Worldwide: An Update On International Legal Positions——Liquidated Damages

1. Introduction

In cross-border transactions, parties commonly insert a "liquidated damages" clause in their contracts. Such a clause clearly stipulates the amount of damages that the defaulting party shall pay if the contract is breached. The purpose is to deter parties from breaching the contract and to allow parties to contractually pre-agree on a measure of damages that may be difficult to prove once incurred, thereby providing parties with certainty and allowing parties to expedite the process of recouping losses.

In an M&A context, liquidated damages often would include, for example, break fees if a party fails to proceed with the transaction, or mandatory discounted buy-outs if a party commits a prohibited act post-transaction. In a sale or supply of goods context, liquidated damages would include an agreed amount of compensation payable, withholding sum, or price reduction should a party fail to perform the contract. However, it should be noted that the ease and extent to which such clauses are enforceable depends to a large part on the governing law of the agreement, amongst other factors. While many jurisdictions allow in principle for liquidated damages to be claimed, contracting parties may find it easier to enforce liquidated damages clauses in certain jurisdictions than in others, given the difference in the precise legal tests used amongst them.

In this article, we briefly examine the current legal position with regard to the enforceability of liquidated damages clauses in four jurisdictions, namely the UK, Singapore, Hong Kong SAR, and the PRC.

2. Legal positions under different jurisdictions

2.1 UK

Previous position

Previously, whether a liquidated damages clause was enforceable in the UK depended on whether it reflected a "genuine pre-estimate of the likely loss" that the innocent party will suffer upon the defaulting party's breach (Dunlop test) ¹. If it is, then such clause would be enforceable. If it is not, and the amount stipulated is instead an extravagant, unconscionable, or unreasonably large amount intended to "penalise" or "punish" the defaulting party, then such a clause would constitute a "penalty clause" which would be struck down by the court as being unenforceable.

In determining whether the liquidated damages clause represents a genuine pre-estimate of the likely loss, the court will determine whether the sum stipulated is "extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved to have followed from the breach." If it is, then the clause would necessarily be penal in nature and therefore be unenforceable. If it is not, then the clause would indeed be a genuine pre-estimate of likely loss – and this is the case even if the sum mandated to be paid is eventually in excess of the innocent party's actual loss.

Subsequently, in Alfred McAlpine Capital Projects Ltd v Tilebox Ltd² , the English Court reviewed the various cases on liquidated damages and concluded that a pre-estimate of damages does not have to be right in order to be reasonable. There must be a substantial discrepancy between the level of damages stipulated in the contract and the level of damages which is likely to be suffered before it can be said that the agreed pre-estimate is unreasonable. Where possible, the court should uphold contractual terms which fix the level of damages for breach.

Current position

In 2015, the UK Supreme Court passed a decision (Cavendish³) that reformulated the legal test with regard to liquidated damages and penalty clauses. A liquidated damages clause is only a penalty if it is a secondary obligation imposing a detriment on the defaulting party "out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation." Under this formulation, three components need to be considered:

• First, does the clause concern a primary obligation (i.e. the legal obligation to procure that the contractual promise be fulfilled) or secondary obligation (i.e. obligation arising from breaches of the primary obligation)? 

     The difference is this: A clause concerning a primary obligation cannot be a penalty, whereas a clause relating to a secondary obligation may amount to a         penalty (and may thus be struck down by the courts). 

• Second, does the innocent party seeking to enforce the clause have a legitimate interest? 

     In this regard, such legitimate interest can include wider commercial interests (i.e. need not be an interest in the financial compensation itself), which can depend very much on the facts and circumstances of each case⁴.   

• Third, is the stipulated sum or remedy under the clause out of all proportion to such legitimate interest (i.e. is it exorbitant or unconscionable having regard to the innocent party's interest in the performance of the contract)? 

Again, the determination in this regard will depend very much on the facts and circumstances of each case with reference to local practice (if available), and could ultimately be a value judgement by the court. In a negotiated contract between properly advised parties of comparable bargaining power, the strong initial presumption must be that the parties themselves are the best judges of what is legitimate in a provision dealing with the consequences of breach.

2.2 Singapore

As a jurisdiction that has historically inherited the common law tradition and was much influenced by the English common law in traditional areas including contract law, while recognising that local jurisprudence is the only legally binding source of case law, Singapore courts often have regard to comparable English common law precedents in the continued development and refinement of its own laws.

