The common law has long held that contractual clauses providing remedies for breach, but which set out consequences out of all proportion to the effects of the breach, are unlawful penalties. The NZ High Court had the opportunity to consider this doctrine in light of recent UK and Australian decisions, in Honey Bees Preschool Ltd v 127 Hobson Street Ltd [2018] NZHC 32, 31/1/2018.
Honey Bees Preschool (Honey Bees) had an agreement with 127 Hobson Street Limited (127), under which Honey Bees leased facilities from which it ran a childcare centre. If 127 failed to install a second lift by a stated deadline, then 127 and its director were to indemnify Honey Bees and its director for all obligations that they might incur prior to the expiry of the lease. Long after the deadline had expired, Honey Bees sought to enforce the indemnity, which would have cost 127 nearly $780,000.00 in lease payments and lift installation charges.
The High Court considered UK and Australian authority on the question of whether the penalties doctrine was engaged, preferring the UK approach, being that the doctrine applies only on breach of contract, where a “secondary obligation” is triggered as the remedy for breach of a “primary obligation”. Here, the indemnity was a secondary obligation following breach of the primary obligation to install the lift.
There remained the issue of whether the particular clause met the test for an unenforceable penalty. The High Court considered that the key question was whether the remedy provided for the breach was “out of all proportion to the legitimate performance interests of the innocent party, or otherwise exorbitant or unconscionable, having regard to those interests”. The relative commercial nous and bargaining power of the parties, and whether they were independently advised, were relevant considerations. Also relevant was the question whether the predominant purpose of the clause was to punish, rather than merely to deter, a breach of the primary obligation to install the lift.
Here the High Court did not consider that the threshold was met. The second lift had been an important inducement for Honey Bees to commit to a long-term lease, and the indemnity was proportionate to its interest in obtaining that. 127’s director was an experienced developer who could have obtained independent advice, but chose to rely on his experience, and should have realised the effect of the clause. There had also been ample time provided to install the lift.