulated is extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved to have followed from the breach.
• A term will be a penalty if the breach consists only of not paying a sum of money, and the sum stipulated is greater than the sum which should have been paid.
• There is a presumption that it 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 impossible. In fact, that is a situation when it is probable that pre-estimated damage was the true bargain between the parties.

In recent years, both the English and the Australian courts have moved away from the strict application of the rules set out in Dunlop. Instead, the focus in both jurisdictions has been on the relationship between the obligation in question and the innocent party's performance interest, or the value of performance to that party.(6)

The shift of focus in the United Kingdom occurred in Cavendish Square Holdings BC v Makdess. The decision addressed two separate appeals heard together – Cavendish and Beaves v ParkingEye Limited. In its decision, the UK Supreme Court altered the application of the rule, moving its focus from a comparison between the alleged penalty and a pre-estimation of the innocent party's loss to a comparison between the alleged penalty and the innocent party's performance interest, while confirming that its scope was limited to secondary obligations.(7)

In Paciocco v Australia and New Zealand Banking Group, the High Court of Australia adopted a similar recast rule, but broadened its scope to include conditional primary obligations.(8) In Wilaci Pty Limited v Torchlight Fund No 1 LP (In Receivership), the NZ Court of Appeal, applying New South Wales law, applied the recast approach to the rule's application. The court found it unnecessary to address the difference between Cavendish and Paciocco concerning the rule's scope on the issue arising for determination on the appeal.(9)

Facts
Honey Bees Preschool leased premises from 127 Hobson Street Limited for 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 in 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 a certain date.

127 Hobson failed to install the second lift by the stipulated date. Honey Bees sued to enforce the indemnity; 127 Hobson resisted, arguing that the indemnity clause was an unenforceable penalty.

Court of Appeal decision
The Court of Appeal upheld the High Court's adoption of the recast penalty rule.(10) It held that the test was whether the secondary obligation challenged as a penalty imposes a detriment to the promisor, out of all proportion to any legitimate interest of the promisee in the enforcement of the primary obligation. It labelled the new test the 'disproportionality test'. It noted that the phrase "out of all proportion" created a particularly high bar and was more demanding than the test expressed in Dunlop (which had previously been regarded as the test in New Zealand). It also noted that, while a comparison between the secondary obligation and likely damages is often appropriate in the context of a damages clause, it may not be appropriate in all situations; the 'legitimate interests' of a party may often be wider than its financial or economic interests because some obligations have commercial justifications that are not directly financial.(11)

The Court of Appeal also adopted another test described as the 'punitive purpose' test – namely, whether the predominate purpose of the secondary obligation is to punish the promisor rather than to protect the legitimate interest of the promisee in performance of the primary obligation. It described this test as a cross-check for the disproportionality test.(12)

The Court of Appeal expressed a preference for the scope of the rule adopted in the English case of Cavendish Square Holdings BC v Makdess,(13) in which the rule was limited to secondary obligations arising on breach. This can be contrasted with the position expressed in Paciocco v Australia and New Zealand Banking Group, in which the rule was said to also apply to conditional primary obligations. 'Conditional primary obligations' are obligations arising on a failure to perform a certain act in circumstances when that failure does not amount to a breach.(14)

The Court of Appeal agreed with the High Court's application of the recast rule. It held that the indemnity applied only to the initial lease period, and not any subsequent renewal period. It also held that the indemnity was limited to economic obligations, such as the payment of rent, and did not apply to covenants such as an obligation to repair damage.(15)

The Court of Appeal upheld the High Court's conclusion that the clause was not a penalty. It held that the apparent harshness of the term was mitigated by the importance of the lift to Honey Bees, something which was, or should have been, known to 127 Hobson, and the lengthy period before the indemnity applied. It held that the clause partially reallocated the risk of non-completion of the second lift to 127 Hobson, noting that, while the parties could have done this in a number of ways, they had chosen to have no indemnity for the first 17 months of the lease followed by full indemnity for the remainder of the lease if the lift had not been installed.(16)

Supreme Court decision
Law
The Supreme Court upheld the Court of Appeal's decision.(17) In doing so, it confirmed New Zealand's adoption of the recast penalty rule.(18) However, it did not support the punitive purpose cross-check proposed by the Court of Appeal. It offered further guidance on the recast rule's relationship with unconscionability and the role of inequality of bargaining power in the recast rule's application.(19)

The Supreme Court was satisfied that the Court of Appeal's formulation of the test was correct.(20) It held that(21):

A clause stipulating a consequence for breach of a term of the contract will be an unenforceable penalty if the consequence is out of all proportion to the legitimate interests of the innocent party in the performance of the primary obligation.

