A liquidated damages clause appears in nearly all construction contracts (for example, 10.5 of NZS 3910:2013). Where the contractor fails to complete the contract works by the agreed due date for completion, it is required to pay the stipulated daily or weekly amount in damages to the principal until such time as the works are completed. There are limited avenues for a contractor challenging the application of liquidated damages and so it has become commonplace for disputes over whether the liquidated damages are a genuine pre-estimate of loss and therefore, enforceable, or whether the clause is void as a penalty. This would still leave the contractor exposed to general damages, but these would need to be proven by the principal.

Developments overseas, particularly in the UK with the decision of Cavendish together with the progress of the Honey Bees Preschool Limited v 127 Hobson Street Limited [2018] NZHC 32 litigation through the Courts in NZ in recent years, has made it less clear when a liquidated damages clause would be upheld and when it might be struck down as a penalty.

The NZ Supreme Court has now clarified the position. In summary, a penalty clause will be unenforceable where the consequence is out of all proportion to the legitimate interests of the innocent party in having the obligation performed. Legitimate interests can include direct loss and indirect loss affecting the overall commercial interests of the parties. A party’s legitimate interest does not extend to punishment, except as a deterrent from breach. In determining whether a clause is unenforceable, the court will consider the construction of the clause at the time of contract formation in the overall commercial context. The respective bargaining power of the parties has a limited impact on the overarching test. Finally, the court is not required to carry out a notional calculation of the damages that would otherwise result, but this may be a useful tool to assist in cases where the legitimate interest is confined to monetary loss.

With confirmation that a party’s legitimate interests can include anything affecting its broad commercial interests, liquidated damages no longer have to be a careful pre-estimate of financial  losses that may be suffered due to the late completion. Assessment of legitimate interests may also extend to loss of opportunity to bid for further work, a deterrent to the contractor to delay the project, reputational damage, or any other legitimate commercial interests linked to the delay. It is unclear exactly how far these interests may extend. This ability to rely on a broad assessment of commercial interests may give principals scope to negotiate greater liquidated damages than before, by arguing that they are seeking to protect their interests broader than direct financial loss.

As a result, the courts are less likely to carry out a notional calculation of the damages that would ordinarily flow in respect of the affected interests to assess proportionality. Instead, the court will make an assessment of whether the liquidated damages figure is "out of all proportion", meaning if the liquidated damages are exorbitant when compared with those legitimate commercial interests. Quite clearly, this is a high standard to be met for any party arguing that the liquidated damages are a penalty.

When considering the rate liquidated damages that are to apply to the project, parties should consider the length of a typical delay and whether the set daily liquidated damages accruing over that period would become exorbitant. However, with the widened definition of interests, and the court less likely to carry out a calculation with which to compare the liquidated damages sum, it seems that it will be much more difficult for parties to evade the consequences of delay by running a penalties argument. Parties should ensure they negotiate any contract containing liquidated damages with eyes wide open.

A more detailed summary of the Supreme Court’s decision is below.

In Honey Bees, the lessee leased space from the landlord and established a childcare centre in a multi-storey, residential, inner-city Auckland building. Honey Bees expended some considerable amount of money developing the premises to eventually cater for about 50 children. However, to be successful, it was agreed the landlord would provide a second lift to allow access for children and parents to the upper floor childcare center. This obligation was covered by a collateral deed which provided the landlord with two years and seven months in which to install the lift. If this obligation was breached and the installation was delayed, the deed provided that the landlord would indemnify Honey Bees for its rent for the remainder of the lease term.

The Supreme Court noted that, because the deed was collateral to the lease, the landlord’s breach did not give Honey Bees a right to cancel the lease (as the obligation appeared in the collateral deed and not the lease itself). The Court also observed that as distinct from a standard 3910-like liquidated damages clause where the agreed sum accrues and is payable on a daily or weekly basis, the obligations under the deed were full and absolute whether the landlord was one minute late or one year late.

In agreement with the Court of Appeal, the five Supreme Court Justices stated the test to be applied as follows:

"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.

[A legitimate interest in performance] includes an interest in enforcing performance or some other 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."

The court said the proportionality test allowed for interests beyond an innocent party’s interest in compensation for direct losses to a more flexible and permissive test to allow for consequences from the breach from indirect losses. This is similar to the approach taken in the English case of Cavendish, in particular the second appeal dealing with Parking Eye decision where a contract clause, which had an £85 fee for parking longer than two hours in a privately-owned shopping centre car park, was held to be enforceable.

The Supreme Court, however, differed from the Court of Appeal in formulating the "cross-check test" developed in the lower court. The cross-check asked whether the predominant purpose of the clause was to punish or to protect interests. If the predominant purpose was to punish, then the clause was a penalty. The Supreme Court held that introducing the notion of assessing the purpose of the clause in question "invites a separate enquiry into the state of the minds of the parties – what was the predominant purpose of the clause?" The Supreme Court acknowledged that the legitimate interests may extend beyond the harm caused by the breach as measured by a conventional assessment of contractual damages. The parties may agree to consequences for breach which recognise the broader impact of non-performance on the parties’ commercial interests. The Supreme Court did, however, caution that "while legitimate interests will not include objectives unrelated to the performance interest, such as punishment, what is also plain is that deterring breach can be a legitimate objective of a clause. Deterring breach is simply the flipside of securing performance."

The court went on to consider what is known as "negotiating damages" where the court undertakes a notional exercise of placing itself in the shoes of the innocent party prior to breach and fixing a price it would charge to ‘license a breach’. Such damages may be awarded as compensation where a court has refused to otherwise enforce a right, or where it was difficult for a plaintiff to prove loss. However, the Supreme Court saw no merit in using it as "a ruler against which to measure proportionality" as this would involve a clash of two distinct sets of legal issues resulting in undue complication. While calculation of damages is not strictly required, the court noted that in the right circumstances, such as with a liquidated damages clause, it would be helpful for the court to review whether a genuine pre-estimate of loss was reflected in the clause. This is likely to apply where the clause exists solely to protect fiscal interests, and such interests are easily calculated.

Finally, the court considered two other matters: The relative bargaining power of the parties and the fact that the impugned clause was not contained within the lease, but within the collateral deed. In dealing with the latter first, it said that this provided no advantage or disadvantage to the analysis on whether the clause was a penalty.

As to bargaining power of the parties, this raised a separate concept to the one being dealt with by the court, being unconscionability. The court noted that "the rule against penalties should not mix in elements of the law of unconscionable bargains or duress", however, the bargaining positions of the parties will be relevant to the inquiry as to the nature and extent of the interest in performance of the primary obligation. Where there has been inequity of bargaining power or one party was not legally advised, the court will more closely scrutinise the claim in respect of the interests protected and proportionality.