The Malaysian Federal Court has recently, in the case of Cubic Electronics Sdn Bhd (in liquidation) v Mars Telecommunications Sdn Bhd [2019] 2 CLJ 723 decided on the often debated point of law relating to the application and effect of liquidated damages clauses.
While this recent Federal Court decision does not overrule the previous judgment of the Federal Court in Selva Kumar a/l Murugiah v Thiagarajh a/l Retnasamy [1995] 1 MLJ 817, the Federal Court has certainly clarified the decision in Selva Kumar in regards to the interpretation of Section 75 of the Contracts Act 1950.
Before Cubic Electronics
Prior to the Federal Court’s decision in Cubic Electronics, the courts have consistently followed the interpretation of Section 75 of the Contracts Act 1950 as laid down in Selva Kumar, which held (among others):
- Although Section 75 of the Contracts Act 1950 provides that an innocent party may receive reasonable compensation ‘whether or not actual damage or loss is proved to have been caused thereby’, the Federal Court held that those words ought to be given a restricted construction. As such, an innocent party who is claiming for actual damages in an action for breach of contract must prove actual damages/loss or the reasonable compensation in accordance with the principles in Hadley v Baxendale [1943-60] All ER Rep 461.
- An exception to the above would be where the court finds it difficult to assess the actual damage/loss as there is no known measure of damages employable. Nevertheless, the evidence ought to still show some real loss which is not too remote.
Due to the restricted interpretation in Selva Kumar, even if an innocent party succeeds in proving a breach of contract, the failure to prove actual damages/losses will result in the refusal of the court to award such damages. Even if the contract contains a liquidated damages clause which stipulates a sum to be paid in the event of a breach, the innocent party will still have to prove actual damage/loss.
The above position was also confirmed in the Federal Court case of Johor Coastal Development Sdn Bhd v Constrajaya Sdn Bhd [2009] 4 MLJ 445.
Decision in Cubic Electronics
After more than 20 years since Selva Kumar, the Federal Court has decided to adopt a more liberal interpretation of Section 75 of the Contracts Act 1950, in line with the position taken in other common law jurisdictions.
In Cubic Electronics, the issue before the Federal Court was regarding forfeiture of deposit (as agreed liquidated damages). Nevertheless, the Federal Court went on to clarify the law on liquidated damages clauses under Section 75 of the Contracts Act 1950:
- As Section 75 of the Contracts Act 1950 allows the innocent party to reasonable compensation ‘whether or not actual damage or loss is proved’, proof of actual loss is not mandatory in order for the court to award damages.
- In the event the innocent party is able to show a breach of contract and that the contract contains a liquidated damages clause, then the innocent party would be entitled to reasonable compensation not exceeding the sum stated in the clause.
- The burden then shifts to the defaulting party to show that the sum stated in the liquidated damages clause is unreasonable. A sum will be considered as unreasonable compensation if it is extravagant and unconscionable in amount in comparison with the highest conceivable loss which could possibly flow from the breach.
- Even though proof of actual loss is not determinative of ‘reasonable compensation’, evidence of actual loss would be useful as a starting point in determining whether the compensation is a reasonable one. There should not be a significant difference between the damages stipulated in the contract and the level of loss/damage which is likely to be suffered by the innocent party.
The Federal Court also clarified that if there is a dispute as to what constitute reasonable compensation, the burden of proof lies with the defaulting party to show that the damages clause including the sum stated therein is unreasonable.
With this new Federal Court decision, it would appear that an innocent party will have a higher chance of receiving the stipulated sum in the liquidated damages clause as compensation for the breach of contract.
United Kingdom
While the Federal Court in Cubic Electronics did refer to the UK Supreme Court’s position in Cavendish Square Holding BV v Makdessi [2015] UKSC 67 in determining what amounts to ‘reasonable compensation’, has the Malaysian Federal Court truly adopted the position in Cavendish? Before we conclude on that, we find it helpful to discuss briefly the position of law in the UK on the enforceability of penalty clauses (liquidated damages clauses).
