International developments in the penalties doctrine

Many in the construction industry who pay close attention to special conditions of contract may have noticed in recent years a subtle change to the wording of liquidated damages provisions. As Sam Thyne explains, a Contractor was previously often required to agree something to the effect that the liquidated sums represented “a genuine pre-estimate of the Employer’s loss”. This verbiage was part of an ongoing struggle for employers to ensure that liquidated damages provisions remained enforceable and were not caught out by the penalties doctrine.

The words “genuine pre-estimate of loss” reflect the long-standing test set out by the House of Lords in the 1915 case of Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co Ltd [1915] A.C. 79. If a sum within a contract that would be applied in instances where there was a failure to carry out an obligation was demonstrated to be a genuine pre-estimate of the wronged party’s loss, then it would be considered liquidated damages. However, if it was not it would amount to a penalty or a “terrorem on the offending party”.

Under the Dunlop approach a specified sum was either liquidated damages or a penalty. For the next hundred years parties attempted to ensure they remained on the correct side of that dichotomy by taking care that the sums stated were reflective of the loss anticipated, and for good measure stating in the contract that the sum was a genuine pre-estimate of loss.  

The subtle change mentioned above was on account of a case in the United Kingdom Supreme Court, Cavendish Square Holdings BV (Appellant) v Tatal El Makdessi (Respondent) (Cavendish), which established the current United Kingdom approach to penalties in 2015. After 100 years the dichotomy of liquidated damages versus penalties was done away with. It was the UK Supreme Court’s view that this was too restrictive an approach as there were more interests besides compensation for loss that liquidated damages provisions aimed to protect. The new test as to what amounted to a penalty was whether it imposed a detriment to the contract breaker out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation.

Provisions agreeing that liquidated damages accurately represent the loss that may be suffered by another party may seem like a form over substance approach with little practical effect, particularly given the comment in Dunlop by Lord Dunedin where it was noted that parties to a contract can call the sum payable whatever they like but, while this may be helpful, what matters is whether the sum is in truth a penalty or liquidated damages. However, following Cavendish, special conditions were updated to state something to the effect that the parties agreed that the liquidated damages they were agreeing to were proportionate to protect the legitimate interest of the other party.

Cavendish has been law in the United Kingdom since 2015. The most recent development in the law of penalties has been in New Zealand where in June of 2020, the New Zealand Supreme Court released its long-anticipated decision in 127 Hobson Street Ltd v Honey Bees Preschool Ltd [2020] NZSC 53 (Honey Bees). With it came some long-awaited clarity and an onslaught of bee-related puns in legal articles.

Rather than concerning inner city apiary interests, Honey Bees was about a childcare facility located within a central Auckland high-rise. At the time of entering into the lease for the premises the parties agreed a collateral deed separate to the lease agreement. Under the collateral deed the landlord agreed that they would install a second lift to the building by a certain date, and if they did not then they would indemnify the lessee for rent and outgoings under the lease until it expired.

Needless to say, the second lift was not installed, and after several years of disagreement, and progress through the lower courts, the Supreme Court was asked to clarify the extent of the penalties doctrine in New Zealand.

The New Zealand Supreme Court determined that the test to be applied was that:

“A clause stipulating a consequence for a 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 … A consequence will be out of all proportion if it can fairly be described as exorbitant when compared with those legitimate interests.”

Sound familiar? New Zealand’s new test draws heavily from developments in both the United Kingdom and Australia, with the New Zealand Supreme Court noting that the reasoning in both Cavendish and the Australian Federal High Court Decision of Paciocco v Australia & New Zealand Banking Group Ltd [2016] HCA 28 was persuasive as to the need to move beyond the old Dunlop dichotomy. 

In the decision of the Court of Appeal on the same matter, the same essential test was used but with an additional cross-check requiring that an assessment of whether the predominant purpose of the impugned clause was to punish the promisor rather than protect the legitimate interests of the promise. However, the Supreme Court did not adopt this safeguard, believing it was neither necessary nor desirable. 

The New Zealand Supreme Court also provided further guidance in determining whether a clause was a penalty. The Court noted:

  • The determination requires an objective exercise of construction, notionally undertaken at the time of contract formation and by reference to the terms and circumstances of the contract. The circumstances can include the broader commercial context within which the contract sits.
  • The legitimate interest must be weighed when assessing the proportionality of the agreed consequence.
  • A party’s legitimate interests may extend beyond the loss caused by the breach as measured by a conventional assessment of contractual damages. They may extend to the impact of non-performance on the broader commercial interests the parties seek to achieve or protect through the contract. Those interests may extend beyond the four corners of the contract, for example if they relate to a system of business of which the contract forms a part.
  • While legitimate interests will not include objectives unrelated to the performance interest, such as punishment, deterring breach can be a legitimate objective of a clause.
  • The bargaining power of the parties will be relevant to determining the nature and extent of the innocent party’s interest in performance of the primary obligation. There is a presumption that commercial parties dealing with each other on equal terms are able to assess the appropriate proportion between the legitimate interest in performance of the primary obligation and the consequence contracted for on breach. The fact that a party was legally advised as to the nature and effect of the transaction will also weigh in favour of upholding the bargain. But where there is evidence of unequal bargaining power, or where one party is not legally advised, a court will scrutinise more closely the innocent party’s claims as to the interests protected, and also the issue of proportionality. 
  • It is not necessary in all cases for the court to assess the damages that would have been awarded at common law for breach, but there may be cases where such calculation is the measure of the performance interest. That is likely to be the case where the impugned clause purports to provide a pre-estimate of damage, or where the impugned clause appears in a contract where the only legitimate interest in performance is properly analysed as the monetary value of the losses which flow directly from that breach, and which are readily calculated.

In the Honey Bees case itself, the Court was satisfied the consequences were not out of all proportion to the legitimate interests of Honey Bees in performance of the obligation to install the lift. The indemnity was therefore enforceable.

Honey Bees had leased the premises on the basis that they would be able to expand their business to cater for 45 children; two lifts were a key component of this objective. Ultimately, the Court determined that the consequences were not exorbitant in the overall circumstances, one relevant circumstance being that the landlord was given ample time to carry out the installation.

So what does this mean for contractors in general in New Zealand and the United Kingdom? Has the death knell sounded across these jurisdictions any hope of rendering a contractual term unenforceable for being penal?

Resorting to the penalties doctrine to render a contract term unenforceable has never been a panacea for contractors. Where, as is often the case in construction contracts, the terms of a contract are heavily negotiated and the parties are well advised, even under the Dunlop approach it is difficult to demonstrate that a liquidated damages term is a penalty. 

Across New Zealand and the United Kingdom, courts now require that a clause be “exorbitant”, “unconscionable”, or “extravagant”. With such a high threshold, the door to arguing that a liquidated damages provision is a penalty is clearly almost closed – only in limited circumstances could you see this being successful.

There is still the remaining issue of whether deterring a construction contractor from finishing a project late is a legitimate interest in itself. While this may appear a straightforward answer given the broad indication of the various courts, of note is that none of the recent cases discussed, including Cavendish, ParkingEye Limited v Beavis, Honey Bees and Paciocco v ANZ are construction cases. 

This means that the courts have not had the opportunity to consider the broad range of considerations that impact construction projects. What is clear is that the courts will look beyond the four walls of the contract at the broader circumstances, and it may be that within these broader circumstances the proportionality of a liquidated damages provision will still be challengeable. 

Previous article