Singapore High Court considers application of “legitimate interest” test to liquidated damage clauses
14 January 2019
In Seraya Energy Pte Ltd v Denka Advantech Pte Ltd and another suit (YTL PowerSeraya Pte Ltd, third party)  SGHC 2 (“Denka Advantech”), the Singapore High Court considered the “legitimate interest” approach in Cavendish Square Holding BV v Makdessi  AC 1172 (“Cavendish”) which has been said to have reformulated the principles applicable to distinguish between a provision for liquidated damages (“LD”), which is enforceable, and one imposing a penalty, which is not enforceable.
The Court reaffirmed that it is bound to apply the classic case on the principles applicable to distinguish between a provision for LD and one imposing a penalty, in Dunlop Pneumatic Tyre Company, Limited v New Garage and Motor Company, Limited  AC 79 (“Dunlop Pneumatic”). Nevertheless, the Court also considered the “legitimate interest” approach in Cavendish to see whether it assisted the plaintiff.
The Court in Denka Advantech referred to Singapore High Court cases that considered Cavendish in the absence of a Singapore Court of Appeal decision on the same. These appear to show a slow but growing acceptance of the Cavendish analysis in Singapore, pending approval by the Singapore Court of Appeal.
This is significant because the “legitimate interest” approach in Cavendish goes further than the principles in Dunlop Pneumatic (e.g. it has been commented that safety fines systems imposed by many contractors would fail as a penalty under Dunlop Pneumatic, but could arguably be legitimised by the Cavendish decision). However, the Denka Advantech decision does at the same time serve as a reminder that LD provisions should not be too widely drafted.
The plaintiff commenced two actions against the defendants for LD under the provisions of three electricity retail agreements (“ERAs”) which the plaintiff terminated due allegedly to wrongful conduct of the defendants. The defendants disputed the enforceability of the LD provisions in the three ERAs and put the plaintiff to strict proof of the damages it had otherwise suffered. The Court was of the view that each provision for LD was a penalty and therefore not enforceable for the reasons below.
High Court’s decision
At the outset, the Court observed that the principles in Dunlop Pneumatic were recently applied by the Court of Appeal in 2015 in Xia Zhengyan v Geng Changqing  3 SLR 732 (“Xia”). However, subsequently in that same year, the UK Supreme Court issued its decision in Cavendish.
It was disputed between the parties whether the court should adopt the new approach propounded in Cavendish, one of the key aspects of which is that the test for a penalty is premised on whether the sum or remedy stipulated as a consequence of breach of contract is “extravagant, exorbitant or unconscionable” with regard to the innocent party’s legitimate interest in the performance of the contract; or still apply the principles in Dunlop Pneumatic. The Court’s findings on the appropriate test are summarised below.
Cavendish not yet considered by the Singapore Court of Appeal but considered in Singapore High Court cases
The Court referred to several High Court cases in chronological order:
- In iTronic Holdings Pte Ltd v Tan Swee Leon and another suit  3 SLR 663 (“iTronic”), George Wei J explained that primary obligations are the legal obligations imposed upon each party to a contract to do what he promised would be done. A breach of the primary obligation leads to the secondary obligation to pay monetary compensation for the loss sustained by the innocent party. The importance of the distinction is that the penalty rule does not apply to a primary obligation to pay an agreed sum. Wei J noted that this distinction was considered in the context of the application of the penalty rule in Cavendish. In the case before him, Wei J considered the provision in question to impose a conditional primary obligation and not a secondary obligation.
- In Allplus Holdings Pte Ltd and others v Phoon Wui Nyen (Pan Weiyuan)  SGHC 144 (“Allplus”), Foo Tuat Yien JC said that at the time of her judgment, the law on when a provision amount to a penalty remained that as stated in Dunlop Pneumatic which was applied in Xia. Applying Dunlop Pneumatic, she was of the view that the provision in question was a penalty because it required the defaulters to pay, upon default, a sum greater than the one which they were supposed to have paid.
- In Hon Chin Kong v Yip Fook Mun and another  3 SLR 534 (“Hon”), the question was whether an initial sum paid for the purchase of shares was paid as a deposit, and if so, whether the penalty rule applied to deposit. Kannan Ramesh J decided that the sum was paid as a deposit and that the penalty rule did not apply to a deposit. He noted Cavendish but said that it had yet to be accepted in Singapore and that he remained bound by various endorsements of Dunlop Pneumatic by the Court of Appeal.
- In CIFG Special Assets Capital I Ltd v Polimet Pte Ltd and others (Chris Chia Woon Liat and another, third parties)  SGHC 22, the question was whether the default interest of 2% per month under a provision of convertible bond subscription agreements was an unenforceable penalty. Audrey Lim JC said that the question was whether the sum stipulated for was extravagant and unconscionable in comparison with the greatest loss that could conceivably be proved to have followed from the breach, citing Dunlop Pneumatic. She also said that this test is qualified by the “strong initial presumption” that the parties themselves are the best judges of what is legitimate in a provision dealing with the consequences of breach in a negotiated contract between properly advised parties of comparable bargaining power, citing iTronic which relied on Cavendish. Applying these principles, the court concluded that the provision in question was not a penalty.
- In Leiman, Ricardo and another v Noble Resources Ltd and another  SGHC 166, the question was whether the relevant provision of a settlement agreement was a penalty. At , Wei J expressed his view that the Cavendish inquiry as to whether the secondary obligation “imposes a detriment on the contract-breaker out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation” offered the most appropriate guidance in the case before him. Applying that approach, he concluded that the provision in question was not a penalty. However, he added that if he were wrong to apply the Cavendish approach in Singapore, he was of the view that the provision was still not a penalty.