In a very recent case (Denka Advantech)⁵ , the Singapore Court of Appeal had a chance to reconsider the legal position on penalty clauses. It affirmed the Dunlop test and declined to adopt the wider legitimate interest test developed in Cavendish, as the concept of "legitimate interest" was too general and could, depending on the facts and circumstances of each case, be utilized in a myriad of ways resulting in great uncertainty. The Singapore Court of Appeal did however affirm the

pronouncement in Cavendish that the rule against penalties should be confined to only apply to secondary obligations (i.e. breaches of primary obligations).

2.3 Hong Kong SAR

Similar to Singapore, Hong Kong SAR adopts the common law system which is historically based on English common law. Although English precedents are no longer binding, Hong Kong SAR courts will continue to seek guidance from them, especially those English Supreme Court cases which are influential in the world of common law.

The Cavendish test was applied in Hong Kong SAR by the Court of Appeal in Bank of China (Hong Kong SAR) Ltd v Eddy Technology Co Ltd (Eddy Technology)⁶ . In this case, the relevant clause under the compromise agreement for the banking facilities provided for revocation of benefits and indulgence granted under the agreement upon default. The Court applied the Cavendish test and held that the defendants had no evidence to show⁷ that the default provisions were extravagant, exorbitant or unconscionable. When the defendants were in breach of the agreement, there was nothing penal for the plaintiff to revert to its full rights as expressly provided for under the default clause.

Subsequent Hong Kong SAR cases⁸ have since followed Eddy Technology and endorsed the reformulated legal test with regard to liquidated damages and penalty clauses in Cavendish, i.e., whether the clause imposed a detriment on the defaulting party that is out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation⁹ .

A recent Court of First Instance case (Dragon Access Holdings Ltd v Lo Chu Hung)¹⁰ has further affirmed the position in Eddy Technology and recognized that the Cavendish test has formed part of the laws of Hong Kong SAR. The Court, again, applied the Cavendish test in determining whether the liquidated damages clause in the provisional sale and purchase agreement amounted to a penalty and held that the defendant had failed to adduce sufficient evidence to demonstrate that the stipulated remedies was extravagant, exorbitant or unconscionable in nature that could justify judicial intervention, having regard to other factors such as the consideration, the period for completion and the deposit amount for the transaction in question.

2.4 PRC

Unlike common law systems which prohibit penalty clauses altogether, PRC law does not expressly prohibit the stipulation of a "penalty" in contract. However, certain limits are imposed – liquidated damages cannot be "excessively higher" than actual losses, and in practice an amount that is more than 30% of the actual losses suffered by the innocent party may be considered as "excessively high" and may be mitigated by the PRC court which will look into the actual losses incurred and award a reduced amount. However, a plaintiff would still need to show proof of actual loss in practice, in order for the court to satisfy itself that the said 30%¹¹ threshold had not been breached; this contrasts with the position under common law that actual loss is not inquired into, as a key idea behind liquidated damages clauses under common law jurisdictions is to save parties the trouble and difficulty of proving actual loss.

This position was previously set out in the PRC Contract Law¹² , and is reiterated in the new PRC Civil Code ¹³ that recently came into effect on 1 January 2021 (which repealed certain specific laws including the PRC Contract Law but systematically integrated its contents).

2.5 Comparison Table & Brief Analysis

To summarise, we set out in table form below the current legal positions with regard to liquidated damages and penalty clauses in the various jurisdictions discussed:

Comparing the above positions, while the UK and Hong Kong SAR have evolved a different test as compared to Singapore, these are not entirely distinct tests, and the fundamental need to ensure that the clause is "compensatory" (and not penal) still applies. In actual application, a genuine pre-estimate of likely loss (as in Dunlop) would likely be a useful indicator of whether an impugned provision imposes a disproportionate detriment having regard to the legitimate interest (as in Cavendish), and vice versa.

On the other hand, the position under PRC law is relatively more straightforward and objective with the typical application of the said 30% threshold (subject, of course, to other factors and the specific facts of the case). However, under PRC law, the parties at the time of contract will not have certainty as to the enforceability of a liquidated damages clause because ascertaining actual loss by its nature can only be done post-contract.

3. Implications and Practical Tips

With the above in mind, we set out below certain practical tips that enterprises that are engaged in, amongst others, international M&A deals, long-term sale or supply agreements and construction projects may find helpful.

