10.06.2020

Liquidated damages and penalty clauses: the last word on Honey Bees

The Supreme Court’s judgment in 127 Hobson Street Limited & Anor v Honey Bees Preschool Limited & Anor [2020] NZSC 53 confirms the test for determining when a clause in a contract designed to secure performance will be an unenforceable penalty.  The decision rejects the previous law that a liquidated damages clause must be based on a genuine pre-estimate of loss, or risk being struck down as a penalty.  Parties wanting to challenge a clause as penal must show it is out of all proportion to, or exorbitant when compared with, the interest being protected.  This is a high bar.

The facts

127 Hobson Street Limited (127 Hobson) agreed to lease building space to Honey Bees Preschool Limited (Honey Bees).  Because the childcare centre would create significant pressure on lift access, 127 Hobson agreed to install a second lift in the building (the Collateral Deed).  The Collateral Deed contained a clause requiring 127 Hobson to indemnify Honey Bees for all Honey Bees’ obligations under the lease (including rent and outgoings) if the lift was not installed on time.  The lift was not installed on time.  Honey Bees used the clause to claim an indemnity from 127 Hobson for its rent and outgoings.  127 Hobson challenged the clause, arguing it was unenforceable as a penalty.

The Honey Bees decision

Until now, the New Zealand position on penalty clauses reflected the British position: to be enforceable, liquidated damages clauses needed to be a genuine pre-estimate of damages.  The UK Supreme Court recently overturned this concept,[1] noting that a party’s legitimate interests might extend beyond compensation for loss.  It proposed a new test, which asked whether the clause in question protects a legitimate performance interest; and whether the penalty imposed is out of all proportion to the interest being protected. 

 The Honey Bees decision provides a definitive ruling on the position in New Zealand.  The key findings are as follows:

  • A clause which imposes a consequence if the contract is breached will be unenforceable if the consequence is “out of all proportion” to the legitimate interest the other party has in the contractual obligation being performed.
  • A clause is not a penalty if the consequences it imposes are designed to protect the party’s interests in the obligations under the contract being performed. These are legitimate interests.
  • Determining whether a clause is an unenforceable penalty requires an objective analysis of the contract, its terms and circumstances, and the broader commercial context.
  • A conventional assessment of contractual damages may not adequately capture a party’s legitimate interests: these may extend beyond the loss caused by the contractual obligations not being performed.
  • Deterring a breach of contract can be a legitimate objective, although punishment is not legitimate.
  • The parties’ bargaining power, their commercial sophistication, and whether they had legal advice will be taken into account in assessing a liquidated damages clause.

The Supreme Court found that by requiring the installation of the second lift, Honey Bees was protecting its legitimate business interests to ensure orderly access throughout the building.  Honey Bees did not take advantage of an unequal bargaining position.  The Court found that the consequences of the indemnity clause being triggered were not out of all proportion to the legitimate interests Honey Bees had secured.  The indemnity clause was not a penalty and was upheld by the Court.

Our comment

Liquidated damages are frequently used in construction contracts, to secure the completion of the works by the Due Date for Practical Completion.  In view of the Honeybees decision, liquidated damages clauses agreed by commercial parties will become increasingly more difficult to challenge.  It will be necessary to show that the level of liquidated damages is wholly disproportionate to the Principal’s interest in securing timely performance of the obligations under a construction contract. 

Parties should consider the specific interests which are being protected through a liquidated damages clause (or any other clause that might be considered punitive).  Parties should be able to articulate a clear basis for the clause being included in the contract, together with a justification for the amount of any “penalty”. 

If you have any questions about the issues raised by this judgment or the law on penalty clauses, please get in touch with our Construction Team, or your usual contact at Hesketh Henry.

 

Disclaimer:  The information contained in this article is current at the date of publishing and is of a general nature.  It should be used as a guide only and not as a substitute for obtaining legal advice.  Specific legal advice should be sought where required.

[1] Cavendish Square Holdings BC v Makdessi; ParkingEye Ltd v Beavis [2015] UKSC 67, [2016] AC 1172, (Cavendish).

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