- In Nanyang Medical Investments Pte Ltd v Kuek Bak Kim Leslie and others  SGHC 263, the question was whether certain provisions in call option agreements constituted unenforceable penalties. Mavis Chionh Sze Chyi JC noted that the parties were agreed that the classic case on the issue of penalties was Cavendish. She observed that Cavendish stated that the penalty rule regulates only the remedies available for breach of a party’s primary obligations and not the primary obligations themselves. She was of the view that the analysis in Cavendish had been endorsed by the Singapore High Court in Allplus and in iTronic, and concluded that the provisions in question created a conditional primary obligation and thus would not constitute a penalty. Accordingly, she did not find it necessary to deal with the defendants’ submissions on the application of the test in Dunlop Pneumatic.
- The Court agreed with the views expressed in Allplus and in Hon that it is bound to apply Dunlop Pneumatic and not Cavendish. Nevertheless, for completeness, the Court considered the “legitimate interest” approach in Cavendish to see if it assisted the plaintiff.
Whether the provisions in question were primary or secondary obligations
The plaintiff submitted that the provision for LD in one of the ERAs was a conditional primary obligation that was triggered by the termination of the contract period before the expiry date. The Court considered that the LD provision in the ERA was a hybrid. If it was engaged because the defendant had terminated the ERA by giving not less than 30 days’ notice, then it appeared to be a conditional primary obligation. On the other hand, if the plaintiff had terminated the contract for cause, as it did, then the LD provision was a secondary obligation.
Whether the plaintiff had in any case a legitimate interest in enforcing the primary obligation
The plaintiff submitted that, based on the manner in which the electricity wholesale market operated and the vertical integration of the generation and retail businesses as part of the model adopted in the industry, it had a legitimate interest, both financially and strategically, in maintaining its ERAs as a hedge against fluctuating pool prices.
The Court’s issue was that the plaintiff’s pleadings did not mention any such legitimate interest as a reason for requiring the defendants to pay LD. Also, the plaintiff’s evidence barely explained the legitimate interest which the LD was meant to address. Its explanation of the plaintiff’s business structure was an attempt to explain how the LD formula was derived, i.e. to show that the figure was not particularly excessive, but not to explain that even if the figure was excessive, it was justifiable because of some legitimate interest other than financial loss.
It may be that it would be extremely inconvenient for electricity retailers to have to prove their damages each time a contract is terminated for default by the counter-party, however, that per se is not good enough to establish legitimate interest as every provision allegedly for LD is meant precisely to avoid such inconvenience which could involve massive efforts that are time-consuming and expensive.
The plaintiff was precluded by its pleadings from raising any legitimate interest to justify the imposition of LD. In any event, it had failed to establish such an interest on the facts. There was no legitimate interest of the plaintiff other than the financial loss it would suffer if the defendants terminated any ERA. Therefore, the question whether the LD was extravagant, exorbitant or unconscionable in relation to the plaintiff’s alleged legitimate interest did not arise.
Principles and tests mentioned in Dunlop Pneumatic
The Court held that the plaintiff did not adequately explain on the facts or in submissions why the principles in Dunlop Pneumatic were not adequate to determine the validity of each LD provision in question. This then brought the parties back to those principles and the tests mentioned in Dunlop Pneumatic:
- Though the parties to a contract who use the words “penalty” or “liquidated damages” may on the face of it be supposed to mean what they say, yet the expression is not conclusive. The Court must find out whether the payment stipulated is in truth a penalty or liquidated damages.
- The essence of a penalty is a payment of money stipulated as to strike fear into the offending party; the essence of liquidated damages is a genuine covenanted pre-estimate of damage.
- The question whether a sum stipulated is penalty or liquidated damages is a question of construction to be decided upon the terms and inherent circumstances of each particular contract, judged of as at the time of the making of the contract, not as at the time of the breach.
- To assist this task of construction, various tests have been suggested, which if applicable to the case under consideration may prove helpful, or even conclusive. Such are:
- It will be held to be penalty 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.
- It will be held to be a penalty if the breach consists only in not paying a sum of money, and the sum stipulated is a sum greater than the sum which ought to have been paid.
- There is presumption (but no more) that it is penalty when ‘a single lump sum’ is made payable by way of compensation, on the occurrence of one or more or all of several events, some of which may occasion serious and others but trifling damage.
On the other hand:
- It is no obstacle to the sum stipulated being a genuine pre-estimate of damage, that the consequences of the breach are such as to make precise pre-estimation almost an impossibility. On the contrary, that is just the situation when it is probable that pre-estimated damage was the true bargain between the parties.
One factor was whether the LD provisions were applicable in a variety of situations from the less serious to the more serious. If so, this could suggest that they were penalties.
Looking at the evidence holistically, it appeared to the Court that each LD provision was included primarily to deter any breach by the counter-party. The Court was of the view that each provision for LD was a penalty and therefore not enforceable.
Denka Advantech provides useful judicial authority at the High Court level that LD provisions which are drafted too widely will not be enforceable, notwithstanding growing consideration of the wider “legitimate interest” approach in Cavendish. The decision builds upon similar conclusions drawn by Foo JC in Allplus.
As a matter of Singapore law, this means that parties should continue to be mindful of the reasons for, and assessment of, LD provisions, even if (and especially if) the same provisions have been used in earlier contracts for different periods. Any LD provision that is not a genuine pre-estimate of damages, not formulated as a primary obligation, and/or not justified by any legitimate interest, will likely be viewed by the Court as a penalty and therefore not enforceable.