The Supreme Court noted that such a test allows for the protection of commercial interests beyond compensation for direct loss, making it a more flexible and permissive test than the test in Dunlop. (22)

While describing the test, the Supreme Court held that legitimate interests include commercial interests which, although connected to the contract at issue, may extend beyond the four corners of the transaction regulated by the contract. It used protection of a way or system of business of which the contract forms a part as an example of such a legitimate interest.(23)

In approving the recast test, the Supreme Court rejected the punitive purpose cross-check proposed by the Court of Appeal.(24) It held that such a cross-check was neither necessary nor desirable, either introducing a separate, and unnecessary issue, as to the state of mind of the parties at the time that the contract was formed, or constituting a restatement of the primary test (in the sense that a clause which provided for exorbitant consequences for breach would likely be seen as punitive).(25)

The Supreme Court also commented on the relationship between the penalty rule and the concept of unconscionability, stating that references in previous cases to unconscionability were a reference to the effect of enforcement of a penalty clause, not that unconscionability, in the sense that one party had taken advantage of another, is an element to be satisfied before a clause will be held to be a penalty.(26) The primary purpose of the penalty doctrine is not to protect against oppression which may flow from exploitation of unequal bargaining power.(27)

The court noted, however, that the relative bargaining position of the parties, which can be seen as linked to unconscionability, will be relevant to the court's enquiry as to the nature and extent of the innocent party's interest in the performance of the primary obligation.(28) There is a general presumption that commercial parties dealing with each other on equal terms should be able to assess the appropriate balance between the legitimate interest in performance of the primary obligation and the consequences contracted for on breach; but, where there is evidence of unequal bargaining power, or where one party is not legally advised, a court may scrutinise the innocent party's claims to the interests protected and proportionality more closely. However, whichever level of scrutiny is appropriate in a particular case, the issue remains whether the stipulated consequences of breach are out of all proportion to the innocent party's legitimate interests in performance.(29)

The Supreme Court made no comment on the remarks in the High Court and the Court of Appeal on the scope of the rule. While not a live issue in the present case, both lower courts expressed a preference for the more limited English approach, in which the rule applies only to secondary obligations arising on breach.(30) The issue remains technically undecided, despite strongly expressed obiter views in both the High Court and the Court of Appeal.

Application
The Supreme Court upheld the lower court's finding that the obligation to indemnify applied only to the remainder of the initial lease (and not to subsequent renewals)(31) and that it was limited to obligations to pay rent and outgoings (and not to any obligation of indemnity by Honey Bees against damages claims which 127 Hobson may have had against it).(32)

The Supreme Court upheld the Court of Appeal's conclusion that the clause reflected an attempt to protect legitimate interests in operating a business on the premises supported by two lifts, and to protect the future growth prospects of the business.(33)

The Supreme Court, like the lower courts, held that the indemnity was not out of all proportion to the legitimate interests which Honey Bees sought to protect and did not constitute a penalty.(34)

The Supreme Court's decision has confirmed New Zealand's adoption of the recast penalty rule and clarified the test and its relationship with concepts of unconscionability and the relative bargaining power of the parties.

The scope of the rule remains theoretically undecided. Although the Supreme Court declined to address to the rule's scope, the High Court and Court of Appeal decisions provide strong indicative support for the adoption of the narrower scope at some point in the future.

For further information on this topic please contact Chris Boswell at Wilson Harle by telephone (+64 9 915 5700) or email ([email protected]). The Wilson Harle website can be accessed at www.wilsonharle.com.

(1) 127 Hobson Street Limited v Honeybees Preschool Limited [2020] NZSC 53.
(2) At [58].
(3) 127 Hobson Street Ltd v Honey Bees Preschool Ltd [2019] NZCA 122 at [42].
(4) Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd [1915] AC 79 (HL).
(5) At [28].
(6) Cavendish Square Holdings BC v Makdessi [2015] UKSC 67 [2016] AC 1172; Paciocco v Australia and New Zealand Banking Group [2016] HCA 28; (2016) 333 ALR 569; Wilaci Pty Limited v Torchlight Fund No 1 LP (In Receivership) [2017] NZCA 152.
(7) Cavendish Square Holdings BC v Makdessi, above n 6.
(8) Paciocco v Australia and New Zealand Banking Group, above n 6.
(9) Wilaci Pty Limited v Torchlight Fund No 1 LP (In Receivership), above n 6.
(10) 127 Hobson Street Ltd v Honey Bees Preschool Ltd, above n 3.
(11) At [33] and [34].
(12) At [37] and [38].
(13) At [50] and [53].
(14) Cavendish Square Holding BV v Makdessi, above n 6, at [14].
(15) 127 Hobson Street Ltd v Honey Bees Preschool Ltd, above n 3, at [50] and [53].
(16) At [61].
(17) 127 Hobson Street Limited v Honeybees Preschool Limited, above n 1.
(18) At [79] and [91].
(19) At [80] to [91].
(20) At [56].
(21) Ibid.
(22) Ibid.
(23) At [63].
(24) At [58].
(25) Ibid.
(26) At [81].
(27) At [88].
(28) At [89] and [91] (f).
(29) At [91] (f).
(30) 127 Hobson Street Ltd v Honey Bees Preschool Ltd, above n 3, at [42]; Honey Bees Preschool Limited v 127 Hobson Street Limited [2018] NZHC 32 at [63].
(31) 127 Hobson Street Limited v Honeybees Preschool Limited, above n 1, at [93] and [94].
(32) At [95] and [99].
(33) At [106].
(34) At [116].