Recent developments on liquidated damages and penalty clauses

A liquidated damages clause in an employment contract is often attractive from an employer's perspective, and it is not difficult to see why. Such a clause provides certainty and does away with the cumbersome task of assessing the damages payable upon the occurrence of an event, typically a breach of contract. A liquidated damages clause is, however, susceptible to challenge on the grounds that it is effectively a penalty, and therefore unenforceable.

This area of the common law has been the subject of recent change given the divergent views taken in Australia and England, in Andrews v Australia and New Zealand Banking Group Limited (2012) 247 CLR 205 ("Andrews") and Cavendish Square Holding BV v Makdessi [2016] AC 1172 ("Cavendish Square") respectively. This has left the position in Singapore somewhat in a state of flux. In a welcome development, the Singapore Court of Appeal has handed down its decision in Denka Advantech Pte Ltd v Seraya Energy Pte Ltd [2020] SGCA 119 ("Denka") in December 2020, and has therefore now provided a measure of certainty by clarifying the applicable approach in Singapore.

This article looks at the decision in Denka and its ramifications for employers in Singapore. We also comment briefly on the position in Hong Kong.

Liquidated damages and penalties

In an employment context, a liquidated damages clause may require the employee to pay the employer an amount which is fixed in advance and specified in the employment contract upon the occurrence of an event, e.g. the employee fails to commence employment by a certain date, or the employee terminates the contract before the end of a fixed term. Such a clause, however, will not be enforceable if the employee can show that it is a penalty. This rule against contractual penalties is very well-established, having been set out over a century ago by the House of Lords in Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd [1915] AC 79 ("Dunlop Pneumatic"). In essence, a clause will be a penalty if it is not a genuine pre-estimate of the loss that could be proved to have followed from a breach of contract.

In Andrews, the High Court of Australia widened the scope of Dunlop Pneumatic and held that the rule against penalties applied not only to secondary obligations (i.e. clauses which impose obligations upon a breach of primary obligations), but also to primary obligations.

In Cavendish Square, the United Kingdom Supreme Court departed from Dunlop Pneumatic by reformulating the rule against penalties within the framework of legitimate interests, i.e. whether the impugned provision is a secondary obligation which imposes 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.

The position in Singapore

In Denka, the Singapore Court of Appeal declined to affirm either Andrews or Cavendish Square, but instead framed its decision squarely within the bounds of Dunlop Pneumatic. In other words, the rule against penalties applies only to secondary obligations; and the key enquiry remains whether the clause represents a genuine pre-estimate of the likely loss caused by the breach of contract.

The position in Hong Kong

In Hong Kong, there has not been any decision of the appellate courts on this issue to date. It appears, however, that the lower courts are inclined to follow the position taken in Cavendish Square, albeit within the context of commercial disputes between companies. It remains to be seen whether in the future the Hong Kong courts will apply Cavendish Square within the context of an employment dispute, particularly in light of the points raised by the Singapore Court of Appeal in Denka, namely:

• Extending the rule against penalties, as the High Court of Australia did in Andrews, would effectively give the courts a wide discretion to strike down primary obligations in a contract, which are often the substantive obligations which the parties have agreed. This would undoubtedly create legal uncertainty, and would erode the other well-established principle of the freedom of contract.

• In Cavendish Square,the UK Supreme Court was wrong to have reformulated the rule against penalties within the framework of legitimate interests because, at a normative level, a clause which sets out an excessive amount to be paid by a defendant in the event of a breach must necessarily be penal, as opposed to compensatory, in nature, even if it is in a plaintiff's commercial interests to have included such a provision on a factual level. A plaintiff's legitimate interest therefore has no role to play at the level of legal principle, except to the extent that the legitimate interest concerned is coterminous with that of compensation.

• The concept of legitimate interest is also too general, and it could be used in numerous ways, particularly in application to particular facts and circumstances, thereby leading to legal uncertainty.

Ramifications for Employers

Given the clarification of the legal position (in Singapore at least), employers should note the following points:

• in order to enable the employer to defend against possible challenge, careful consideration should be given at the outset to whether a proposed liquidated damages clause represents a genuine pre-estimate of loss;

• the rule against penalties applies not only to payments of a sum of money, but can conceivably be used to challenge similar practices such as requiring the employee to forfeit share options; and

• given the potentially divergent legal position in Hong Kong, care must be taken when adapting clauses found in Singapore template documentation for use in Hong Kong, and vice versa.

For employers in Hong Kong, while it would appear that the current position remains relatively less stringent than in Singapore for the time being, the points outlined above should nevertheless be borne in mind as a matter of best practice.