Compensation Clause in a Tenancy Agreement
Parties to a tenancy agreement may insert certain clauses to ensure that they will be compensated when the other party has breached the agreement. However, in some situations, such clauses may not be enforceable. In the recent Court of Appeal decision in Ip Ming Kin v Wong Siu Lan [2013] HKCU 1216, the Court expressed its view on the enforceability of a compensation clause in a tenancy agreement.
Case analysis
In Ip Ming Kin, supra, the plaintiff tenant (“Tenant”) had attempted to rent the shop premises from the defendant landlord (“Landlord”) in December 2009. They entered into a tenancy agreement in a standard form in Chinese under which the Landlord agreed to let the shop to the Tenant for 12 months at a monthly rental of HK$17,300. At the end of the tenancy agreement, two clauses in Chinese were inserted and if translated into English means the Tenant has to pay 10 months’ rent in advance and the Landlord is required to compensate double the amount of the rent if she is not able to deliver up vacant possession to the Tenant on 15 March 2010 (the “Compensation Clause”). The Tenant was also required to pay two months’ rent as rental deposit. Upon signing the tenancy agreement, the Tenant paid by cheque a sum of money equivalent to the rentals for the whole term of 12 months.
Later, the Landlord failed to deliver up vacant possession on 15 March 2010 and the Tenant claimed damages for 12 months’ rent as the agreed compensation. The judge in the District Court gave judgment in favour of the Tenant.
On the Landlord’s appeal to the Court of Appeal, the Landlord contended that the Compensation Clause was a penalty in nature because the real purpose of the Compensation Clause was not to provide compensation for breach but to hold the Landlord in terrorem, and to deter the Landlord from breaking the contract.
Penalty clause is unenforceable
It is well established that the Court will not enforce a penalty clause so as to permit a party to a contract to recover in an action a sum greater than the damages which he would be entitled at common law.
As such, the Court has to find out whether a compensation clause is a penalty clause or a valid liquidated damages clause. It is a question of construction to be decided upon the terms and inherent circumstances of a particular contract, judged of as at the time of the making of the contract, not as at the time of the breach. The test is objective and the onus of showing that the provision for compensation was a penalty is on the party who is sued upon it.
The essence of a penalty is a payment of money stipulated as in terrorem of the offending party. As stated by Colman J in Lordsvale Finance Plc v Bank of Zambia [1996] QB 752, whether a provision is to be treated as a penalty is a matter of construction to be resolved by asking whether at the time the contract was entered into the predominant contractual function of the provision was to deter a party from breaking the contract or to compensate the innocent party for breach. The contractual function is deterrent rather than compensatory can be deduced by comparing the amount that would be payable on breach with the loss that might be sustained if breach occurred.
Dunlop test
In Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd [1915] AC 79, Lord Dunedin set out various tests in distinguishing a liquidated damages clause from a penalty clause. For example, if the sum stipulated for is extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved to have followed from the breach, then it will more likely be held to be a penalty.
There is also a presumption that it is a penalty when 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. However, this presumption can be rebutted if it is a genuine pre-estimate of what the loss is likely to be.
In concluding that the Compensation Clause is a liquidated damages clause rather than a penalty clause and thus enforceable, the Court of Appeal considered the following factors:
1. The amount of compensation was not a figure imposed on the Landlord in terrorem. On the contrary, it was freely offered by the Landlord to justify the requirement for the Tenant to pay upfront the rent for the entire period of tenancy.
2. The amount of compensation was a genuine pre-estimate of damage and was justifiable given the fact that the amount of the projected profits the Tenant expected to make is comparable.
Points to note
It should be noted that this kind of cases are fact sensitive. But the legacy of the case is that when entering into a tenancy agreement, it is possible to insert a compensation clause in the agreement to ensure that the aggrieved party would be compensated for the amount as negotiated and agreed by the parties. However, such amount of compensation should not be extravagant or unconscionable when comparing with the damages likely to be suffered. Otherwise, the compensation clause will be recognized as a penalty clause and becomes unenforceable.
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Important: The law and procedure on this subject are very specialised and complicated. This article is just a very general outline for reference and cannot be relied upon as legal advice in any individual case. If any advice or assistance is needed, please contact our solicitors.
