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