Rule against penalties: Singapore Court of Appeal affirms Dunlop test

The decision of the Singapore Court of Appeal on 15 December 2020 in Denka Advantech Pte Ltd & another v Seraya Energy Pte Ltd & another [2020] SGCA 119, has affirmed that, under Singapore law, the rule against penalties remains as stated by Lord Dunedin in Dunlop Pneumatic Tyre Company, Ltd v New Garage and Motor Company, Limited [1915] AC 79.

In reaching its decision, the Court declined to adopt the wider legitimate interest test introduced by the UK Supreme Court in Cavendish Square Holding BV v Makdessi [2016] AC 1172 and also declined to extend the rule against penalties to situations outside of a breach of contract, as outlined in the Australian case Andrews and others v Australia and New Zealand Banking Group Limited (2012) 247 CLR 205.

This decision will be of particular interest in the context of construction, infrastructure and energy contracts, which often contain provisions for liquidated damages in the event of delay, but it is also relevant to other sectors in Singapore.

The claims

The case concerned three electricity retail agreements, entered into in 2012 between Seraya Energy Pte Ltd (Seraya), an electricity retailer and a wholly owned subsidiary of electricity generator YTL PowerSeraya Pte Ltd (YTL), and its customers Denka Advantech Pte Ltd and Denka Singapore Pte Ltd (together, Denka).

The electricity retail agreements were due to expire on 31 January 2021 and each contained a liquidated damages clause, linked to Seraya’s express contractual right to terminate the agreements in various circumstances, including for Denka breaching the obligations under the agreements. The liquidated damages were to be determined by a formula: A x B x 40%, where A was the number of months between the date the contract was terminated and 31 January 2021, and B was the average amount payable by Denka in the period before termination.

On 20 August 2014, Denka wrote a letter to YTL stating that “the supply of steam and electricity shall cease”. In subsequent correspondence, YTL and Seraya held that the electricity retail agreements had been repudiated by Denka in that letter. Seraya accepted Denka’s repudiation of one of the agreements in a letter dated 28 August 2014 and subsequently terminated the other two agreements in October and November 2014 pursuant to the express termination provisions in the agreements.

Seraya brought claims against Denka based principally on the wrongful termination of the three electricity retail agreements. Denka denied liability for wrongful termination on several grounds and also argued that Seraya was not entitled to liquidated damages as the relevant provisions were unenforceable penalties.

The decision

The Court of Appeal concluded that, in applying the Dunlop test, the liquidated damages clauses were not penalties and were therefore enforceable.

The Court held that, having considered the expert evidence, the amounts payable by Denka as liquidated damages were not extravagant and unconscionable when compared to the greatest loss that could conceivably be proved to have followed from the breach. Therefore, Seraya was awarded the net sum of S$30,829,369.79 pursuant to the liquidated damages provisions.

The rule against penalties

The Singapore Court of Appeal noted that, until recently, the leading common law case on the rule against penalties was Dunlop, in which Lord Dunedin set out the traditional test of whether a clause that takes effect on breach is a “genuine pre-estimate of loss” and therefore compensatory, or whether it is aimed at deterring a breach and therefore penal, referring to the following four factors:

1. The provision would be penal if the sum stipulated for is extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved to have followed from the breach.
2. The provision would be penal if the breach consisted only in the non-payment of money and the provision provided for the payment of a larger sum.
3. There is a presumption (but no more) that the provision would be penal if the same sum is payable in a number of events of varying gravity.
4. The provision would not be treated as penal by reason only of the impossibility of precisely pre-estimating the true loss.

The Court of Appeal noted that there had been two recent common law cases relevant to the rule against penalties: Andrews, pursuant to which the High Court of Australia held that the rule on penalties was not limited only to clauses operating on a breach of contract; and Makdessi, which set out a new “true test” in relation to penalties, based on whether the relevant clause is a secondary obligation which imposes a detriment on the party in breach, out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation. (Click here to read our previous briefing outlining the differences between the law in the United Kingdom and Australia).

Accordingly, the Court of Appeal considered that there were two questions to address:

1. whether the rule against penalties should be limited only to clauses imposing secondary obligations for a breach of contract; and
2. what the applicable legal criteria for the rule against penalties should be.

In relation to the first question, the Court declined to extend the rule against penalties to situations other than breach of contract, as outlined in Andrews, stating that any such extension would vest in the courts a discretion that was both wide and uncertain, and this would enable the courts to review a wide range of clauses on substantive grounds, resulting in a significant incursion into the freedom of contract.

In relation to the second question, the Court declined to follow the legitimate interest approach outlined in Makdessi, stating that the concept of “legitimate interest” was a very general concept that could utilised in many ways, particularly in relation to its application to the facts and circumstances of a given case. Its “protean character” could potentially be used “too flexibly” and this would lead to too much uncertainty both in terms of parties prior to entry into a contract and also in terms of a court subsequently interpreting the contract. In particular, the Court noted that the focus is whether the clause concerned provided a genuine pre-estimate of the likely loss at the time of contracting. In this regard, the only “legitimate interest” which the rule is concerned with is that of compensation.

Conclusion

The traditional “genuine pre-estimate of loss” test from Dunlop and its guidelines remain in place in Singapore law. In this regard, Singapore law now diverges from the position in England, which rewrote the English law on penalties in the Makdessi case.

It is notable, however, that other common law jurisdictions including Australia, Hong Kong and Malaysia have been similarly reluctant to depart from the Dunlop principles when interpreting commercial contracts.