Contract

Case alert - Penalties doctrine clarified

The Supreme Court has confirmed the legal test for the penalties doctrine in contract law, in 127 Hobson Street Ltd v Honey Bees Preschool Ltd [2020] NZSC 53. Following overseas approaches, it is based on a proportionality test.

Disproportionality test

The test to be applied is summarised at [91] of the Judgment, and by the following quote:

"A clause stipulating a consequence for breach of a term of the contract will be an unenforceable penalty if the consequence is out of all proportion to the legitimate interests of the innocent party in performance of the primary obligation. When we refer in this judgment to legitimate interests in performance, that includes an interest in enforcing performance or some appropriate alternative to performance. A consequence will be out of all proportion if the consequence can fairly be described as exorbitant when compared with those legitimate interests." [57]

No cross-check for punitive purpose test

Disagreeing with the Court of Appeal, the Supreme Court thought that a cross-check for a punitive purpose would be unhelpful. It would have invited a separate inquiry into the state of mind of the parties and could have led to a different result [58].

Applicable to conditional obligations?

The Supreme Court noted the existence of the other area of controversy, about whether a breach is an essential pre-requisite to engaging the rule against penalties [41].  However, as the appeal did not concern that issue [42], the Supreme Court did not comment further. We are still left with obiter comments of the Court of Appeal signalling disagreement with the approach of the High Court of Australia in Andrews v Australia and New Zealand Banking Group Ltd [2012] HCA 30, (2012) 247 CLR 205 about the penalties doctrine potentially applying more broadly to conditional obligations (ie not just breaches) [42].

Conclusion

Overall, the case provides valuable clarity about the modern New Zealand approach to the penalties doctrine in contract law.