22 September 2021
It is common practice to include liquidated damages clauses in a commercial contract, which acts as a pre-estimation of loss so as to provide in advance a fixed sum to be paid by way of compensation. Liquidated damages clauses may be triggered when a party to a contract is in breach of its contractual obligations. The essence of such clauses is to provide certainty and avoid the complicated task of assessing the damages to be paid arising from a breach of contract.
Different jurisdictions adopt different tests, and the tests have evolved over time. In this article, we will examine the most updated legal positions with regard to the enforceability of liquidated damages clauses in Hong Kong, Singapore, and Mainland China.
Hong Kong
Although English precedents are no longer binding in Hong Kong, the Hong Kong courts have continued to seek guidance from the UK courts and their decisions. Notably, the Hong Kong Court of Appeal recently settled the ambiguities surrounding the position of the courts on penalty clauses in Law Ting Pong Secondary School -v- Chen Wai Wah [2021] HKCA 873 which confirmed the approach laid out in the UK Supreme Court decision Cavendish Square Holdings BV -v- Talal El Makdessi [2016] AC 1172. The Cavendish approach provides that a liquidated damages clause is regarded as a penalty clause only if it is formulated and acts as a secondary obligation, imposing a detriment on the defaulting party. The test for making such an inquiry set out in Cavendish involves firstly the identification of the legitimate interest of the innocent party protected by the clause in question by the court, and then an assessment of whether the clause is ‘out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation’, considering the circumstances in which the contract was made, not at the time of breach.
Law Ting Pong concerned the recruitment and appointment of a teacher in July who then backed out of the employment contract in late August, failing to give three months’ notice of termination as required by the conditions of the contract. As stipulated, the alternative to a three months’ notice would be a payment in lieu (‘the Termination Provision’). The main issues at hand concerned whether the Termination Provision was legally binding, and whether it would then be unenforceable as a penalty clause. The Hong Kong appellate court ruled in favour of the employing school, holding that (1) the Termination Provision was a primary obligation of the contract as it provided a mechanism for termination, (2) enforcement was recovery of a contractual debt rather than a remedy for breach of contract, and (3) the Termination Provision was not unenforceable as a penalty clause even though employment under the contract had not yet commenced. Significantly, the court also held that even if the Termination Provision was considered a liquidated damages clause, it would still not constitute a penalty clause upon application of the Cavendish approach. The Termination Provision could not be considered as ‘out of all proportion’ to the employing school’s interests, as employers have legitimate interests in maintaining a stable workforce. The court also regarded the difficulties the employing school would face in appointing a replacement teacher and the need to employ temporary teachers in the resulting gap.
Ultimately, the confirmation of the Cavendish approach in Law Ting Poon has resolved uncertainties in commercial and employment contracts in Hong Kong law. More developments are certainly expected to come with regard to the particulars of what may amount to legitimate interests, and what would constitute as ‘out of all proportion’ to such interests.
Singapore
Singapore, despite also being heavily influenced by English law, differs from Hong Kong in its direct declination to adopt the Cavendish decision. Instead, the Singapore Court of Appeal affirmed the Dunlop test the recent case Denka Advantech Pte Ltd & another -v- Seraya Energy Pte Ltd & another [2020] SGCA 119. The Singapore courts opine that the concept of ‘legitimate interest’ in the Cavendish approach is too flexible and discretionary, and therefore prefer the Dunlop test to focus on the secondary obligation on the defendant to pay reasonable compensatory damages. The Dunlop test, as laid down by Lord Dunedin in Dunlop Pneumatic Tyre Company Ltd -v- New Garage and Motor Company Limited [1915] AC 79 is a simple test which questions whether a liquidated damages clause reflects a ‘genuine pre-estimate of the likely loss’ at the time of contract, which the innocent party would suffer at a breach of contract.
The Dunlop principles affirmed in Denka provide that: (1) a provision is a penalty clause if the stipulated sum is ‘extravagant and unconscionable’ in comparison to the maximum conceivable loss that could be proven to have been a consequence of the breach; (2) a provision is a penalty clause if a breach concerns only the non-payment of monies and provides for the payment of a larger sum; (3) a provision may be a penalty clause if the stipulated sum is payable in multiple events of varying gravity; and (4) the provision is not a penalty clause if a precise pre-estimation of loss is impossible. Additionally, the SGCA also examined and declined to adopt the expansion of the Dunlop test derived from the legal position of Australian courts, firmly maintaining the traditional principles, with the rules regarding penalty clauses only applying when such clauses are triggered by a breach of contract and not in other circumstances.
This decision in Denka has also settled uncertainties in Singaporean law, by affirming that the Dunlop test is to continue to be adopted rather than the Cavendish approach in determining whether a clause is unenforceable as a penalty. Ultimately, the focus of the Singapore courts revolves around the genuine pre-estimate of loss at the time of contracting, placing a focus on proportionate and reasonable compensation to an innocent party in the event of a breach of contract.
Mainland China
With regard to Mainland China, which is a civil law jurisdiction, the approach and test is completely different from that of Hong Kong and Singapore.
There is no express legal provision in Mainland China that prohibits penalty clauses. However, there are restrictions in place on the upper limits regarding liquidated damages clauses, where the stipulated sum should not be ‘excessively higher’ than actual losses.
Article 29 of the Interpretation of the Supreme People's Court on Issues Concerning the Application of the Contract Law of the People's Republic of China (II) provides for the People’s Court to revert and rule on the basis of actual losses suffered by the innocent party in the event that agreed liquidated damages are found to be too high. This is to be done in accordance with ‘the principles of justice and integrity and good faith’. The courts are likely to intervene and reduce the sum to be rewarded if the amount stipulated surpasses 30% of the actual losses suffered. This is further stipulated in Article 585 of the Civil Code of the People’s Republic of China, which provides that the People’s Court or an arbitration institution may make appropriate reductions upon request of a party.
Comparison between the approaches and tests adopted by HK, Singapore and Mainland China
As noted from the above, the tests adopted by the three jurisdictions are completely different.
Similarities can be found between HK and Singapore in which both tests require the clause to be compensatory with no element of penalty. The tests are indeed intertwined, in which the ‘pre-estimation of the loss likely to occur’ in Dunlop test is a useful indicator to determine whether it imposes a ‘disproportionate detriment’ in the Cavendish test, and vice versa.
On the other hand, the test adopted by the Mainland China appears to be comparatively more straightforward. The clause is unenforceable, and the court will intervene to reduce the stipulated amount once the agreed sum is 30% greater than the actual loss.
Fundamentally, the difference between the jurisdictions is found in the principles that each court holds to be the most important to uphold. The recent approach in Hong Kong may suggest that courts are partial towards commercial justification, whereas in Singapore the law has prioritised fairness in compensation. In Mainland China, the considerations are less circumstantial than both Hong Kong and Singapore.
The drafting of liquidated damages clauses should therefore be carefully considered depending on the parties involved in the contract and the applicable law.
