The general doctrine of penalties provides that contractual clauses imposing disproportionate penalties for breach are unenforceable.
The Supreme Court on Friday released its decision in 127 Hobson Street Ltd v Honey Bees Preschool Ltd  NZSC 53, providing the authoritative test for what constitutes an unenforceable penalty clause in New Zealand.
Honey Bees case
The case concerned Honey Bees Preschool Ltd, which operated a preschool in premises leased from 127 Hobson Street Ltd. At Honey Bees' request, 127 Hobson Street agreed to install a second elevator in the building by a certain date, failing which it would indemnify Honey Bees for its obligations under the Lease until its expiry. When the second elevator was not installed on time, Honey Bees sought to enforce the indemnity, by not paying rent. 127 Hobson Street contended that the indemnity was unenforceable, so that rent should be paid.
Both the High Court and Court of Appeal held that the indemnity was enforceable.
On appeal, the Supreme Court affirmed the Court of Appeal decision, on the basis that indemnifying Honey Bees for its rental payment obligations under the lease was not out of all proportion to Honey Bees' legitimate interests in having a second elevator on time (interests such as protecting the future growth prospects of its business).
Reaching the decision involved an application of the legal test for what constitutes an illegal penalty clause, to determine whether the impugned clause was exorbitant compared to Honey Bees' legitimate interest. This required a close analysis of:
What is the current test for a penalty clause? The proportionality test
The Supreme Court held that a clause will be a penalty if the consequences of breach of contract are out of all proportion (ie exorbitant compared to) the legitimate interests of the innocent party.
the test is objective, and to be based on the circumstances at the time of contract formation;
the legitimate interests of the innocent party that must be weighed in the balancing exercise might not be limited to conventional estimates of loss, and may include wider commercial or business interests;
deterring a breach can be a legitimate interest (although punishment is not);
if the party seeking to impose the liquidated damages was in superior bargaining position, the court may be more willing to conclude that the clause is a penalty; and
it is not necessary for the court to assess the damages that would be available at common law, unless this amount represents a legitimate interest to be weighed (eg because the impugned clause purports to be a pre-estimate of damage, or the only legitimate interest at play is monetary).
What does this mean?
It is hard to successfully challenge a clause agreed by commercial parties on the basis that it is a penalty. This case does not make it any easier.
It confirms that the analysis should focus on the legitimate interest being protected, rather than whether the liquidated damages are "genuine pre-estimate of loss" (the traditional approach following Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co Ltd  AC 79 (HL)). The Supreme Court also rejected (as subjective) the relevance of any inquiry as to whether the predominant purpose of the liquidated damages clause was to punish the party in breach rather than protect the legitimate interests of the other party.
The practical advice remains to record at the time of contracting what interests the liquidated damages provisions are intended to protect, and how they have been measured.
The case can be found here.