UK Supreme Court rewrites English law rule on penalties whilst Hong Kong (for the moment at least) still continues to follow the traditional test

In a judgment handed down on 4 November, the UK Supreme Court has in effect re-written the rule on contractual penalties in England & Wales, holding that the underlying rationale of the rule in English law has been misunderstood and that, as a result, the rule has been applied in many situations where it is both unnecessary and unjust: Cavendish Square Holding BV v Talal El Makdessi; ParkingEye Limited v Beavis [2015] UKSC 67. 

The Supreme Court has rejected the traditional test of whether a clause that takes effect on breach of contract is a “genuine pre-estimate of loss” and therefore compensatory and enforceable, or whether it is aimed at deterring a breach and therefore penal and unenforceable.  The true principle, as established in the Cavendish judgment, is whether the clause is out of all proportion to the innocent party's legitimate interest in enforcing the counterparty's obligations under the contract. If so, it will be penal and therefore unenforceable.

The traditional "genuine pre-estimate of loss" test still applies in Hong Kong.  The various guidelines set out by the House of Lords in Dunlop Pneumatic Tyre Co. v New Garage Co. [1915] AC 79 still form the underlying basis of most, if not all, decisions on penalties in Hong Kong.

The Supreme Court's decision introduces a more flexible test as to whether or not a clause will be found to be a penalty.   Of course, the question of precisely what will amount to a legitimate interest, and whether a particular clause is out of proportion to that interest, will be open to debate in many cases. But the decision provides a much more helpful starting point, and is likely to mean less interference in contracts freely negotiated between commercial parties of similar bargaining power.

In Hong Kong, on the other hand, the court has only gone so far as to hold, in Philips Hong Kong Ltd v Attorney General of Hong Kong (1993) 61 BLR 49, PC, following the Supreme Court of Canada's decision in Elsey v JG Collins Insurance Agencies Ltd (1978) 83 DLR (3d), that where there is equal bargaining power between the parties, the court will not readily strike down a requirement to pay a stipulated sum on the occurrence of a breach of contract as being a penalty. In Polyset Ltd v Panhandat Ltd [2000] 4 HKC 203, the Court of Appeal held that a forfeiture of deposit of up to 35% of the purchase price was not a penalty because the parties had equal bargaining power and the amount was not 'out of proportion' to the possible loss if the market suddenly dropped.

It will be interesting to see whether the Hong Kong courts, when faced with future cases on penalties, explore and decide to follow the Cavendish decision or continue to apply the traditional genuine "pre-estimate of loss" test extended by Philips.

In the meantime, parties drafting contracts in Hong Kong with liquidated damages clauses (i.e., a clause entitling a party to a pre-determined amount on the occurrence of a breach) may benefit from keeping the following tips in mind to ensure, as far as possible, that such clauses are not held to be void as penalties:

1. Consider whether the amount stipulated in the clause is a genuine pre-estimate of the loss that is likely to occur;
2. Where a genuine pre-estimate is not possible, consider whether the amount can be commercially justified;
3. Consider keeping a record of all the negotiations (oral and written) and the commercial factors that the parties have considered which go to justifying the stipulate amount; and
4. Where possible, avoid a single amount that is payable irrespective of whether the loss is minor or of a greater magnitude.

For more details on the UK Supreme Court decision, click here.  To discuss the case or any other matter, please contact Julian Copeman, Gareth Thomas or your usual Herbert Smith Freehills contact.