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court upholds ‘modern’ judicial approach to penalty clauses in Hong Kong employment case | Insights and Events

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

Background

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

Clause 6 of the employee’s 2016 letter of employment (“purpose clause”) provided:

The Group cannot dismiss you within three years of the start of this employment contract. If the Group dismisses you within three years of the start of this employment contract, you will receive two full years of salary as compensation. If this employment is terminated by you within three years, one month’s written notice or one month’s pay in lieu of notice is required, and after resignation, you will not be permitted to work in any organization belonging to the same industry. or to the sector concerned or to the compensation of two full years of salary will not be granted.

The employee was dismissed on April 1, 2016, together with a three-month notice indemnity, an annual leave indemnity and an end-of-year bonus. The employee then filed a claim with the Labor Court (LT) for 24 months’ wages under the object clause.

Initial LT decision

The LT considered, among other things, whether the subject matter clause was a penalty or a liquidated damages clause, and found that “…since there is no evidence to show that the parties attempted to make a true pre-estimate of the loss in the event of a breach of the new agreement, the object clause is a liquidated damages clause and not a penalty.“*

(*Note: on this point, the Honorable Mr. Justice David Lok at the CFI said: “The presiding officer made a serious mistake here. I think what she meant was that since there is no evidence to suggest that the parties attempted to make a true pre-estimate of the loss in the event of a breach, the subject matter clause is a penalty clause. This should have been the logical conclusion of his discovery.“)

In so deciding, the LT had considered that the payment of three months’ salary in lieu of notice constituted adequate compensation, since the employee had been found to suffer from cancer after his dismissal, so that he would not could in no way work due to treatment.

The employee entered the TPI.

FCI appeal decision

The CFI criticized LT’s reasoning on the issue of sanction as being overly simplistic, as it had relied solely on the fact that there had been 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 High School case, which, according to the CFI, should now be considered “Hong Kong law reflecting the modern judicial approach in reviewing the application of the sentencing rule“.

In addition to not taking the right approach, the TPI said the LT also seriously mixed up the effects of its findings.

If the LT meant that the subject matter clause was a damages clause and not a penalty, then he should have allowed the employee’s claim for 24 months pay as the “compensation” specified in the clause.

“Modern Approach” – Case of Law Ting Pong High School

The previous approach to penalty clauses was set out in the UK case Dunlop pneumatic tire against new garage [1915] AC 67, and the main question was whether the payment of a sum of money was a true pre-estimate of damages (damages) or whether it was a form of punishment imposed on the offending party (penalty).

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

In Law Ting Pong High School, the teacher (employee) signed a letter of appointment, but did not report to work on the first day. The employment contract documents contained a termination clause, providing that either party could terminate employment upon three months’ written notice or payment in lieu. The court had to decide, among other things, whether this provision was inapplicable as a penalty clause.

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

Further, the CA concluded that even if the provision were a liquidated damages clause (i.e., a secondary obligation), it would not be an unenforceable penalty clause, since the school ( the 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 to the legitimate interest of the school.

The court took into account factors such as the possible disruption of the school timetable and the difficulties in finding a replacement teacher at short notice. Therefore, he held that even if such a provision were a damages clause, it would still be enforceable since it did not violate the penalty rule.

Two-step investigation to penalty rule

In this latter case, the CFI confirmed that the “modern approach” in Law Ting Pong High School should be followed. This involves a two-step investigation:

  1. First, the court must interpret the clause to determine whether it is a contractually agreed method of legal termination of the contract (which is a principal obligation to pay), or whether the stipulated sum has the nature of damages for breach of contract (which is a secondary obligation arising from the breach of a primary obligation of result). If it is a principal obligation, the doctrine of penalty is not engaged and the court will generally have no jurisdiction to consider the fairness of the clause.

    This is a matter of interpreting the provision, looking first at the actual wording used in the provision itself, as well as other factors that may be relevant in determining the nature of the payment to determine the intended contractual function of the provision.

  2. Second, if payment is considered a secondary obligation, then the court must identify the legitimate interest of the innocent party protected by the clause and assess whether it is disproportionate to that legitimate interest. The court must take into account the circumstances in which the contract was made, including the context, reason and purpose of why the parties agreed to the terms of the relevant provision.

The TPI felt it had no choice but to refer the matter to the LT, since the LT had made no investigation into the true nature of the payment. In addition, if payment was considered a secondary obligation in the event of default, the TPI did not have sufficient information to determine whether there was a legitimate interest to be protected, as well as whether it was proportionate to this legitimate interest – this investigation of the facts could only be carried out by the LT and not by the CFI (as the court of appeal).

Takeaways for employers

Penalty clause law in Hong Kong has moved on from whether a clause is a “true pre-estimate of loss”. The court will now take a two-step approach to determining whether a clause is unenforceable as a penalty clause.

Employers must be careful to determine whether a clause relating to the payment of a sum of money is a primary or secondary obligation.

In the event that an employer seeks to bind an employee to a “fixed term”, having a clause that requires the employee to pay wages for the remainder of the fixed term if he terminates his employment before the fixed term can be invalidated as a penalty clause. It may also contravene Section 6 of the Employment Ordinance which provides the employee’s right to terminate employment at any time by giving proper notice.

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

The judgment is available at the following link:

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