In 127 Hobson Street Ltd v Honey Bees Preschool Ltd the High Court adopted a recast rule against contractual penalties.(1) While the Court of Appeal previously applied the recast rule, that case fell under New South Wales law (the law of the contract), not NZ law. That decision was the subject of a previous article, which suggested that the recast rule's status would not be regarded as truly settled until confirmed by an appellate court applying NZ law (for further details please see "Contractual penalties again"). This has now occurred with the Court of Appeal upholding the High Court judgment, confirming New Zealand's adaption of the recast rule.(2)
In doing so, the Court of Appeal has set out the context for adopting the revised rule. The growth in consumer protection legislation has meant that contractual overreach is now dealt with primarily by legislative intervention, overtaking the role of the common law prohibition against penalties; the result has been greater emphasis on freedom of contract, particularly between commercial parties.(3) The court has also clarified the recast rule, adopting the terminology of the disproportionality and punitive purpose tests, and further explained the recast rule's relationship to the previous rule.(4)
Before 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,(5) 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(6):
- A term will be considered 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 the breach.
- A term will be considered 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 the 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 recent years, both the English and 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, in other words, the value of performance to that party.(7)
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 while confirming that its scope was limited to secondary obligations.(8)
In Paciocco v Australia and New Zealand Banking Group the High Court of Australia adopted the recast rule, but broadened its scope to include conditional primary obligations.(9) 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.(10)
Facts 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 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.
High Court decision After reviewing earlier decisions from the NZ authorities, subsequent developments in England and Australia and the Court of Appeal's decision in Torchlight, the High Court adopted the recast penalty rule, 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, limiting it to secondary obligations only. It went on to hold that the obligation in the case on appeal was secondary in nature (and thus subject to the recast penalties rule), considering that the assessment 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)
It held that Honey Bees had wanted to protect two related performance interests through the bargain – namely, ensuring installation of a second lift by a specified time and securing 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 (ie, the breaching party was operated by an experienced property developer, managing 12 commercial properties)(18) and the fact that the plaintiff had 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 the penalties rule's function was not "to protect commercially sophisticated property investors from their commercial decisions".(20)
Law The Court of Appeal affirmed the High Court's adoption of the recast penalty rule as expressed in Torchlight.(21) In doing so, the court was influenced by the United Kingdom's change of approach, particularly as New Zealand's earlier approach had been based on Dunlop. The court was reassured by the similarity between subsequent developments in England and Australia and was influenced by the effect of greater consumer protection legislation on the role of the common law (and the increased judicial focus on freedom of contract). Increased legislative protection for consumers meant that contractual overreach could be primarily dealt with through unconscionability and impaired consent, with the penalties rule used only in cases of gross overreach.(22)
The court adopted new terminology to describe the rule. It described the primary test as the "disproportionality test" – that is, 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.(23) The phrase "out of all proportion" creates a particularly high bar and is more demanding than that expressed in Dunlop.(24) 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, as a party's legitimate interests may often be wider than its financial or economic interests. Certain clauses may have commercial justifications that are not directly financial.(25)
The disproportionality test can be cross-checked against 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. The court adopted the formation of this test as it had been expressed in Torchlight. As a result, the inquiry focused on the predominate, rather than the sole, purpose of the clause.(26)
The court rejected a proposition that the prohibition against penalties is equitable in nature, rather than a common law rule. While the rule had its origins in equity, it should now be regarded as essentially a common law rule.(27)
As far as the scope of the rule is concerned, the court expressed a preference for the United Kingdom's formulation in Cavendish, in which the rule was confined to secondary obligations, rather than the Australian formulation, in which the rule can apply to conditional primary obligations (ie, a conditional obligation arising on failure to meet another primary provision) but it noted expressly that the observation was obiter.(28) As a result, the rule's scope remains open to future argument.
Application The court agreed with the lower court's application of the rule. The indemnity applied only to the initial lease period – and not any subsequent renewal period – and was limited to economic obligations such as the payment of rent, not to covenants such as an obligation to repair damage.(29)
The court upheld the finding that the clause was not a penalty. 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. The clause partially reallocated risk for non-completion of the second lift to 127 Hobson. The parties could have done so in several ways. They chose 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.(30)
The Court of Appeal has now confirmed the application of the recast penalty rule in New Zealand but, as 127 Hobson has been granted leave to appeal to the Supreme Court, the final word is awaited.
The question of the rule's scope remains open. While the court expressed a preference for the English formulation, in which the rule is limited to secondary obligations, it stated explicitly that its observation on the point was obiter.
(7) Cavendish Square Holdings BC v Makdessi  UKSC 67,  AC 1172; Paciocco v Australia and New Zealand Banking Group  HCA 28; (2016) 333 ALR 569; Wilaci Pty Limited v Torchlight Fund No 1 LP (In Receivership)  NZCA 152.
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