Enforcement of liquidated damages clauses in Hong Kong after Cavendish

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Authored by: KK Cheung and Leo Wong

Loss and damage arising from delay in construction works are notoriously difficult to quantify, even with the assistance of quantum experts. To overcome this, parties usually specify in construction contracts liquidated damages (LD) for loss and damage arising from delayed completion of the project, so that the parties can work out the LD by comparing the actual completion date and the contractual completion date (as extended) and multiplying that period with the agreed LD rate, without having to consider what actual loss and damage the employer has suffered due to the delay and adduce factual and expert evidence in support, the outcome of which can be very uncertain. However, if an LD clause is regarded as a penalty clause, Hong Kong Courts will not enforce it and in such scenario only general damages can be claimed (subject to proof). It is therefore important for construction practitioners to know when an LD clause would be enforced and when it probably would not, in particular when formulating or accepting or challenging an LD clause. This article discusses the approaches taken by Hong Kong Courts after the landmark ruling of the UK Supreme Court in Cavendish Square Holding BV v Makdessi [2015] UKSC 67, which was discussed in ourprevious article.

LD clauses generally enforceable

Construction practitioners should bear in mind that it is not easy to challenge LD clauses. Hong Kong Courts are generally reluctant to interfere with the parties’ freedom of contract, especially when the contracting parties are business people of comparable bargaining power with proper advice.

• “The court has to be careful not to set too stringent a standard and bear in mind that what the parties have agreed should normally be upheld. Any other approach will lead to undesirable uncertainty especially in commercial contracts” (Philips Hong Kong Ltd v A-G of Hong Kong [1993] 1 HKLR 269, HK Privy Council)

• “The threshold for the court’s intervention is necessarily high. Where business people are dealing with each other at arm’s length, their freedom to contract as they please is something the courts respect and protect.” (Polyset Ltd v Panhandat Ltd (2002) 3 HKLRD 319, HK Court of Final Appeal)

• “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” (Cavendish Square Holding BV v Makdessi [2015] UKSC 67, followed in Law Ting Pong Secondary School v Chen Wai Wah [2021] 3 HKLRD 185, Court of Appeal)

Therefore, if a contractor thinks that the LD amount stipulated in the tender document is extravagant, it should either negotiate with the employer for a downward adjustment or just refuse to submit the tender. By submitting the tender, the contractor would be deemed to have agreed to the LD amount to be imposed and be bound by the LD clause upon the employer’s acceptance of the tender. In this scenario, the contractor should expect that the Court would generally uphold the LD clause and the contractor would be ordered to keep its side of the bargain.

When LD clauses would not be enforced

While LD clauses are generally enforceable, the Hong Kong Courts may intervene when they find an LD clause penal. As regards what makes an LD clause “penal”, different approaches have been taken by the Hong Kong Courts:-

1. It will be held to be a penalty if the LD amount is extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved to have followed from the breach.
   
2. It will be held to be a penalty if the breach consists only in not paying a sum of money and the LD amount is a greater sum than the sum which ought to have been paid.
   
3. It will be a rebuttable presumption that it is a penalty if a single lump sum is made payable by way of compensation on the occurrence of one or more or all of several events, some of which may occasion serious and others but trifling damage.
   
4. It is no obstacle to the LD amount being a genuine pre-estimate of damage that the consequences of the breach are such as to make precise pre-estimation almost an impossibility; on the contrary, that is just the situation when it is probable that pre-estimated damage was the true bargain between the parties.

(Dunlop Pneumatic Tyre Company Limited v New Garage and Motor Company Limited [1915] A.C. 79, UK House of Lords).

• “As long as the sum payable in the event of non-compliance with the contract is not extravagant, having regard to the range of losses that it could reasonably be anticipated it would have to cover at the time the contract was made, it can still be a genuine pre-estimate of the loss that would be suffered and so a perfectly valid liquidated damage provision” (Philips Hong Kong Ltd v A-G of Hong Kong [1993] 1 HKLR 269, HK Privy Council)

• “…[the agreement] must not impose upon the breaker of a primary obligation a general secondary obligation to pay to the other party a sum of money that is manifestly intended to be in excess of the amount which would fully compensate the other party for the loss sustained by him in consequence of the breach of the primary obligation.” (Photo Production Ltd v Securicor Transport Ltd [1980] AC 827 at p.850F, approved in Polyset Ltd v Panhandat Ltd (2002) 3 HKLRD 319, HK Court of Final Appeal)

All of these principles seem to point to one thing – the Hong Kong Courts would not enforce an LD clause if the LD amount is manifestly intended to exceed the “greatest loss” that could conceivably be proved to have followed from the breach at the time the contract was made and the “full compensation” for such loss. However, that position appears to have evolved in recent years:-

