Introduction

Employers and employees are free to negotiate and agree on the terms of their employment contracts. So long as the employment contract does not extinguish or reduce any right, benefit, or protection conferred upon an employee by the Employment Ordinance (Cap. 57), the courts will usually give effect to the contract in a dispute. What about “compensation clause” in an employment contract?  Is it enforceable?

In Ng Yan Kit Alfred & Anor v Ever Honest Industries Limited & Anor [2022] HKCFI 1834, a recent judgment handed down by the Court of First Instance (“CFI”), the CFI reaffirmed the Court of Appeal’s decision in Law Ting Pong Secondary School v Chen Wai Wah [2019] HKCFI 2236 in applying the penalty rule. Whether a “compensation clause” is enforceable depends on whether it is a penalty clause. If it is, it is not enforceable. In an employer/employee relationship, the parties may include a liquidated damages clause, which is enforceable. 

Ng Yan Kit Alfred & Anor v Ever Honest Industries Limited & Anor

Background

The 1^st claimant employee, Mr Ng, was employed by the defendants as their Vice-President and Director under an employment contract dated 11 January 2016. The compensation clause in issue (“Compensation Clause”) provides:

“The Group cannot dismiss you within three years upon the commencement of this employment agreement.  If the Group dismisses you within three years after this employment agreement commences, you will be paid two whole years’ salary as compensation.  If this employment is terminated by you within three years, one month’s written notice or one month’s salary in lieu of notice is required, and after resignation, you will not be allowed to work in an organisation that is in the same or relevant industry or the compensation of two whole years’ salary will not be granted.” (emphasis added)

Mr Ng’s case was he was first employed by a company (with provisional liquidators appointed) to work for the related companies of the 1^st defendant’s group from 1 August 2014. His then position was Deputy General Manager. Later, in March 2015, the 1^st defendant employed Mr Ng as a Director.

In January 2016, the 1^st defendant company and Mr Ng entered into a new employment contract with the Compensation Clause. Since the 1^st defendant had undergone difficult times, including suspension of trading of its stocks, restructuring of its debts and resumption of trading of its stocks, and Mr Ng had made considerable contribution to the 1^st defendant in passing through its stormy days, the then CEO of the 1^st defendant, offered new terms of the employment to Mr Ng including the Compensation Clause. Apart from recognising his contribution, the then CEO indicated to him that the 1^st defendant hoped Mr Ng could work stably for the company for a period of at least 3 years and he would work together with the then CEO to investigate some serious improper conducts relating to the company. It was under these circumstances that the parties entered into the new employment contract dated 11 January 2016 with the Compensation Clause.

Later, there was disagreement between the senior management of the 1^st defendant and the then CEO and Mr Ng.  The then CEO left his employment in March 2016. On 1 April 2016, the 1^st defendant terminated Mr Ng’s employment by a notice of termination with his last day of work on 31 March 2016 and paid Mr Ng three months of salary as payment in lieu of notice, annual leave payment and year-end bonus.

Mr Ng commenced proceedings in the Labour Tribunal claiming 2 years’ salary under the Compensation Clause.  The Labour Tribunal dismissed Mr Ng’s claim and Mr Ng appealed to the CFI.

Appeal at the CFI

The focus of the appeal was whether the Compensation Clause is a penalty clause? If it is, it is not enforceable. On the other hand, if it is not and it is a liquidated damages clause, it is enforceable.

The CFI was of the view that in order to determine whether a clause is a penalty clause, it must be examined in light of the most recent Court of Appeal’s decision in Law Ting Pong Secondary School v Chen Wai Wah, in which the court had the opportunity to consider the latest approach adopted by the UK Supreme Court in Cavendish Square Holding BV v Makdessi and ParkingEye Ltd v Beavis [2016] AC 1172 in applying the penalty rule. The approach in Law Ting Pong Secondary School should now be regarded as the law in Hong Kong reflecting the modern judicial approach in considering the application of the penalty rule.

We discussed the Court of Appeal’s decision in Law Ting Pong Secondary School v Chen Wai Wah in one of our employment articles issued in July 2021 entitled “Employees backing out of accepted job offers before commencement will have to serve notice of termination or make payment in lieu of notice, the Court of Appeal rules”. Please click here to read.

The modern approach involves a two-step inquiry:

First, the court has to construe the relevant clause in the contract to determine whether it is a contractually agreed method of lawful termination of the contract, or whether the sum stipulated is in the nature of damages for breach of contract.  In the case of the former, it is a primary obligation to pay rather than a secondary obligation arising upon the breach of a primary obligation of performance, which is the case for the latter. Ultimately, this is a matter of construction. For such exercise, the starting point must be the wording used in the relevant provision itself. That said, in the construction exercise, it is the substance and not the form that counts. The court would not ignore other factors that may be relevant in determining the nature of the stipulated payment. The circumstances under which a particular agreement was made is always relevant in construing the meanings of the terms of a contract and ascertaining the intended contractual function of the provision.

Second, in the event the payment is a secondary obligation arising upon the breach of a primary obligation of performance, the next step requires the court to identify the legitimate interest of the innocent party that is being protected by the clause, and then assess whether the clause is out of proportion to such legitimate interest by considering the circumstances in which the contract was made. This inquiry requires the court to look at all the circumstances of the case, including the background, the reason and the purpose as to why the parties agreed on the terms in the relevant provision.

In Mr Ng’s appeal, the CFI found the Presiding Officer erred in applying the legal test in dealing with his claim. There was no proper inquiry regarding the true nature of the “compensation” agreed between Mr Ng and the 1^st defendant. The CFI remitted the case back to the Labour Tribunal for further fact-finding.

Takeaway

Interpretation of contracts is not always an easy task. Employment contracts should be interpreted against their background facts and practical objectives that they intend to achieve. One should be mindful not to read a clause too literally or out of context, which could often result in misinterpreting the relevant clause.

In the employment context, “compensation clause” will only be enforceable if it is not a penalty clause. If the parties intend to include a liquidated damages clause in the employment contract, they pay heed in formulating the clause to minimise the risk of it being held unenforceable under the penal rule. It is good practice to seek legal assistance with liquidated damages clauses to avoid unwanted legal disputes.