Penalty enforcement due to breach of contract

A new approach to penalty enforcement?

Kevin House, Senior Commercial PartnerPenalty enforcement due to breach of contract

One of the basic doctrines of contract law for many years has been that a Court will not enforce a penalty provision. A penalty provision is a term in a contract which enables one party to punish the other. Punishment occurs when the consequences of a breach are such that the adverse affect on the party subject to the penalty is disproportionate to the loss the other has suffered.

The inclusion of a default provision is usually expressed as an obligation to pay liquidated damages. By liquidated, is meant an ascertainable fixed sum. The rule has been that the liquidated damages must be a genuine pre-estimate of loss. A recent High Court decision in New Zealand has changed the approach to enforceability of liquidated damages. In the case Honey Bees Preschools Limited sought to enforce an indemnity provision in relation to a breach of a deed which was collateral to their lease of the premises. The problem was the landlord had agreed to install a second lift in the premises and, by the deed, to indemnify Honey Bees for all obligations it may incur under the lease, including rent and other expenses if the lift was not fully operational by a particular date. Honey Bees sought to enforce the indemnity but the landlord’s defence was that it was an unenforceable penalty.

The Court considered whether the penalty doctrine applied only upon breach of contract, i.e. only clauses with secondary obligations to compensate for breach of primary obligations could be struck out as penalties. Recent cases in the United Kingdom and Australia have shown a difference in approach. The judge here preferred the United Kingdom approach, in that the penalty doctrine applied only to secondary obligations. The judge construed the indemnity as creating a liability which was secondary to the breach of the landlord’s primary obligation to install the lift. The indemnity was therefore capable of being characterised as a penalty, meaning the penalty doctrine applied. The question was whether it was in fact a penalty.

The Judge decided that the indemnity was not a penalty. It was there to protect Honey Bees’ legitimate business interests and its enforcement was proportionate to the protection sought. The Court’s focus was on Honey Bees’ reasons for wanting the installation of the lift, including:

(i)              that the liability would only arise some 31 months after the document was executed, thereby giving the landlord more than ample opportunity to install the lift;

(ii)             the landlord’s commercial knowledge was such that the landlord should have known of the importance of the lift;

(iii)           Honey Bees had incurred significant expenditure on fitting out its premises; and

(iv)            as a result of prior dealings, Honey Bees had doubts about the reliability of the landlord in relation to the installation of the second lift on time and the strongly worded indemnity therefore was appropriate as a consequence of non-performance.

From the point of view of commercial parties negotiating a contract, the inclusion of a provision indicating the purpose of the indemnity clause, including in particular identifying the interest being protected by the provision and its consequences if not performed, is now far more likely to be upheld by a Court. While any argument over enforcement will be dependent on its particular facts a party seeking to enforce an appropriately worded indemnity provision should have more confidence in the likelihood of a Court finding in its favour than had previously been the case.

The information contained in this paper is necessarily of a generalised nature and specific advice should be sought in relation to any particular situation.