On 18 April 2019, the Court of Appeal released the judgment of Kós P in the case of 127 Hobson Street Ltd & Parbhu v Honey Bees Preschool Ltd & James  NZCA 122, in which the Court upheld an indemnity in relation to the lease of a preschool. Hardly an earth shattering issue, but the analysis of the operation of the rule against penalties is highly significant.
Besides, what is not to like about a case called Honey Bees?
Honey Bees entered into a commercial lease with 127 Hobson Street for a term of six years, with three rights of renewal. The premises was to be used as a preschool. Central to the grant of the lease was the installation of a second lift in the building, providing direct access to the preschool. The obligation to instal the lift was recorded in a collateral deed, together with an indemnity effectively releasing Honey Bees from all liability under the lease for the entire term if the lift was not installed and fully operational by 31 July 2016.
The lift was not installed by the due date; Honey Bees claimed under the indemnity; 127 Hobson Street argued the indemnity was an unenforceable penalty.
Applying traditional principles
Looked at objectively, a number of issues arise.
First and foremost, 127 Hobson Street's obligation was to instal the promised lift. Applying the traditional principles of genuine pre-estimate of loss, it is hard to assess the financial loss to Honey Bees resulting from a breach of that obligation. Access was still available to the premises using the existing single lift. The damage to Honey Bees was primarily one of convenience. Yet, the consequences of breach of the promise was real enough, and the undertaking in the indemnity absolute.
Second, it has long been assumed that a collateral undertaking, outside of the primary obligation in a construction contract, may avoid the rule against penalties - for example, the provision of a bond or other financial instrument which might be surrendered if the project is completed on time. In this case, it appears the undertaking in the collateral deed was to be concealed from 127 Hobson Street's bankers, however the primary obligation in the deed was to instal the second lift and the secondary obligation was to indemnify Honey Bees for its primary obligations under the deed of lease.
Third, applying established principles, a failure to meet the 31 July 2016 installation date meant the entire rent and open reimbursement for the initial term was forfeit. It was not pro rated - it was a zero sum test.
Lord Dunedin's 4 principles from Dunlop Pneumatic Tyre
The foundation for the exception to the rule against penalties was laid over 100 years ago by Lord Dunedin in Dunlop Pneumatic Tyre Co v New Garage & Motor Co Ltd  A.C. 79. In that case, Dunlop had imposed a penalty of £5 for every tyre, cover or tube sold in breach of the supply agreement. Lord Atkinson, in that case, noted that although the financial loss from such a breach might be trivial, the reputational damage resulting from such a breach should not be overlooked.
Lord Dunedin expounded four guiding principles in assessing whether or not the rule against penalties had been breached -
(1) the use of the words "penalty" or "liquidated damages" are not conclusive;
(2) the essence of a penalty is a payment stipulated in terrorem; the essence of liquidated damages is genuine pre-estimate of damage;
(3) the question is one of construction of the terms and surrounding circumstances at the time the contract was entered into, not at the time of breach; and
(4) a number of tests may assist, namely (a) is the sum extravagant and unconscionable; (b) is the breach for payment of money, and the remedy greater than the sum not paid; (c) there is a presumption it will be a penalty if a lump sum is payable for a relatively trivial breach; and (d) it is no obstacle to enforcement if genuine pre-estimation is impossible "that is just the situation when it is probable that the pre-estimated damage was a true bargain between the parties."
It is interesting to note the laissez faire language of the early 20th century in Lord Dunedin's judgment, compared to the more interventionist approach taken over the ensuing decades. The willingness to look more widely, into the surrounding circumstances at the time the contract was awarded, is also interesting in the context of the UK's reluctance to follow the more liberal approach to interpretation favoured by the NZ courts.