• “A provision was penal if it was a secondary obligation which imposed 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…therefore, the fact that a provision did not provide for a pre-estimate of loss, or that it was deterrent, did not necessarily mean that it was penal, since the legitimate interest of the innocent party might extend well beyond the recovery of compensation for his loss…deterrence is not penal if there is a legitimate interest in influencing the conduct of the contracting party which is not satisfied by the mere right to recover damages for breach of contract…the dichotomy between the compensatory and the penal is not exclusive. There may be interests beyond the compensatory which justify the imposition on a party in breach of an additional financial burden…”(Cavendish Square Holding BV v Makdessi [2015] UKSC 67)

• “The true test was held to be whether the clause is out of all proportion to the innocent party’s legitimate interest in enforcing the contract…an innocent party could have a legitimate interest in the performance of the contract or some appropriate alternative to performance that goes beyond compensation…In applying the test, the court should first identify the legitimate interest of the innocent party that is being protected by the clause, and then assess whether the clause is out of all proportion to the legitimate interest by considering the circumstances in which the contract was made.” (Law Ting Pong Secondary School v Chen Wai Wah [2021] 3 HKLRD 185, HK Court of Appeal, applying Cavendish Square Holding BV v Makdessi [2015] UKSC 67)

• “The modern inquiry is no longer subject to the distinction between a penalty and genuine pre-estimate of loss. The court should first identify the legitimate interest of the innocent party that is being protected by the clause, and then assess whether the clause is out of all proportion to the legitimate interest by considering the circumstances in which the contract was made…On the question of penalty interest, in judging what is extravagant, exorbitant or unconscionable, the extent to which the parties were negotiating at arm’s length on the basis of legal advice and had every opportunity to appreciate what they were agreeing must at least be a relevant factor: Bank of China (Hong Kong) Ltd v Eddy Technology Co Ltd [2019] 2 HKLRD 493 , §§3 & 8, applying Cavendish, §§152 & 35…Whether the interest rates were extravagant, unconscionable or incommensurate with any legitimate interest is for the party in breach to show: Cavendish, at §143.” (China Great Wall AMC (International) Holdings Co Ltd v Royal Bond Investment Ltd [2021] HKCFI 2882, following Law Ting Pong Secondary School v Chen Wai Wah [2021] 3 HKLRD 185)

From the above-mentioned judgments of the Hong Kong Courts, it can be seen that in order to decide whether an LD clause is penal, the emphasis is now placed on considering the relationship between the legitimate interest of the innocent party and the LD amount.

It is important to note that Cavendish did not overrule Dunlop. Rather, the UK Supreme Court remarked that:

(a) the unsatisfactory distinctions between “a penalty” and “a genuine pre-estimate of loss” and between “a genuine pre-estimate of loss” and “a deterrent” originate from an over-literal reading of the 4 tests in Dunlop and a tendency to treat them as almost immutable rules of general application which exhaust the field when they are not; and

(b) the 4 tests set out in Dunlop above have proved perfectly adequate to deal with the great majority of cases decided in England since Dunlop which concerned more or less standard damages clauses in consumer contracts and would usually be perfectly adequate to determine the validity of LD clauses in cases involving straightforward damages clauses (where the innocent party’s legitimate interest will rarely extend beyond compensation for the breach).

It was in such context that the UK Supreme Court introduced the broader test in Cavendish. As explained by the Hong Kong Court of Appeal in Law Ting Pong (applying Cavendish), “notions of whether the clause has a deterrent purpose or whether it is a genuine pre-estimate of loss would be subsumed by the broader enquiry into the legitimacy of the interest that supports the provision”.

Before challenging an LD clause, construction practitioners ought to first identify the legitimate interest to be protected by the LD clause and then, based on evidence available, assess whether the LDs are out of all proportion to the legitimate interest, in particular when the LDs are meant to go beyond pecuniary compensation for loss and damage directly flowing from the breach in question. In an ordinary construction contract, the legitimate interest of the employer is to complete the project on time and the loss which he may suffer is usually additional finance cost and/or loss of use which should not be difficult to assess. However, this exercise may not be straightforward in other cases such as non-commercial projects with elaborate provisions for calculation of LD and phased completion.

Whilst the Court of Final Appeal of Hong Kong has yet to have the opportunity to consider this “breakthrough” in Cavendish and it remains to be seen whether it would continue to focus on “genuine pre-estimate of the probable damage” or move on to the test of legitimate interest as adopted by the Court of Appeal, it is foreseeable in the future that more and more cases of the Court of Appeal and the Courts below will adopt the line of authorities following Cavendish.

Key Contacts

Kwok Kit (KK) Cheung

Partner | Litigation and Dispute Resolution

Email or call +852 2825 9427