When using UK or Hong Kong SAR law (which apply the wider legitimate interest test as set out in Cavendish) as the governing law in your contracts, given that primary obligations fall outside the penalty regime altogether, potentially penal clauses should be drafted as being a conditional primary obligation (e.g. a conditional, primary obligation to pay), as opposed to being a remedy for breach of contract. Also, key areas of the deal where parties have a commercial interest should be identified and expressly stated in the transaction document, which may make establishing legitimate interest later an easier task.

When using Singapore law (which still applies the traditional Dunlop test) as the governing law in your contracts, in practice contracts are often drafted to expressly indicate that parties regard the liquidated damages amount stipulated to be a genuine pre-estimate of likely loss. While the inquiry is always one of substance over form, this may to a certain extent indicate to the court that parties are on equal footing and have freely negotiated for the same. Also, documenting the calculation of likely losses in support of how the stipulated compensation amount is derived, and stipulating different compensation amounts for varying types and severities of breach, will be helpful.

Under the common law generally, as a matter of legal principle, courts have also recognized that where parties had freely negotiated a contract under equal bargaining power with the benefit of legal advice, the clause concerned would have a stronger chance of being upheld. The purpose of the underlying transaction and the particular primary obligation breached must be considered to have a composite view of the contract and the nature of parties' relationship. Evidence and documentation on these could therefore potentially aid the court in arriving at the decision that the clause should be upheld.

In addition, given the difference in position between different jurisdictions with regard to whether penalties are enforceable, some of the provisions that are considered common and acceptable in a PRC law-governed contract may be unacceptable in a common law-governed contract. For example, a PRC law-governed contract may elect to use language such as "penalty fee" or 'for the purpose of penalising", but use of such terms would generally be considered prima facie evidence of a "penalty" in common law jurisdictions, resulting in the clause not being upheld. It would thus be prudent to avoid such language in the drafting of a common law-governed contract.

4. Conclusion

We hope that the above provides a useful primer to you when negotiating various international contracts, in aiding you to assess which governing law may be more beneficial in each such contract, and in understanding what adjustments and specific negotiation points need to be considered. Of course, the prevailing circumstances and particular interests of each party in each case are critical. The same contractual concept can be interpreted differently depending on the governing law of your contract. Seek appropriate advice from a qualified and experienced lawyer to ascertain the meaning and implications of such term so as to best protect your rights and interests in each contract.

Footnotes

1. Dunlop Pneumatic Tyre Company, Ltd v New Garage and Motor Company, Limited [1915] AC 79.

2. Alfred McAlpine Capital Projects Ltd v Tilebox Ltd [2005] EWHC 281; [2005] B.L.R. 271; 104 Con. L.R. 39 TCC.

3. Cavendish Square Holding BV v Talal El Makdessi and ParkingEye Ltd v Beavis [2015] UKSC 67.

4. For example, a fellow shareholder has legitimate interest in ensuring that the founder-shareholder does not compete against the group where loyalty and personal relationships of the founder-shareholder were essential to the group's business (as in Cavendish).

5. Denka Advantech Pte Ltd and another v Seraya Energy Pte Ltd and another and other appeals [2020] SGCA 119.

6. Bank of China (Hong Kong) Ltd v Eddy Technology Co Ltd [2019] 2 HKLRD 493.

7. The burden is on the defendant to establish that a clause is a penalty clause (Dragon Access Holdings Ltd v Lo Chu Hung [2020] HKCU 4002 §95, Brio Electronic Commerce Ltd v Tradelink Electronic Commerce Ltd [2016] 2 HKLRD 1449 §14).

8. Dah Sing Bank, Ltd v Rich Star Investment Development Ltd & Ors [2020] HKCFI 1251, FWD Life Insurance Co (Bermuda) Ltd v Lam Chi Chuen Alpha [2019] HKCFI 2878.

9. Hsin Chong Construction Co Ltd [2019] HKCFI 1531.

10. Dragon Access Holdings Ltd v Lo Chu Hung [2020] HKCU 4002.

11. Section 29, Interpretation II of the Supreme People's Court of Several Issues concerning the Application of the Contract Law of the People's Republic of China, High Court [2009] No.5. Note that this is only an indicator, and other factors to consider would include, for example, the severity and duration of the breach, any fault on the part of the innocent party, the legal entity of the innocent party (whether business or individual), etc.

12. Section 114, PRC Contract Law (now repealed).

13. Section 585, PRC Civil Code.

Originally Published 5 February 2021

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.