Unenforceable penalty or protecting a legitimate interest?

Now is a good time to review any damages clauses contained in your commercial contracts, with the release on 5 June 2020 of the Supreme Court’s judgment in 127 Hobson Street Limited v Honey Bees Preschool Limited clearly articulating the test that will be applied when determining if these clauses are enforceable. Damages clauses are clauses specifying the consequences (in terms of payments to occur) where there is a breach of contract.

Summary of Facts

Honey Bees Preschool Limited (Honey Bees) leased premises on the fifth floor of a multi-story building in Auckland’s CBD from 127 Hobson Street Limited (Landlord) to run a childcare business. The lease was for an initial term of six years until 2019, with a final expiry date of 2037 (taking into account rights of renewal). The building was serviced by only one lift but had been designed and built for a second lift to be fitted at some future date.

As part of the incentive for Honey Bees to lease the premises, the Landlord had agreed to install a second lift in the building by 31 July 2016 – which in the opinion of Honey Bees, was crucial for its business growth. If the lift was not installed by that date the Landlord had agreed to indemnify Honey Bees for all obligations under the lease (including payment of rent, operating expenses & other payments) until the lease expired. The agreement to install a second lift was not a term of the Deed of Lease and was only recorded in a side agreement – a ‘Collateral Deed’ – which was executed at the same time as the Deed of Lease.

The lift was not installed by the required date, and Honey Bees issued proceedings to enforce the indemnity. The Landlord defended the claim on the basis that this was an unenforceable penalty.

Supreme Court Decision

The Supreme Court ultimately held that the indemnity was enforceable, and the Landlord was obligated to indemnify Honey Bees until the expiry of the current lease (i.e. until 2019).

The Court clarified that the test when considering a damages clause is as follows:
“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 performance of the primary obligation” .

Elaborating on this test, the Court offered the following guidance:

  • Legitimate interests – the legitimate interests of the innocent party must be assessed at the time of formation of the contract. Legitimate interests can be broader than the monetary value of performance, such as protecting broader commercial objectives. Deterring breach can also be a legitimate objective of a clause (although punishment is not).
  • Calculating the damages that arises from the breach is not invariably required, but could be helpful in some cases (e.g. if the clause is suggesting a pre-estimate of loss).
  • The Court will assess if the consequence can fairly be described as exorbitant when compared with those legitimate interests.
  • The Court will not undertake an inquiry into whether the predominant purpose of the damages clause is to punish the promisor, rather than protect the legitimate interests of the promisee in performance of the primary obligation (a consideration that the Court of Appeal had previously considered relevant), as this would focus on the state of mind of the parties not the legitimate interests.
  • The Court will “scrutinise more closely” the claimed legitimate interest where there is evidence of unequal bargaining power or where one party is not legally advised, rather than starting with a presumption that the parties can assess the legitimate interests and the consequences.

The Court also made the following observations that were directly relevant to the facts of the case for Honey Bees:

  • Legitimate interests – the legitimate interests of the innocent party must be assessed at the time of formation of the contract. Legitimate interests can be broader than the monetary value of performance, such as protecting broader commercial objectives. Deterring breach can also be a legitimate objective of a clause (although punishment is not).
  • Calculating the damages that arises from the breach is not invariably required, but could be helpful in some cases (e.g. if the clause is suggesting a pre-estimate of loss).
  • The Court will assess if the consequence can fairly be described as exorbitant when compared with those legitimate interests.
  • The Court will not undertake an inquiry into whether the predominant purpose of the damages clause is to punish the promisor, rather than protect the legitimate interests of the promisee in performance of the primary obligation (a consideration that the Court of Appeal had previously considered relevant), as this would focus on the state of mind of the parties not the legitimate interests.
  • The Court will “scrutinise more closely” the claimed legitimate interest where there is evidence of unequal bargaining power or where one party is not legally advised, rather than starting with a presumption that the parties can assess the legitimate interests and the consequences.
  • Weighing up the interests Honey Bees had in performance of the obligation to install the lift against the consequences of the indemnity clause being triggered, the Supreme Court was satisfied that these consequences were not out of all proportion to the legitimate interests of Honey Bees.

Takeaways from this case

In many ways the decision in this case turned on the facts. However, it does present as a timely reminder to review any damages clauses (including indemnity provisions) that are contained in your business agreements to ensure that these will actually be enforceable if triggered.

We recommend that, at the time of drafting, any party wishing to include such a clause carefully considers (and documents) the legitimate interests it wishes to protect, and undertakes an assessment that the consequences sought are not out of proportion to the legitimate interest to protect. It may also be appropriate to consider including a discussion of these legitimate interests with the other party.

As noted, these ‘legitimate interests’ can extend to interests outside the scope of the monetary value of performance. Broader commercial objectives can be taken into account, such as Honey Bees’ interest to seek to protect future growth prospects of the business. Notably, deterring a breach can also be a legitimate objective of a clause.

On evidence of unequal bargaining power, including when a party does not receive legal advice, the court will take this into account in its assessment. However, if a party does have the opportunity to receive legal advice but chooses not to take it, it may be more difficult to overturn the clause. We suggest that if there is any hint of uncertainty or the contract is of high value, a party should always take legal advice before signing an agreement.

If you are concerned whether a damages clause in any of your contracts is enforceable, or would like assistance in drafting these, please reach out to one of our Business Law team who would be more than happy to assist.

Contact

Graeme Crombie is a Lane Neave partner in the corporate team

Graeme Crombie
Partner, Lane Neave

t +64 3 372 6392
m +6 21 634 849
e graeme.crombie@laneneave.co.nz

Peter Orpin
Special Counsel, Lane Neave

t +64 3 353 8014
m +64 29 244 9001
e peter.orpin@laneneave.co.nz

Ben Cooper
Solicitor, Lane Neave

t +64 3 377 6876
e ben.cooper@laneneave.co.nz