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The enforceability of liquidated damages clause

May 17, 2016
When a contract is breached, the innocent party may sue for compensation, based on the actual loss suffered.

In order to avoid delays in determining this amount, a contract may specify an amount of the compensation – or “liquidated damages” – to be paid in case of a breach.

Under Hong Kong law, this is permissible as long as the amount is a “genuine pre-estimate” of damages at the time the contract is made. In contrast, if the amount stated is out of proportion of the likely damages, it will be unlawful and unenforceable.

A difficulty in the application of this rule occurs if, at the time when the contract was signed, it would be so difficult (if not impossible) to estimate the loss caused by the breach, can a liquidated damages clause still be used in such circumstances?

In the recently-decided case of Brio Electronic Commerce Ltd v Tradelink Electronic Commerce Ltd [2016] HKEC 989 before the Hong Kong Court of Appeal, the contract contained a “non-solicitation” clause under which the parties agreed not to “poach” the clients of each other. The contract also provided a sum of HK$ 5 million as the liquidated damages.

Later, the defendant hired two of the plaintiff’s clients. The plaintiff sued the defendant for the damages of HK$ 5 million, as prescribed by the contract.

The defendant argued that the HK$ 5 million was not enforceable because it was not a genuine pre-estimate of damages. Naturally enough, revenue from different clients were different. Indeed, it may be that the business from a single major client could be more than the combined business from five other clients. Therefore it would be difficult, if not impossible, to (pre-)estimate the loss from losing a client at the time when the contract is signed. The consequences in terms of damage could vary substantially.

The Court of Appeal held that, when considering whether such a liquidated damages clause is valid, one must consider the matter from the standpoint of the parties at the time when they entered into the contract.

Where a breach could have a range of consequences, the court held that the clause would be a penalty where the specified amount was extravagant compared with the greatest loss that could be proved to flow from the breach. This approach recognizes that the consequences of a breach cannot be foreseen with precision, and allows the parties to stipulate for a sum which will provide adequate compensation in the event of breach.

On the facts of the case, at the time the contract was signed, the plaintiff was very concerned about losing of customers as it would seriously affect its survival in the market. In the circumstances, therefore, an assessment of the likely damage flowing from a breach by reference to two years' commissions was not unreasonable.

The court also held that the nature of the damage would appear to be the same for potential breaches of the non-solicitation clause. Although the breach could occur on a number of occasions, this was not something that had been held to raise any presumption or inference that the sum agreed was a penalty. To hold otherwise would in effect require the parties to estimate in advance the amount of damages payable for every different way in which a breach might occur. This should not be what the parties were expected to do from a commercial perspective.

Based on the above, the court upheld the liquidated damages clause. This judgement underlines that the Hong Kong Courts will uphold liquidation damages clauses but care is nonetheless needed in the drafting process to avoid this being struck down as an unenforceable penalty.
For more information on Commercial and M&A matters, please contact:-

Chris Gordon | | +852 2861 8413
Chris Lambert | | +852 2861 8417
Jennifer Wong | | +852 2861 8318
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