Kós P's reformulation
For the drafters of contracts for major construction projects, the cause of sleepless nights is the formulation of the liquidated damages clauses, and grounds for extensions of time to protect the completion date. Has the project team properly assessed the likely losses resulting from delay (or any other breach, for example the achievement of availability, efficiency and output?); are the events giving rise to liquidated damages clear and properly under the control of the contractor; do the grounds for extension of time cover all relevant events, including acts of prevention or delay by the owner. The list is as long as the imaginations of litigating lawyers raising the prohibition against penalties.
When the indemnity contained in the collateral deed came before the Court of Appeal, Kós P started his analysis by reaffirming the Court's caveat in Wilaci Pty Ltd v Torchlight Fund No 1 LP (in rec)  NZCA 152 (itself following the High Court of Australia decision in Paciocco v ANZ Banking Group  HCA 28) and confining the question of the enforceability of the collateral deed as to "whether or not the disputed clause imposes a detriment on 127 Hobson out of all proportion to any legitimate interest of Honey Bees in enforcement of the primary obligation to construct the second lift."
In phrasing the "ultimate question" in this way, the Court was echoing (and expressly following) the reasoning in the UK Supreme Court decision of Cavendish Square Holding BV v Talal El Makdessit  UKSC 67, which expressed the test in the following terms:
"... whether the impugned provision is a secondary obligation which imposes a detriment on the contract-breaker out of all proportion to any legitimate interest of the party in the enforcement of the primary obligation."
That "legitimate interest" in the view of the UK Supreme Court may extend beyond pecuniary compensation for the breach.
Following the reasoning in Cavendish, Kós P observed that a "commensurate redirection of the penalties prohibition in New Zealand is necessary." In the Court's view, the balance of common law "tilts more in favour of freedom of contract, and the enforcement of consensually selected remedies" than it had at the time that Lord Dunedin formulated his four guiding principles in Dunlop.
His Honour then went through the core principles for the application of the prohibition against penalties:
1. The disproportionality test - does the secondary obligation (ie, the penalty) impose a detriment out of all proportion to any legitimate interest in the enforcement of the primary obligation (the contractual breach)? The key words here may well be more "legitimate interest" than "disproportionality". Quoting Lord Mance, in Cavendish:
"In judging what is extravagant, exorbitant or unconscionable, I consider (despite contrary expressions of view) that the extent to which the parties were negotiating at arm's length on the basis of legal advice and had every opportunity to appreciate what they were agreeing must at least be a relevant factor."
2. The punitive purpose test - whether the predominant purpose of the secondary obligation is to punish the promisor rather than protect the legitimate interest in the performance of the primary obligation, judged by referent to the circumstances at the time the contract was formed. The secondary obligation cannot predominantly be a deterrent, or in terrorem.
3. Prohibition equitable or legal? - the rule is essentially one of the common law.
4. Prohibition premised on breach only? - the prohibition against penalties operates only in the case of breach, and not in the case of contingent obligations unrelated to breach (obiter dicta).
The indemnity in the collateral deed was held not to be a penalty.
Historically, liquidated damages for delay were considered to be for the benefit of the contractor. They provide certainty, and they shield contractors from the true cost of delay. Typically, an owner would undertake a conservative estimation of potential losses, they would exclude trading and commercial losses covered by business interruption insurance and they would then apply a discount. Factoring in reputational damage and other less quantifiable losses might arguably increase the exposure for contractors, but at the same time it reduces the potential for challenge on spurious grounds and strengthens the sanctity of contract.
As observed by Kós P:
"Today, contractual overreach calls for assessment primarily through the lens of impaired consent, unconscionability or consumer law infringement. That means there is less for the prohibition against penalties to do. Commercial parties should generally be left to the certainty of the bargains they have made, including the remedies they have elected collectively, save in cases of overreach."
The case not only reflects the reality of how liquidated damages are assessed, but also what Lady Brenda Hale, President of the UK Supreme Court, describes as the incremental development of the law from established principles. Or as Kós P might say, from the establishment of ratio decidendi rather than policy or pragmatism. Finding a bright line between those distinctions might, it has to be acknowledged, be problematic; but less so than riding the unruly horse of public policy, it has to be said.