Prior to the UK Supreme Court’s transformative decision in Cavendish, it has traditionally been accepted that the test for determining whether a particular liquidated damages clause is in fact an unenforceable penalty clause would depend on whether the stipulated sum was a genuine pre-estimate of the loss that could be caused by the breach of the relevant primary obligation (Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co [1914-15] All ER Rep 739). The Dunlop approach was predicated on the assumption that the sole purpose of a liquidated damages clause is to compensate the innocent party for losses arising from a breach of contract. Thus, the liquidated damages provision in a contract would be unenforceable if the amount stipulated was “extravagant, exorbitant or unconscionable”.
Though there were some developments on this area by the English courts thereafter, the UK Supreme Court finally shed a new light on the law on penalty clauses in the case of Cavendish. The UK Supreme Court reformulated the approach towards penalty clauses as follows:
- The penalty rule applies only to secondary obligations, i.e. obligations triggered by a breach of contract. The rule does not apply to primary obligations (i.e. obligations imposed on each party to procure whatever he has promised to do).
- If the penalty rule applies, the court will then consider whether the consequence of a breach is out of all proportion or “unconscionable” or “extravagant” having regard to the legitimate interests of the innocent party.
The Cavendish approach is certainly wider than the Dunlop approach in that it allows for consideration of contractual purposes beyond the desire to recover compensation for a breach, including but not limited to considerations of commercial interests. This shift in position also indicates the reluctance of the courts to interfere with the parties’ freedom of contract, as well as to give legal certainty to the operation of a damages clause.
Coming back to the Malaysian position, whilst the Federal Court did decide that the concept of ‘legitimate interest’ and ‘proportionality’ as enunciated in Cavendish would be relevant in determining what amounts to ‘reasonable compensation’ under Section 75 of the Contracts Act 1950, the Federal Court did not in fact adopt entirely the test for primary obligation and secondary obligation. Although, it is important to note that the first step in claiming under the liquidated damages clause is to show that there is a breach of contract.
Other Common Law Jurisdictions
It is interesting to note that the other neighbouring common law jurisdictions, such as Singapore, Australia and Hong Kong, have also not adopted the Cavendish approach wholesale (except Singapore as explained below).
Singapore
Since the UK Supreme Court decided in the case of Cavendish, the Singapore courts have considered and applied the same approach when it comes to penalty rules or liquidated damages clauses. This can be seen in cases such as iTronic Holdings Pte Ltd v Tan Swee Leon [2016] SGHC 77 and Nanyang Medical Investments Pte Ltd v Kuek Bak Kim Leslie and others [2018] SGHC 263.
However, in another Singapore High Court case of Hon Chin Kong v Yip Fook Mun [2018] 3 SLR 534, the Court reverted to the Dunlop test of genuine pre-estimate. The High Court took the position that the Dunlop approach shall continue to be law in Singapore, and that the Cavendish approach is not applicable in Singapore.
Nevertheless, it is important to note that in Hon Chin Kong, the High Court clarified that the law of penalties (i.e. the Dunlop approach) would not apply to true deposits, whereas it was observed that the Cavendish approach may be wide enough to apply to true deposits.
In another recent Singapore High Court case of Seraya Energy Pte Ltd v Denka Advantech Pte Ltd and another suit (YTL PowerSeraya Pte Ltd, third party) [2019] SGHC 2, the Court considered the “legitimate interest” approach in Cavendish. However, the Court reaffirmed that it is bound to apply the classic case of Dunlop on the principles applicable to distinguish between a provision for liquidated damages and one imposing a penalty.
Having said, the Singapore High Court in Denka Advantech did refer to other Singapore High Court cases that considered the UK Supreme Court case of Cavendish. However, as at the date of this article, there is no Singapore Court of Appeal decision on this matter. Nevertheless, the discussions on the Cavendish approach seem to suggest that there is a slow but growing acceptance of the Cavendish position in Singapore.
Australia
The Australia courts similarly adopts the Dunlop approach when determining whether a liquidated damages clause is enforceable or a penalty.
In the High Court of Australia case of Andrews and others v Australia and New Zealand Banking Group Ltd [2012] HCA 30, the Court held that when the contract requires the payment of compensation that is non-proportional to the pre-estimated loss, the clause may be considered as a penalty and thus, unenforceable.
