How are enforceable penalties set out in contracts?

Contracts are commonplace in business and life. A well-drafted contract can provide certainty and clarity for businesses and others by creating legal obligations for each party to do what they say they will. But what if a party to a contract doesn’t do what they promised they would? Are you allowed to penalise that party for not fulfilling their obligations under the contract? We will explore the enforce-ability of so-called ‘penalty clauses’ in light of a recent decision in the Court of Appeal.

What is a penalty clause?

It is common for businesses to try to reduce their risk of suffering a loss under a contract. One way businesses try to minimise their risk is by including a clause in the contract that requires money to be paid to them to compensate for loss if the other party doesn’t do what they promise.

In the past, such a clause has been considered a ‘penalty’ clause if the amount claimed is far more than the loss that is likely to be suffered from a breach of the contract. A disproportionately large amount could be seen as a punishment for breaching the contract, rather than a deterrent.

For example, you might enter into a contract to supply 400 apples to a food truck owner by 31 October so she can sell them as candy apples at a festival. The contract includes a clause that requires you to pay the owner $20 for every apple that you do not supply. The food truck owner intends to only make $1 of profit per apple sold. The $20 per apple is far more than the foreseeable loss of $1 per apple and is likely to be considered a penalty.

In the past, the courts have only been willing to enforce such clauses if the amount claimed was a reasonable (our italics) estimate to compensate for any foreseeable loss when the contract was signed. If the amount claimed was far more than the foreseeable loss, then the court would view this as a punishment for breaching the contract and would not enforce it.

The Honey Bees Preschool case

The late 2019 Court of Appeal decision in 127 Hobson Street Ltd v Honey Bees Preschool Ltd [1] clarified the law relating to penalty clauses. The case involved the lease of the fifth floor of a central Auckland commercial building to a childcare provider, Honey Bees Preschool Ltd. The building only had one lift that serviced the whole building.

Part of the agreement between the preschool and the landlord required the landlord to install a second lift in the existing empty lift shaft. The agreement also stated that, if the lift was not installed by a certain date, the landlord would cover the remaining rent and outgoings for three years and five months, until the initial lease term ended. The lift was not installed by the due date so Honey Bees issued court proceedings.

In the Honey Bees case the court created a new approach by looking at whether there was a legitimate business interest, and whether the amount claimed was out of proportion to the protection of that legitimate business interest.

Legitimate business interest confirmed

The court stated that monetary loss was not necessarily the only legitimate business interest that could be protected –there may have been other business risks. In the Honey Bees case the preschool needed the second lift to obtain a consent to increase the number of children enrolled, otherwise their business was not viable. This was considered a legitimate business interest.

In our candy apples example, the food truck owner may not be allowed back to any future festivals if she does not have 400 apples. The court may consider this to be a legitimate business interest that may justify a greater amount of compensation than just $1 per apple.

This Court of Appeal ruling provides businesses and others with greater freedom to enter into contracts that require a larger amount of compensation for a breach than might previously have been enforced by the courts. The compensation amount under the contract, however, still needs to be proportionate to the legitimate business interest. In our candy apple example above, $20 per apple would still likely be disproportionate and not enforceable.

The Honey Bees decision has been appealed to the Supreme Court; we will report on its outcome.

If you are considering including a penalty clause in your contracts, or would like to know whether any penalty clauses in existing contracts are enforceable, do talk with us.

[1] 127 Hobson Street Ltd v Honey Bees Preschool Ltd [2019] NZCA 122.

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