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Hong Kong Court of Appeal moves away from the genuine pre-estimate of loss test for penalty clauses in Hong Kong

  • Hong Kong
  • Employment law

23-08-2021

A recent Hong Kong Court of Appeal decision (Law Ting Pong Secondary School v Chen Wai Wah, [2021] HKCA 873) confirms that the modern approach on penalty clauses as laid down in the UK Supreme Court case of Cavendish Square Holding BV v Talal El Makdessi [2015] UKSC 67 (“Cavendish”) also applies in Hong Kong. 

Background

We have previously reported on this case when it was in the Court of First Instance (on appeal from the Labour Tribunal). You may refer to our earlier report for the factual details of the case.

The Claimant is a secondary school who made an offer to the Defendant teacher on 17 July 2017, which constituted an offer of appointment, a conditions of service and a letter of acceptance. The Defendant teacher signed both the conditions of services and the letter of acceptance on the same day. The conditions of services provides that the Defendant teacher had to give three months’ notice or make payment in lieu of three months’ notice to terminate the employment contract (the “Termination Provision”). On 22 August 2017, the Defendant teacher backed out of the employment contract without giving notice or making any payment in lieu of notice.

The Claimant school succeeded in the Labour Tribunal as the Presiding Officer took the view that all three documents together constituted the employment contract between the parties. The Labour Tribunal ordered the Defendant teacher to make a payment in lieu of notice for his contractual notice period to the Claimant school.

The Defendant teacher then appealed to the Court of First Instance, which overturned the Labour Tribunal’s decision. The Court of First Instance found that the letter of acceptance did not form part of the employment contract and the Defendant teacher’s act of signing was simply complying with the prescribed mode of acceptance prescribed by the offer of appointment. The employment relationship did not commence until 1 September 2017 and thus the Defendant teacher was not under employment by the Claimant school when he backed out of the employment contract on 22 August 2017. Thus, there was no applicable notice period and no payment in lieu of notice was payable.

The Decision of the Court of Appeal

The Claimant school further appealed to the Court of Appeal, which overturned the Court of First Instance’s decision and ruled in favour of the Claimant school.

The Court of Appeal found that the letter of acceptance forms part of the employment contract and the terms of all three documents were accepted as a “package deal”. In signing the letter of appointment, the Defendant teacher accepted that the terms of the conditions of service would come into immediate effect. Thus, the termination provision became effective upon the signing of the employment contract on 17 July 2017 and the Defendant teacher was bound by the Termination Provision to give three months’ notice or make payment in lieu of notice to terminate the employment.

Analysis

This case also confirms that Hong Kong law adopts the modern approach as laid down in Cavendish in determining whether a liquidated clause is a penalty.

Hong Kong has long adopted the test in Dunlop Pneumatic Tyre Co. Ltd v. New Garage & Motor Co. [1915] AC 79 , which provides that a clause is a penalty and thus unenforceable if it is not based on a genuine pre-estimate of loss. On the other hand, The Supreme Court of the United Kingdom reformulated the test in Cavendish in 2015. The Cavendish test provides that a clause is a penalty and thus unenforceable if it is a secondary obligation that “imposes a detriment on the  contract-breaker out of all proportion to any legitimate interest of the innocent party” in enforcing the contract.

In applying the Cavendish test, the Court of Appeal held that the termination provision is a primary obligation of the contract  rather than a secondary obligation which only arise upon a breach of a primary obligation. The payment of a sum in lieu of notice is a contractually agreed and lawful means to terminate the employment contract. The Termination Provision thus does not operate upon a breach of contract and the analysis for a penalty clause is not engaged.

The Defendant teacher is unlikely to succeed even if the Cavendish analysis for penalty clause is engaged. Firstly, the Claimant school has a legitimate interest in enforcing the performance of the employment contract as it has to ensure a steady and sufficient number of teaching staff to address students’ need. Secondly, the Defendant teacher backed out of the employment contract less than 10 days before the start of the new school year. Thirdly, the three months’ notice period and the payment of a sum in lieu of notice is not extravagant. Thus the Termination Provision does not impose a detriment on the Defendant teacher out of all proportion to the legitimate interests of the Claimant school.

The Cavendish test was referred several times in the Court of First Instance and this Court of Appeal decision confirms that the law in Hong Kong adopts the modern approach. The adoption of the Cavendish test in the employment context is in line with developments in this area as courts are increasingly inclined to uphold liquidated damages clauses and are gradually moving away from the traditional genuine pre-estimate of loss analysis.

What this means for employers

This is a welcomed decision for employers. Payment in lieu of notice clauses in employment contracts are likely to be enforceable as they are considered as primary obligations and the doctrine of penalties is not engaged, as long as they proportionately protects employers’ legitimate interest.

Another interesting aspect of this case is to illustrate how lengthy and costly the litigation process can be compared with the amount in dispute. In this case, the amount of payment in lieu of notice awarded to the Claimant school was HK$139,593.20 and while the Claimant school was ultimately successful in the second appeal after almost four years since the dispute first arose, it has only been awarded HK$70,000 for its legal costs incurred. We believe that the unrecoverable legal costs on both sides would have significantly exceeded the amount of the damages awarded. This is a matter employers and employees should consider when they bring their claims in the Labour Tribunal as it may not always be the most cost-effective solution to their dispute.