The High Court recently clarified the New Zealand position on when the penalties doctrine might be engaged.
Honey Bees Preschool Ltd (Honey Bees) leased premises from 127 Hobson Street Ltd for the purposes of operating a childcare centre. The lease required the landlord to install a second lift on the premises and, if this was not operational by 31 July 2016 (some 31 months after the Deed of Lease was executed), to indemnify Honey Bees against all obligations it may incur in relation to the premises (including rent and other expenses). This indemnity would have the effect of allowing Honey Bees to occupy the premises for approximately two years rent-free.
Scope of penalty doctrine
The Court first considered the competing approaches to the scope of the penalty doctrine in Australia and the UK. The UK Supreme Court has ruled that the penalties doctrine is only engaged where breach of a primary obligation (eg failure to provide goods as required by contract) results in the triggering of a secondary obligation (eg payment of a fee or damages). The High Court of Australia did not consider a breach of contract as required for the penalty doctrine to be triggered and that a primary obligation could be construed as a penalty.
Whata J preferred the approach of the UK and held that the penalties doctrine extended only to secondary obligations. While the indemnity provision in the lease resembled a conditional primary obligation, in substance it was akin to a secondary obligation and therefore was within the scope of the penalties doctrine.
When is a clause a penalty clause?
The High Court then considered when a secondary obligation would amount to a penalty. Prior to Honey Bees, New Zealand followed the longstanding threshold tests outlined by Lord Dunedin in Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd. Lord Dunedin said that a clause will be an unenforceable penalty if it is ‘extravagant and unconscionable’ and not a ‘genuine pre-estimate of loss’ arising from a breach.
Recent case law from the United Kingdom and Australia has departed from the concept of ‘genuine pre-estimate of loss’ – instead adopting a wider legitimate interest test. Under this test, a clause is a penalty where the detriment to the contract breaker was “out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation”.
In applying In applying the ‘legitimate interest’ test, Whata J considered the following factors were relevant in concluding that the obligation to indemnify was not a penalty:
- Honey Bees’ concerns regarding non-performance were legitimate.
- The defendant had 31 months to install the lift without triggering the indemnity provisions.
- The defendant should have known the importance of the lift to the plaintiff’s business.
- The landlord’s non-performance would affect the plaintiff’s ability to operate a successful childcare facility at capacity.
- Both parties were commercially astute. The defendant was an experienced property developer who managed 12 commercial properties. Any vulnerability it possessed was self-imposed through its reliance on internal expertise rather than seeking legal advice from its solicitor.
- The purpose of the indemnity clause was to ensure performance, not to punish the defendant.
Significance of decision
The High Court has clarified the approach to penalty clauses in New Zealand. In adopting the “legitimate interest” test the Court has arguably narrowed the circumstances in which clauses will be unenforceable penalties, albeit this is still to be affirmed by appellant higher court.
 Cavendish Square Holding BC v Makdessi  UKSC 67.
 Andrews v Australia New Zealand Banking Group Ltd  HCA 30, (2012) 247 CLR 205; Paciocco v Australia New Zealand Banking Group Ltd  HCA 28, (2016) 258 CLR 525.
 Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd  AC 79 (HL).
 Andrews above n 2 at .