Milestone Decision of the Court of Appeal on the Modern Approach to Penalty Clauses

07 July 2021

Overview and two important takeaways

The Court of Appeal (“CA”) has recently handed down a milestone decision on Hong Kong commercial and employment laws: Law Ting Pong Secondary School v Chen Wai Wah [2021] HKCA 873 (the “CA Decision”). This case concerns the remedies available to a secondary school (the appellant) after one of its teachers (the respondent) wrongfully revoked his employment contract just a few days before the formal opening of the academic year. One of the arguments advanced by the teacher was that the payment in lieu of notice clause in the employment contract is an unenforceable penalty clause.

The CA rejected the teacher’s arguments and allowed the school’s appeal. Among other things, there are two important takeaways:

(1) First, the CA Decision has confirmed that Hong Kong Courts welcome and would adopt the modern approach to control penalty clauses as laid down by the Supreme Court of the United Kingdom in Cavendish Square Holdings BV v Talal El Makdessi [2016] AC 1172 (the “UKSC Judgment”).

In gist, instead of asking whether the clause represents a genuine pre-estimate of loss and/or is in terrorem, the modern test requires the Court to “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 legitimate interest by considering the circumstances in which the contract was made” (see, e.g., paragraphs 69-70 of the CA Decision).

The CA Decision has therefore authoritatively resolved the uncertainty as to whether Hong Kong law on penalty clauses should be fine-tuned and/or modernised after the UKSC Judgment, which has sparked debates among practitioners and academics in the common law world since 2015: see, e.g., Remedies for Torts, Breach of Contract, and Equitable Wrongs (2019, Oxford University Press) by Professor Andrew Burrows QC (Hon) (as Lord Burrows JSC then was).

(2) Second, with the insightful comments by the learned Lam VP in the CA Decision, the law against penalty clauses may not apply to payment in lieu of notice clauses in the employment context, although that will still depend on how the clause is being drafted and agreed.

As pinpointed by the learned Lam VP at paragraph 7 of the CA Decision, “termination by advance notice or payment in lieu of such notice is quite common” and His Lordship did not think “it is in the interest of the development of employment law to complicate the matter by bringing the concept of penalty to such a common practice.”

Such inspiring comments would surely have material and important implications on the drafting of employment contracts and the resolution of employment disputes in the future.

Commentary

The CA Decision is most welcome. The modern approach to penalty clauses, now confirmed to be part of Hong Kong laws, essentially (1) dissuades a simplistic evaluation of merely checking whether the agreed payment is a genuine pre-estimate of loss and/or is in terrorem and (2) places emphases on the qualitative aspect of the contracting parties’ legitimate interests.

Such an approach indeed makes good commercial and common sense. For instance, when parties entered into the contract on a commercial basis, and there is no compelling evidence of an abuse of bargaining power, it is logically sensible and reasonable for the Court to uphold the legitimate interests of the contracting parties and be slow in striking down a clause on the basis that it is penal. After all, certainty (including certainty of agreed contract terms) is important to the operation of commercial activities.

For the above reasons, the CA Decision has provided important guidance on the laws governing both (1) penalty clauses and (2) payment in lieu of notice clauses. Readers are invited to study the same if and when a related issue arises.

Tommy Cheung acted for Law Ting Pong Secondary School, the appellant in the appeal.

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