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Enforceable liquidated damages clause or unenforceable penalty clause? Court of Appeal finds the former in recent case

In the recent case of Brio Electronic Commerce Ltd v Tradelink Electronic Commerce Ltd, CACV 271/2013, Hong Kong’s Court of Appeal upheld the decision of the Court below which had awarded HK$5million damages to the Plaintiff for the Defendant’s breach of non-solicitation undertakings in the contract between them. The Court of Appeal agreed with the Court below that the contractual clause fixing damages at HK$5million in the event of a breach (the Clause) was an enforceable liquidated damages clause and not an unenforceable penalty clause.

In the appeal, the Defendant did not challenge the finding that it was in breach of contract, but contended that the Clause fixing damages for breach at HK$5 million was an unenforceable penalty clause. It therefore sought to have the award of damages set aside and the action dismissed on the basis that the Plaintiff had not adduced any evidence as to its actual loss arising from the breach and so had not proved any actual damages.

The Clause in question provided that the Defendant agreed that the Plaintiff would be irreparably injured by a breach of any of the terms in the Clause and that in the event of breach the Defendant should immediately make full payment of HK$5million to the Plaintiff. The contract also contained a materially identical clause going the other way, in favour of the Defendant, in the event of the Plaintiff’s breach.

The Defendant’s Counsel contended that the Court below had been wrong to find that the Clause represented a genuine pre-estimate of damages so as to be an enforceable liquidated damages clause. The Clause should instead, he argued, be regarded as an attempt to deter the Defendant from breaching the contract and was thus a penalty and unenforceable.

The Defendant’s Counsel accepted that the Defendant had the burden of establishing that the Clause was a penalty clause and submitted that in order to determine whether that was the case, guidance could be derived from the English House of Lords decision in Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co Ltd [1915] AC 79. That case sets out factors to be considered when deciding whether a payment stipulated as payable on breach of contract is in truth a penalty or liquidated damages.

The Defendant’s Counsel suggested that assistance could also be derived from the English Court of Appeal decision in Murray v Leisureplay Plc [2005] EWCA Civ 963, which provided a step by step guide to the questions the Court

should ask itself to determine whether a clause is a penalty and which involved a comparison between the amount stipulated in the contract as payable in the event of breach and the amount that would be payable for such breach under common law.

However, Hong Kong’s Court of Appeal was of the view that the particular questions set out in the Murray case were too rigid an approach to a question that should be considered in broad general terms. Further, a comparison between the amount stipulated in the contract as payable on breach and what would be awarded at common law would, the Court said, “…remove one of the commercial advantages that a liquidated damages clause is recognised as achieving – the dispensation with the need to adduce evidence on damages and to calculate them, particularly in cases where proof of the amount of damages suffered may be difficult to achieve to any degree of precision”. The Court of Appeal said that this was not the correct approach as it focused on the actual breach found to have taken place and then sought to compare the damages that might be suffered with the amount of damages stipulated in the contract. However, what was required, the Court of Appeal said, was to consider the likely outcome of a breach at the time the contract was entered into.

Where a breach could have a range of outcomes or consequences, the Court said, then much could be said for the proposition stated in the Dunlop case, namely that a clause will be held to be a penalty where the amount stipulated is extravagant, compared to the greatest loss that could be proved to flow from the breach. That approach, the Court said, recognises that the consequences of the breach cannot be foreseen with precision and allows the parties to stipulate a sum which will provide adequate compensation in the event of a breach.

The Court of Appeal dismissed the appeal and held that the Court below had been right to have taken into account the following and to have concluded that the Clause was a valid liquidated damages provision:

  • The contract was a commercial contract, entered into after lengthy negotiations.
  • The assessment of damages for a breach of the relevant clause was a highly uncertain and difficult exercise.
  • The HK$5million stipulated in the contract was the parties’ best pre-estimate of the damages likely to be suffered in the event of a breach of contract, which was on the facts, by no means extravagant or unconscionable.

It is a pity that the Court of Appeal did not take the opportunity to express its view on the recent English Supreme Court decisions in Cavendish Square Holdings BV v Talal El Makdessi and ParkingEye Limited v Beavis [2015] UKSC 67 (detailed in our previous article), in which the Supreme Court, for the first time in a century, considered the principles underlying the law on contractual penalty clauses and reformulated the test to be applied where a contractual clause is challenged as being a penalty clause. In particular, the Supreme Court held that it is not helpful to consider whether the stipulated damages are the parties’ genuine pre-estimate of loss. Instead, the Court said that the real question is whether the clause is penal, since the fact that a clause is not a genuine pre-estimate of loss does not, without more, make it penal. Under the new test laid down by the Supreme Court, the first question is whether the clause is a primary or secondary obligation under the contract. If the latter, it may be unenforceable if it imposes a detriment on the contract breaker out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation. Whether this new test will be adopted by the Hong Kong Courts in future, remains to be seen, given that it was not considered in the Brio Electronic Commerce case.

To Hong Kong lawyers, there is nothing unusual in the Hong Kong Court of Appeal decision. However, this may not be the case for US lawyers. We understand that in many States of America, the Court can adopt a “second look” approach, which enables the Court to strike out a clause as being a penalty if the defendant can prove that the plaintiff has not actually suffered any loss, which is exactly what the Court of Appeal was reluctant to do in the present case.

Key Contacts

Kwok Kit (KK) Cheung

Partner | Litigation and Dispute Resolution

Email or call +852 2825 9427

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