A Sting in the Tail?

127 Hobson Street Limited v Honey Bees Preschool Limited

The Supreme Court has delivered an important decision on the law of penalties in 127 Hobson Street Limited v Honey Bees Preschool Limited [2020] NZSC 53. Honey Bees Preschool Limited (Honey Bees) was a preschool that leased premises from 127 Hobson Street (Landlord). One of the obligations under the lease was for the Landlord to provide a second elevator in the building to facilitate access to Honey Bees’ business on the fifth floor. The Landlord was to install the elevator by a specified date.

Mr Parbhu, a director of the Landlord, guaranteed the obligations of the Landlord under the lease. He also agreed to indemnify Honey Bees for their rent and outgoings under the lease until expiry should this obligation not be met. Effectively, this meant that if the lift was not installed by the due date, Honey Bees would receive free rent for the term of the lease (six years).

The second lift was not installed in time. However, it was not clear whether Honey Bees, an otherwise successful business, suffered any financial loss due to the lack of a second elevator. Nevertheless, Honey Bees claimed Mr Parbhu was liable for their entire rent and sought to enforce the indemnity. Mr Parbhu claimed the clause was invalid, as it was a penalty clause pursuant to which he faced paying significant damages in excess of any losses suffered by Honey Bees.

The Supreme Court upheld the decisions of the lower Courts that the clause was not a penalty clause. Traditionally, the test had been whether the clause in question was a legitimate pre-estimate of damages.¹ However, recent case law, particularly from the UK Supreme Court, indicated the real issue was whether the clause protected a legitimate interest. The Supreme Court agreed with this assessment and applied the English test in New Zealand.

In finding for Honey Bees, the Court considered the ultimate test was whether a term of the contract is out of proportion to the legitimate interest of the innocent party in performance of the primary obligation. The Court made several observations, including:

1. A legitimate interest may extend beyond standard contractual doctrine and may relate to a system of business the contract forms a part of.
2. Punishment is not itself a legitimate interest but deterring breach of contract can be.
3. The bargaining power of the parties may be relevant for non-commercial parties.
4. It is not necessary for a Court to assess damages, but it may be helpful for it to do so.

The Supreme Court’s decision significantly limits the doctrine of penalties and will be a boon to those interested in greater contractual freedom. On the other hand, the test is far more contextual and less certain than the previous test outlined in Dunlop. A great deal of detailed and contextual analysis may now be necessary in determining if a contractual provision is a penalty clause. This will almost certainly require delicate navigation of the law in this area, although case law may eventually make the law of penalties more certain.

1. Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co Ltd [1915] AC 79 (HL).

This publication is intended as a general overview and discussion of the content dealt with. It should not be used in any specific situation, in which case you should seek specific legal advice.