On four occasions over 2015, Ministry of Health enforcement officers went to the area and saw people smoking in the outdoor zones while some of the blinds were pulled down, creating partially enclosed spaces.
"Throughout this period, communications continued to be exchanged between the Ministry officers and the directors of Shearwater as to the interpretation of 'internal area' under the Act, and measures which could be taken to ensure that the areas were compliant with the legislation," the judge said.
"None of the measures suggested by the Ministry were implemented by Shearwater. Instead, the directors continued to maintain that Shearwater was not in breach of the Act."
On some of the occasions enforcement officers visited the site, they said they saw ashtrays on the tables and limited or no signage telling people not to smoke while the blinds were down.
Determination of whether the area could be considered internal revolved around whether the plastic blinds counted as "closeable openings".
The relevant section of the act said an internal area in relation to any premises or vehicle, means an area within or on the premises or vehicle that, when all its doors, windows, and other closeable openings are closed, is completely or substantially enclosed by a ceiling, roof, or similar overhead surface, and walls, sides, screen, or other similar surfaces, and those openings.
The District Court judge said the blinds were closeable openings, and the word "when" in the Act definition meant the blinds were assumed to be closed at the time of assessment.
That meant an area was seen to be internal if it was capable of becoming internal when all the openings were closed.
Justice Edwards said an area cannot be considered internal unless it is enclosed or substantially enclosed at the date of the infringement.
"Deeming entire walls or roof-like surfaces to be in places when they are not is inconsistent with both the scheme and purpose of the Act."
Justice Edwards said a factual assessment needed to be made of an area at the time of infringement.
Shearwater conceded the outdoor area was completely or substantially enclosed on one of the four occasions, but says there is not enough evidence to prove that for the three other cases.
Justice Edwards allowed the appeal "insofar as it relates to the interpretation of 'internal area' under the Act".
Hospitality Association advocacy and policy manager Dylan Firth said a lot of the group's members were being pulled up on smoking areas, and the issue was caused by vague wording in the Act.
"There's a lot of confusion as to where does it cross the line."
He believed the recent decision set a precedent that helped to clear things up a small amount, but that clarity came at the cost of a court process that was "difficult for a small business to handle".
"I think the industry will be happy to see that there's some guidance now around that, however there's a lot more to the Act that's still difficult to interpret.
"I think people would rather see some definitive 'what's internal what's not' put out there."
Shearwater's lawyer Johann Strauss agreed the decision set a precedent.
"It is the first High Court decision that squarely addresses the proper interpretation and application of the definition of 'internal area' in the Smoke Free legislation," he said.
"The importance for restaurants and bars and similar establishments is that in terms of this judgment they can have retractable roofs or sides that they can open or roll down to provide shelter from inclement weather without falling foul of the legislation provided that the whole area is not substantially enclosed at the time.
"Up until now the Ministry of Health has been applying the legislation on the basis that any area that can be enclosed is in fact enclosed whether it is in fact enclosed at the time or not.
"The practical effect is the following. If a bar owner provides a smoking area on the pavement and then installs a retractable roof and plastics sheets which can be rolled down in case of rain or bad wind, they could no longer allow smoking on the pavement because the Ministry deemed the area internal because it can be substantially enclosed irrespective of whether the roof is rolled out and the sides down or not - this judgment decides that this is wrong and one must look at the position at the time."
