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In Ng Yan Kit Alfred and Another v. Ever Honest Industries Ltd and Another [2022] HKCFI 1834, the Court of First Instance (CFI) confirmed that the approach to considering penalty clauses in Law Ting Pong Secondary School v Chen Wai Wah [2021] HKCA 873 should be followed in Hong Kong.

Background 

The employee was a vice president and director of the defendant companies. 

Clause 6 of the Employee's 2016 Letter of Employment ("Subject Clause") provided: 

The Group cannot dismiss you within three years upon the commencement of this employment agreement. If the Group dismisses you within three years after this employment agreement commences, you will be paid two whole years’ salary as compensation. If this employment is terminated by you within three years, one month’s written notice or one month’s salary in lieu of notice is required, and after resignation, you will not be allowed to work in an organisation that is in the same or relevant industry or the compensation of two whole years’ salary will not be granted.

The employee was dismissed on 1 April 2016, with three months' payment in lieu of notice, annual leave payment and end of year bonus. The employee subsequently brought a claim in the Labour Tribunal (LT) for 24 months' salary under the Subject Clause. 

Original LT Decision

The LT considered, among other things, whether the Subject Clause was a penalty or a liquidated damages clause, and held that "…since there is no evidence to show that the parties have attempted to make a genuine pre-estimate of the loss in case of a breach of the New Agreement, the Subject Clause is a liquidated damages clause and not a penalty."* 

(*Note: on this point, the Hon Mr. Justice David Lok at the CFI said: "The Presiding Officer has made a serious error here. I think what she meant is that, as there is no evidence suggesting that the parties have attempted to make a genuine pre-estimate of the loss in the case of a breach, the Subject Clause is a penalty clause. That should have been the logical conclusion from her finding.") 

In so deciding, the LT had considered that payment of three months' salary in lieu of notice was adequate compensation, since the employee was found to have suffered from cancer after he was terminated, so he could not have worked in any event due to treatment. 

The employee appealed to the CFI.

CFI Appeal Decision

The CFI criticised the LT's reasoning on the penalty issue as being too simplistic, since it had only relied on the fact that there was no attempt by the parties to make a genuine pre-estimate of loss (which is the old approach to penalty clauses).

The decision did not reflect the modern approach set out in the Law Ting Pong Secondary School case, which the CFI said should now be regarded as "the law in Hong Kong reflecting the modern judicial approach in considering the application of the penalty rule". 

In addition to failing to adopt the proper approach, the CFI said that the LT had also seriously mixed up the effects of its findings.

If the LT meant that the Subject Clause was a liquidated damages clause and not a penalty, then it should have allowed the employee's claim for 24 months' salary as the "compensation" specified in the clause.

'Modern Approach' – Law Ting Pong Secondary School Case

The previous approach to penalty clauses was set out in the UK case of Dunlop Pneumatic Tyre v New Garage [1915] AC 67, and the primary question was whether the payment of money was a genuine pre-estimate of damage (liquidated damages), or whether it was a form of punishment to the offending party (penalty). 

However, this position changed following the UK Supreme Court cases of Cavendish Square Holding BV v Makdessi and ParkingEye Ltd v Beavis [2016] AC 1172, followed by the Hong Kong case of Law Ting Pong Secondary School.

In Law Ting Pong Secondary School, the teacher (employee) signed a letter of appointment, but did not show up for work on her first day. The employment contract documentation contained a termination clause, providing that either party could terminate the employment by giving three months' written notice or payment in lieu. The court had to decide, among other things, whether this provision was unenforceable as a penalty clause. 

The Court of Appeal (CA) held that the payment of a sum in lieu of notice was a contractually agreed method of lawful termination of the employment contract, and it was not in the nature of damages for breach of contract. In other words, it was a primary obligation to pay, rather than a secondary obligation arising upon the breach of a primary obligation of performance. 

Furthermore, the CA found that even if the provision was a liquidated damages clause (i.e., secondary obligation), it would not be an unenforceable penalty clause, since the school (employer) had a legitimate interest in enforcing the performance of the employment contract – and in the circumstances, the provision was not out of all proportion with the school's legitimate interest.

The court considered factors such as possible disruption to the school schedule and difficulties finding a replacement teacher at short notice. Therefore, it held that even if such provision was a liquidated damages clause, it would still be enforceable since it did not offend the penalty rule. 

Two-step Inquiry to Penalty Rule

In this latest case, the CFI confirmed that the 'modern approach' in Law Ting Pong Secondary School should be followed. This involves a two-step inquiry: 

  1. First, the court must construe the clause to determine whether it is a contractually agreed method of lawful termination of the contract (which is a primary obligation to pay), or whether the sum stipulated is in the nature of damages for breach of contract (which is a secondary obligation arising upon the breach of a primary obligation of performance). If it is a primary obligation, then the doctrine of penalty is not engaged, and the court will generally have no jurisdiction to review the fairness of the clause.

    This is a matter of construction of the provision, looking first at the actual wording used in the provision itself, and also at other factors which may be relevant in determining the nature of the payment to ascertain the intended contractual function of the provision. 

  2. Second, if the payment is found to be a secondary obligation, the court must then identify the legitimate interest of the innocent party being protected by the clause, and assess whether it is out of all proportion to such legitimate interest. The court must consider the circumstances in which the contract was made, including the background, reason and purpose as to why the parties agreed on the terms in the relevant provision. 

The CFI held that it had no option but remit the case back to the LT, since the LT had not made any inquiry as to the true nature of the payment. Furthermore, if the payment was held to be a secondary obligation upon breach, the CFI did not have sufficient information to determine whether there was a legitimate interest to be protected, as well as whether it was proportionate to such legitimate interest – this investigation of facts could only be conducted by the LT and not the CFI (as the appellate court).

Takeaways for Employers

The law on penalty clauses in Hong Kong has moved on from whether a clause is a 'genuine pre-estimate of loss'. The court will now take a two-step approach to determine whether a clause is unenforceable as a penalty clause. 

Employers should be careful to identify whether a clause relating to payment of money is a primary or secondary obligation. 

In the case where an employer is looking to bind an employee to a "fixed term", having a clause that obliges the employee to pay wages for the balance of the fixed term should they terminate employment before the fixed term may be struck down as a penalty clause. It may also contravene s.6 of the Employment Ordinance that provides a right for the employee to terminate employment at any time by giving the appropriate notice.

A better way to structure this arrangement would be provide for termination by either party giving the agreed notice during the fixed term – with the agreed length of notice being the longer of (a) a certain number of months (e.g., 24 months) less the number of completed months of continuous employment with the employer, and (b) the minimum notice period (e.g., three months).  

The judgment is available at the following link:

https://legalref.judiciary.hk/lrs/common/ju/ju_frame.jsp?DIS=145043&currpage=T