Introduction

It is common practice for parties to include a liquidated damages clause in commercial contracts to stipulate the amount of damages payable by the defaulting party in the event of a breach of contract. One of the advantages of incorporating a liquidated damages clause in commercial contracts is that it enables the parties to contractually agree on the quantum of damages which do not need to be proved and thereby provides them with certainty as to their liability.

However, there has been considerable uncertainty as to:-

1. the enforceability of liquidated damages clauses; and
2. their applicability after termination of the contract,

towards which the Hong Kong and the UK courts had taken different approaches.

In this article, we will discuss and examine the past, present and future of the enforceability and applicability of liquidated damages in Hong Kong and UK.

1.     Test for enforceability

The past

Historically, the UK courts adopted the test laid down in Dunlop Pneumatic Tyre Company, Ltd v New Garage and Motor Company, Limited [1915] AC 79, such that a liquidated damages clause was enforceable only if it reflected a “genuine pre-estimate of loss” that the innocent party will suffer upon the defaulting party’s breach (“Dunlop Test”). A clause imposing an extravagant, unconscionable or unreasonable amount of agreed damages would be struck down as a penalty clause.

The present

Subsequently in 2015, the UK Supreme Court in Cavendish Square Holding BV v Talal El Makdessi and ParkingEye Ltd v Beavis [2015] UKSC 67 departed from the Dunlop Test and highlighted the distinction between the primary and secondary obligations of a contract.

The primary obligation is the obligation to perform the contract, whereas the secondary obligation is the obligation that arises from the breach of contract. The rule against penalty is only applicable to a clause that concerns secondary obligations.

The test is whether the impugned clause is a secondary obligation which imposes an extravagant, exorbitant or unconscionable detriment on the defaulting party out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation (“Cavendish Test”). In determining whether the impugned clause would be regarded as a penalty clause and therefore unenforceable, the court would consider all relevant facts and circumstances of each case.

For cases involving negotiation between parties with comparable bargaining power, a strong presumption must be that the parties themselves are the best judges of what is legitimate in a provision dealing with the consequences of breach.

Recently, in Law Ting Pong Secondary School v Chen Wai Wah [2021] HKCA 873, the Hong Kong Court of Appeal confirmed and applied the Cavendish Test in determining whether a liquidated damages clause is enforceable. In this case, the claimant (a local secondary school) hired the Defendant as its teacher. One of the terms of employment required the Defendant to give 3 months’ notice to terminate his employment or make a payment in lieu (“Termination Clause”). One of the issues that the court dealt with was whether the Termination Clause was unenforceable by reason that it is a penalty clause.

The court applied the Cavendish Test and held that the doctrine of penalty is applicable only where the Termination Clause concerns a secondary obligation, i.e. there is a breach of contract. The court held, among others, that (i) the Termination Clause concerns a primary obligation of the contract as it provided a mechanism for termination, and (ii) the Termination Clause was not unenforceable as a penalty clause despite employment under the contract had not yet commenced. Applying the Cavendish Test, the court was of the view that, even if the Termination Clause was a liquidated damages clause, it would not be penal in nature as it was not “out of all proportion” to protect the claimant’s legitimate interests to ensure the availability of its teaching staff.

In the subsequent case of China Great Wall AMC (International) Holdings Co Ltd v Royal Bond Investment Ltd [2021] HKCFI 2882, in considering whether the contractual provisions governing the interest rate in default of loan repayment are penalty in nature, the Hong Kong Court of First Instance followed the Court of Appeal’s approach in Law Ting Pong and applied the Cavendish Test. It was expressly stated in paragraph 30 of the said judgment that:

“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…”

The future

It is expected that both the Hong Kong and the UK Courts will continue to adopt the Cavendish Test in the future to govern the enforceability of liquidated damages clauses. However, while a consistent approach has been adopted in Hong Kong and UK in relation to the enforceability of the liquidated damages clause, differences on the applicability of liquidated damages clause after the termination of contract between Hong Kong and UK has yet to be reconciled.

2.     Applicability after termination of contract

The past

In Crestdream Ltd v Potter Interior Design Ltd [2014] HKCFI 1283, the Hong Kong Court of First Instance held that a liquidated damages clause would continue to apply subsequent to termination. In that case, the plaintiff engaged the defendant contractor to carry out building and fitting-out works in a residential flat but the defendant contractor abandoned the works and left the premises. The plaintiff then terminated the contract and appointed a replacement contractor to complete the unfinished works. The plaintiff claimed damages, including liquidated damages, against the defendant contractor.

