An employer agrees to a clause in an employment contract requiring it to pay an employee two years’ salary if it terminates the employee’s employment within the first three years of the contract. Can that employer later terminate the employee and seek to avoid paying the two years’ salary by claiming that the clause is a penalty clause and therefore unenforceable?
Although the Judge in this recent decision1 of the Hong Kong Court of First Instance (CFI) could not rule on the question because he did not have all of the information, the Labour Tribunal’s earlier decision that the employer could claim that it was a penalty was overturned, and the case was sent back to the Labour Tribunal to be tried again.
In doing so, the CFI confirmed that the correct approach to determining whether a contractual clause is a penalty clause or not is to apply the “modern approach” test (which we discussed in our previous bulletin).
Background
Mr Ng (Claimant) was employed as a Vice-President and Director of Ever Honest Industries Ltd (Employer). To recognise the Claimant’s contributions to the Employer’s group in his previous roles, and hoping that the Claimant would remain in his present roles for at least three years, the Employer included the following compensation clause in the Claimant’s new employment contract:
“The Group cannot dismiss you within three years upon the commencement of this employment agreement. If the Group dismisses you within three years after this employment agreement commences, you will be paid two whole years’ salary as compensation. If this employment is terminated by you within three years, one month’s written notice or one month’s salary in lieu of notice is required, and after resignation, you will not be allowed to work in an organisation that is in the same or relevant industry or the compensation of two whole years’ salary will not be granted.” (Subject Clause)
About three months later, the Employer terminated the Claimant’s employment. The Claimant then made a claim for two years’ salary as compensation under the Subject Clause.
If the Subject Clause is a penalty clause, intended to punish the party breaching the contract, it is not enforceable. However, if the Subject Clause is a liquidated damages clause, intended to compensate the innocent party for the loss they would suffer as a result of the breach, it is enforceable.
At the Labour Tribunal, the Presiding Officer dismissed the claim. She held that the Subject Clause was a penalty clause and therefore unenforceable, relying solely on the fact that there was no evidence to show that the parties had attempted to make a genuine pre-estimate of the loss.
The Claimant appealed to the CFI.
The “modern approach” test for penalty clauses
The CFI was of the view that the Labour Tribunal had applied the wrong test in deciding whether the Subject Clause was a penalty clause. As laid down in Law Ting Pong Secondary School v Chen Wai Wah [2021] CA 873(in which the Court of Appeal adopted the approach by the UK Supreme Court in Cavendish Square Holding BV v Talal El Makdessi [2016] AC 1172), the modern approach to determining whether a clause is a penalty clause involves a two-step inquiry:
- First, to determine the nature of the compensation to be paid by the Employer under the Subject Clause for termination of the Claimant’s employment within the 3-year period – is it a primary obligation (i.e. a contractually agreed method of lawfully terminating the employment contract) or a secondary obligation (i.e. damages to be paid for breach of contract)?
- Second (and only if the compensation is a secondary obligation), to identify the legitimate interest of the Claimant that is being protected by the clause and determine whether the compensation is out of proportion to that legitimate interest. In doing so, the Court will need to consider all of the circumstances in which the contract was made.
Because the Labour Tribunal had not applied the correct test, it had not made any inquiry into the nature of the compensation, nor the reason that the Subject Clause was included. That meant the CFI did not have the facts before it to decide for itself whether the Subject Clause was a penalty or not, so it had to send the case back to the Labour Tribunal.
Key takeaways
As the Judge said, “obviously, the clause was poorly drafted”. The key takeaway for employers is therefore to make sure that if you want to include unusual terms in an employment contract, make sure you get legal advice on the drafting.
The case is also a really interesting insight into the bargaining power that employees can have when negotiating with an employer – a point that is particularly relevant in the current job market. Whilst the Employer in this case was no doubt thrilled to get the Claimant “locked in” to the new contract, some additional consideration around the consequences if things didn’t work out with the Claimant might have been worthwhile. There are a range of innovative incentive arrangements that employers can use to motivate key employees without risking significant expense to the employer if things don’t work out, and in this case the Employer may have been better off with a different arrangement.
For further information, please contact:
Tess Lumsdaine, Herbert Smith Freehills
tess.lumsdaine@hsf.com
