Penalty Clauses Clarified

It is common for commercial agreements to include a clause setting out some form of consequence if a breach occurs.  Sometimes these take the form of a “liquidated damages” clause, which specifies that a certain sum of money will be payable when a breach occurs, sometimes with the amount increasing over time. 

However, there is a general principal of law that states that you cannot enforce a clause which is intended to punish the breach of the contract.  Because of this general rule that a “penalty clause” cannot be enforced, it is important when either preparing a commercial agreement, or seeking to enforce one, to decide whether a clause is an unenforceable penalty clause or not.

The Supreme Court[1] has recently considered this question and set out the test for determining whether a clause is an unenforceable penalty clause.  One of the primary considerations is proportionality between the legitimate interests injured by the breach and the consequence imposed.  It is important to look at all the circumstances, including the broader commercial context to determine what those legitimate interests may be.  It is relevant to consider factors such as the bargaining power of the parties, and whether the agreement forms part of a larger commercial dealing, and it is recognised that deterring breach can be a legitimate objective.

Importantly, the question is considered on the facts of the case, as determined at the time when the contract was formed, not when the breach occurs.  This means it is important for the parties to a commercial contract to consider what form of consequence will be appropriate and proportionate for a breach at the outset, when the contract is being formed. 

The most efficient way to ensure your clauses will be enforceable is to consider what the actual effect on your business will be if the other party breaches an agreement, and to have one of the skilled members of our Commercial Team assist with ensuring the contract reflects this.  If a breach does occur, our Litigation Team has experience in High Court litigation relating to penalty clauses, and will now be able to rely on this new leading decision in representing our clients’ interests.  

[1] 127 Hobson Street Limited and Anor v Honey Bees Preschool Limited and Anor [2020] NZSC 53 (5 June 2020)