The law of penalties was also considered in the Federal Court of Australia case of Paciocco v Australia and New Zealand Banking Group Limited [2014] FCA 35. The Federal Court similarly followed the Dunlop approach and held that a stipulated (to pay a sum or other property) will not constitute a penalty at law or in equity unless it is ‘extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved’. Further, the Federal Court clarified that whether a sum stipulated is a penalty or liquidated damages is to be determined upon the terms and inherent circumstances of the contract, judged at the time of making of the contract.
To assist further, the Federal Court also set out some considerations which may be considered:
- Whether the sum stipulated is extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved.
- Whether the breach consists only in not paying a sum of money, and the sum stipulated in the clause is a sum greater than the sum which ought to have been paid.
As the Australian courts have yet to consider the case of Cavendish, it would be interesting to see whether the Australian courts will depart from the Dunlop approach.
Hong Kong
The issue relating to liquidated damages clause was recently decided by the Hong Kong Court of Appeal in the case of Brio Electronic Commerce Ltd v Tradelink Electronic Commerce Ltd [2016] HKEC 989. In this case, the contract in dispute had a non-solicitation clause whereby parties agreed not to ‘poach’ the clients of each other. The contract further provided a sum of HK$5 million as liquidated damages for the breach. In the Court of Appeal, the defendant did not challenge the finding that it was in breach of contract. However, the defendant contended that the term fixing damages at HK$5 million was not an enforceable liquidated clause as it was not a genuine pre-estimate of damages (following the Dunlop approach).
In arguing its case, the defendant’s counsel suggested that the Hong Kong Court of Appeal follow the English Court of Appeal decision in Murray v Leisureplay Plc [2005] EWCA Civ 963, which provided a step by step guide to the questions the court should ask itself to determine whether a clause is a penalty. In doing so, the court would have to make a comparison between the amount stipulated in the contract as payable in the event of breach and the amount that would be payable for such breach under common law.
Nevertheless, the Hong Kong Court of Appeal took the view that the approach taken in Murray was too rigid. In upholding the liquidated damages clause, the Court of Appeal held, among others, as follows:
- A comparison as suggested in the English Court of Appeal case of Murray would remove one of the commercial advantages that a liquidated damages clause is recognised at achieving, e. the dispensation with the need to adduce evidence on damages and to calculate them, particularly in cases where proof of the amount of damages suffered may be difficult to achieve to any degree of precision.
- When considering whether a clause is valid liquidated damages clause or a penalty, one must consider the standpoint of the parties at the time when they entered into the contract.
- Where a breach could have a range of outcomes or consequences, a clause will be held to be a penalty where the amount stipulated for is extravagant compared with the greatest loss that could be proved to flow from the breach. This approach recognises that the consequence of a breach may not be foreseen with precision and hence, allows parties to stipulate a sum representing adequate compensation in the event of breach.
Although the case of Brio was decided after the UK Supreme Court delivered its decision in Cavendish, the Hong Kong Court of Appeal did not take the opportunity to express its views on Cavendish. It remains to be seen whether the new test laid down in Cavendish would be adopted by the Hong Kong courts in the future.
Conclusion
Although the other common law jurisdictions, including Malaysia, has yet to align its laws on penalties with the UK position in Cavendish, the courts are certainly more reluctant to disturb parties’ freedom to contract, especially in commercial contracts.
As for Malaysia, the Federal Court decision of Cubic Electronics has certainly provided some clarification on the law on liquidated damages clause. Parties therefore ought to ensure that the amount stipulated in the liquidated damages clause is a reasonable amount of compensation for the breach.
Specifically for construction contracts, parties should properly consider the genuine pre-estimate of losses and the reasonable time for completion of the works when agreeing on the liquidated damages clause given that there is no longer a requirement for the innocent party to prove actual loss. We await further judicial guidance on the application of these principles in construction contracts.
Written by Amy Hiew & Pan Yan Teng
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LAM WAI LOON (lam@hlplawyers.com)
SERENE HIEW (serene@hlplawyers.com)
