Hong Kong Court of Appeal embraces modern test for penalty clauses following UK Supreme Court in Cavendish when considering employer's right to enforce termination notice provision

In a notable judgment (Law Ting Pong Secondary School v Chen Wai Wah [2021] CA 873), the Hong Kong Court of Appeal (CA) has adopted the modern approach to penalty clauses handed down in the UK Supreme Court in Cavendish Square Holding BV v Talal El Makdessi [2016] AC 1172. The recent appellate decision has arguably laid to rest uncertainty surrounding Hong Kong law on penalty clauses following recent case law developments, including Cavendish, which in effect rewrote the law of penalties in the UK. In two previous Hong Kong decisions (covered in our previous blog post here), the CA had already embraced a broad and flexible approach in determining whether a clause was a penalty, although in those cases the Court did not go as far as the approach in Cavendish.

The CA also confirmed that, as notice provisions in an employment contract provide a mechanism for termination of the contract, they will not generally be unenforceable as a penalty, even where employment under the contract has not yet commenced. Such clauses may still practically deter an employee (or employer) from backing out of an employment contract before employment commences.

Lastly, the CA reaffirmed and applied the law on contractual interpretation as set out in Jumbo King Ltd v Faithful Properties Ltd & Ors [1999] 3 HKLRD 757 and recently reiterated by the Court of Final Appeal in Eminent Investments (Asia Pacific) Ltd v DIO Corporation (2020) 23 HKCFAR 487.

Background

On 17 July 2017, Law Ting Pong Secondary School (Claimant), a direct subsidized school, recruited Chen Wai Wah (Defendant) as its teacher for the school term commencing on 1 September 2017 (Offer), and issued three documents ie, a Letter of Appointment, Conditions of Service and a Letter of Acceptance. On the same day, the Defendant accepted the Offer and returned to the Claimant a signed copy of the Letter of Acceptance with the Conditions of Service attached. The Letter of Acceptance stated that the Defendant accepted the appointment in accordance with the Conditions of Service and understood that the conditions of the new employment contract would come into immediate effect upon acceptance of the Offer.  One of the terms required the employee to give three months' notice to terminate his employment with the Claimant or make a payment in lieu (Termination Provision). On 22 August 2017, the Defendant backed out of the employment contract.

The key issues in dispute were (i) whether the Termination Provision became legally binding upon the signing of the Letter of Acceptance and the Conditions of Service, which also called into question whether the Letter of Acceptance formed part of the employment contract between the parties; and (ii) whether the Termination Provision was unenforceable as a penalty clause.

Decisions of the lower courts

The Labour Tribunal found in favour of the Claimant on both issues and awarded the Claimant with the payment in lieu of notice stipulated in the Termination Provision with interest. The Defendant appealed to the Court of First Instance (CFI), which overturned the Labour Tribunal's ruling.  The Claimant then appealed to the CA.

CA's decision

Contractual interpretation

On the contractual interpretation issue, the CA found that the Termination Provision was legally binding, and that the Letter of Acceptance (and its contents) formed part of the employment contract between the parties. In reaching this conclusion, the CA applied the well-established principles laid down by Lord Hoffman NPJ in Jumbo King Ltd v Faithful Properties Ltd & Ors [1999] 3 HKLRD 757 (reiterated by the Court of Final Appeal in Eminent Investments (Asia Pacific) Ltd v DIO Corporation (2020) 23 HKCFAR 487), stating that the test for contractual interpretation is "what a reasonable person would have understood the parties to mean, having regard to the parties' agreement as a whole, the factual and legal background against which it was concluded and the practical objects which it was intended to achieve".

Given that (i) the Defendant was given all three documents together when the Claimant made its employment offer, and (ii) the Defendant was required to sign and return a copy each of the Conditions of Service and the Letter of Acceptance, the Court held that it could be reasonably understood that the Claimant was offering employment on the basis set out in all three documents as a "package deal". The Termination Provision was also specifically drawn to the attention of the Defendant in the Letter of Acceptance, which a reasonable person would also have understood to have come into effect immediately upon acceptance of the Offer. Accordingly, it was held that both parties must give three months' notice or make payment in lieu of notice should any of them wish to terminate the contract, even before the commencement of the Defendant's teaching duties on 1 September 2017.

Penalty clause

On the penalty issue, applying the UK Supreme Court's decision in Cavendish Square Holdings v Makdessi [2016] AC 1172, the CA ruled that the doctrine of penalty can only be engaged when there has been a breach of contract.  In other words, it is a secondary obligation that is triggered by a breach of a primary obligation. The CA held that the Termination Provision, specifically the obligation to pay in lieu, was a primary obligation as the provision provided a mechanism for termination of the contract. Therefore, enforcement by the Claimant was recovery of a contractual debt as opposed to a remedy for breach, and the Termination Provision was therefore not rendered unenforceable as a penalty even though employment under the contract had not yet commenced.

Importantly, the Court went on to hold that even if the Termination Provision was to be regarded as a liquidated damages clause, the Termination Provision did not constitute a penalty clause upon applying the approach laid down in Cavendish.

In particular, the CA agreed with the breakthrough in Cavendish that the inquiry to be made is no longer a distinction between a penalty and a genuine pre-estimate of loss, which has long been the approach to penalty clauses in Hong Kong and in England & Wales prior to Cavendish. The CA stated that in applying the new test, 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 innocent party's legitimate interest by considering the circumstances in which the contract was made.

An innocent party's legitimate interest can go beyond compensation, and includes a legitimate interest in the performance of the contract, or some appropriate alternative to performance. The CA also held that the clause in question was to be judged in light of the circumstances at the formation of the contract, and not at the time of breach.

On the facts of this case, the Court concluded that the three months' notice period and payment in lieu clause under the Termination Provision could not be said to be out of all proportion to the Claimant's interest in enforcing the contract. Here, the Court acknowledged that employers have a legitimate interest in maintaining a stable and steady workforce, and had regard to the recruitment efforts by the Claimant, difficulties it would face in appointing a replacement teacher, the need to engage temporary teachers in the interim, and the reciprocity of the Termination Provision.

Insight

The CA has settled a key aspect of law which is often invoked in a claim for liquidated damages upon a breach of contract. The modern approach (in Cavendish) to the law on penalties is now part of Hong Kong law. Under the new test, a clause may be enforceable even if it does not represent a genuine pre-estimate of loss. However, the question of precisely what will amount to a legitimate interest in enforcing a counterparty's obligations, and whether the remedy provided is out of all proportion to that interest, may be open to debate in many cases.

When drafting commercial terms, it may be helpful to ensure any remedy one will be entitled to claim upon the counterparty’s breach is proportionate to their interest in enforcing performance. Alternatively, it may be possible to avoid the application of the rule on penalties altogether with careful drafting, though classification of a term will depend on substance rather than mere form.

For employers, the decision confirms that termination provisions will not be unenforceable as a penalty particularly where the employment contract is on foot, but the employment has not yet commenced. Provided the provisions are carefully drafted, this can be used as an important tool in discouraging employees from backing out of employment. While in this case the three month notice period was reciprocal, as parties are free to agree on the length of notice, the decision may also embolden employers to use differing notice provisions for employer and employee as a retention tool.