In the absence of the defendant at the hearing and without the benefit of hearing the defendant’s arguments, the Hong Kong Court of First Instance followed the English case of Hall & Shivers v Jan Van Der Heiden [2010] EWHC 586 (TCC), under which the orthodox approach that a liquidated damages clause only applies up to termination of the contract was rejected. The Hong Kong Court of First Instance then held that the defendant contractor’s liability to pay liquidated damages would continue beyond the termination of the contract.

Notably, in the case of Hong Kong (SAR) Hotel Limited v Wing Key Construction Company Limited (unrep., HCCT 3/2010, 16 May 2016) which postdates the Crestdream case, the plaintiff engaged and terminated the defendant as the main contractor for failure to rectify safety irregularities, and a replacement contractor was engaged to pick up the work. However, in this case, the parties did not make reference to the Crestdream case, and did not argue for liquidated damages to continue beyond the completion date or termination date. As such, the law in Hong Kong is not yet settled in this regard.

Subsequently, the English Court of Appeal in Triple Point Technology, Inc v PTT Public Company Ltd [2019] EWCA Civ 230, [2019] 3 All ER 767 considered the applicability of a liquidated damages clause where a contract was terminated after works were delayed and before they were completed.

By a software contract dated 8 February 2013 (“Software Contract”), PTT engaged Triple Point for the design, installation, maintenance and licencing of software for PTT and agreed to remunerate Triple Point by reference to “milestones” stipulated the particular work to be completed by each milestone. The Software Contract contained a clause that provided for liquidated damages for delay (“LD Clause”). Triple Point completed the first two stages of Phase 1 on 19 March 2014 with a delay of 149 days. PTT paid for the work done for the first two stages but terminated the Software Contract on 15 February 2015 and refused to make further payments in respect of other works which had not been completed. Triple Point claimed against PTT for the unpaid invoices, whereas PTT counterclaimed, among the others, liquidated damages for delay pursuant to the LD Clause.

The English Court of Appeal set out the three approaches that may be adopted towards liquidated damages clauses in case of delay in completion of works:

1. 1. 1. Liquidated damages only fall due when works are completed, or the entitlement to liquidated damages is extinguished upon termination of the contract prior to completion of the works by the contractor (“1^st Approach”).
      2. Liquidated damages accrue from the contractual completion date to either (a) actual completion or (b) termination, whichever is earlier (“2^nd Approach”).
         
      3. Liquidated damages accrue from the contractual completion date to actual completion of works notwithstanding the termination of the original contract and the engagement of another contractor for the completion of the relevant works (“3^rd Approach”).

While noting that the 2^nd Approach is the orthodox approach in construing liquidated damages clauses, the English Court of Appeal nevertheless relied on the old and short judgment by the House of Lords in British Glanzstoff Manufacturing Co Ltd v General Accident, Fire and Life Assurance Co Ltd [1913] A.C. 143 and casted doubt on the 2^nd Approach on the ground that “if a construction contract is abandoned or terminated, the employer is in new territory for which the liquidated damages clause may not have made provision.”

The English Court of Appeal, without providing detailed analysis, held that:

1. 1. 1. the 1^st Approach is applicable to the facts in Triple Point; and
      2. PTT is not entitled to recover liquidated damages in respect of the works that have not been completed.

Such decision was criticized for inadequacy of reasoning, inconsistency with the general commercial practice and causing confusion in the construction industry.

The present

More recently, the UK Supreme Court reversed the English Court of Appeal’s decision in Triple Point. The Supreme Court noted that the approach taken by the English Court of Appeal was inconsistent with commercial reality and the accepted function of liquidated damages. The Supreme Court held that liquidated damages that have become due before termination are accrued rights that survive termination. For this reason, PTT is entitled to recover the liquidated damages for the delayed works up to the date of termination of the Software Contract.

Any deviation from this orthodox position, such as the innocent parties’ entitlement to liquidated damages be deprived upon early termination or the innocent parties’ entitlement to recover liquidated damages be extended post-termination, shall be expressly stated in the Contract.

This decision is well received by practitioners for providing the necessary guidance over this uncertain issue and restoring the widely accepted approach that liquidated damages will accrue from the agreed completion date for the works and be payable for the period of delay up to completion or earlier termination of the contract.

The future

In Hong Kong, it remains to be seen whether the courts will endorse the approach in Crestdream that liquidated damages survives termination, which is a binding case law in Hong Kong, or depart from Crestdream and follow the Triple Point approach. Whilst Hong Kong courts are no longer bound by English case law since the handover in 1997, the Hong Kong courts have continued to seek guidance from the English courts and UK Supreme Court cases have been highly persuasive precedents. As such, we will not be surprised that the Triple Point approach will be followed in due course.

Prevention is better than cure, we strongly encourage you to seek proper legal advice during contract negotiation stage (for example to advice on the enforceability and applicability of the liquidated damages clause) and to avoid disputes and provide cost-savings in the long run.