Singapore Court of Appeal rejects the Cavendish test for Liquidated Damages

This article is produced by CMS Holborn Asia, a Formal Law Alliance between CMS Singapore and Holborn Law LLC.

A. Overview

In Denka Advantech Pte Ltd v Seraya Energy Pte Ltd [2020] SGCA 119, the Singapore Court of Appeal (“SGCA”) had the opportunity to consider the applicable law with regard to penalty and liquidated damages (“LD”) clauses.

The SGCA considered the “legitimate interests” test in the UK case of Cavendish Square Holding BV v Makdessi [2016] AC 1172 (“Cavendish”), but ultimately affirmed the prior formulation by Dunlop Pneumatic Tyre Company, Limited v New Garage and Motor Company, Limited [1915] AC 79 (“Dunlop”) that a clause is not penal if it is based on a genuine pre-estimate of loss. The Court found that the “legitimate interests” test in Cavendish was too general a concept, and its malleable nature lends itself to much uncertainty for contracting parties, particularly as to the specific result (or relief) that parties could attain in Court.

However, the SGCA clarified that the rejection of the “legitimate interests” test does not mean that elements of the Cavendish test are completely inapplicable in Singapore. Notably, the key elements for determining “legitimate interests” (such as the commercial interests and relative bargaining power between the contracting parties) remain relevant insofar as they help the Court determine if the clause was penal based on the Dunlop principles.

B. Background

Seraya Energy Pte Ltd (“Seraya”) had commenced two lawsuits against Denka Advantech Pte Ltd (“Denka”) for damages arising out of three electricity retail agreements (“ERAs”), in which Seraya was to supply electricity to certain premises managed by Denka.

Due to certain disputes, Denka alleged that it was allowed to repudiate the ERAs, and thereafter sought to end the ERAs. Seraya sued for breach of contract, and claimed for LD under the ERA contracts, which stipulated a sum of damages payable by Denka in the event of a default (“LD clauses”).

The Courts had to consider whether the LD clauses in the ERAs were penal (not proportionate to the actual loss that could have resulted), as generally, a clause that is penal is unenforceable (“Penalty Rule”). However, as the test for what constitutes a penal clause was recently reformulated in the UK case of Cavendish Square Holding BV v Makdessi [2016] AC 1172 (“Cavendish”), the Courts had to decide if it would apply the new Cavendish test or the prior formulation in Dunlop.

At first instance, the High Court (“SGHC”) declined to apply the Cavendish test, preferring the prior formulation in Dunlop, and in so doing rejected Seraya’s claim(s) under the LD clauses. Seraya appealed to the SGCA. More information regarding the SGHC’s decision can be found in our previous article: Singapore High Court considers application of “legitimate interest” test to liquidated damage clauses.

C. The Penalty Rule

The Dunlop Principles

For years, the key principles for whether a clause offends the Penalty Rule has been laid out in Dunlop, the primary consideration being whether the LD clause in question was a genuine pre-estimate of the loss that could be incurred. If the clause was extravagant and unconscionable compared to the greatest possible loss that could result, it was deemed to be a penalty clause. Briefly, Dunlop laid out 4 key principles to determine if a clause is penal:

1. The clause would be penal if the sum stipulated for is extravagant and unconscionable in comparison with the greatest loss that could conceivably result from the breach (“greatest loss principle”);
2. The clause would be penal if the breach consisted only of the non-payment of money and the clause demanded a larger sum as compensation;
3. There is a rebuttable presumption that the provision is penal if a “single lump sum” is payable upon the occurrence of various events (which have varying degrees of severity leading to differing levels of losses); and
4. The clause would not be penal if it is impossible to perform a precise pre-estimation of the loss that may be incurred.

The Cavendish Test

However, the Penalty Rule was recently reformulated by the UK Courts in Cavendish. Simply put, Cavendish states that an LD clause is a penalty only if it was out of all proportion to any “legitimate interests” of the aggrieved party. These “legitimate interests” could extend beyond purely compensation for the aggrieved party and can include wider commercial-based interests and considerations. LD clauses would no longer be limited to a genuine pre-estimate of loss, but could require LD for a larger amount, to protect parties’ “legitimate interests”.

D. SGHC’s decision

The SGHC observed that the Dunlop principles were applied by the SGCA as recently as 2015, in Xia Zhengyan v Geng Changqing [2015] 3 SLR 732 (“Xia”). However, Xia predates the UK Supreme Court’s decision in Cavendish.

Without prior guidance from the SGCA on the applicability of Cavendish, the SGHC found that it was bound by the SGCA’s prior decision in Xia to adopt Dunlop. This reasoning was in line with other SGHC decisions post Xia and Cavendish, which expressly rejected Cavendish on the basis that the SGCA had yet to apply the Cavendish test.

The SGHC determined that the primary intention of the LD clauses in the ERAs was to deter any breach by Denka. Applying the Dunlop principles, the SGHC found that the clause was not a genuine estimate of damages, arising from Denka’s breach, and was therefore unenforceable. For completeness, the SGHC also considered the Cavendish test, but held that the “legitimate interests” test would yield the same result.

E. SGCA’s decision

Decision on legal principles

In determining the issue, the SGCA considered:

1. Expanding the scope of the Penalty Rule to situations outside of a breach of contract; and
2. Reformulating the Penalty Rule to adopt the “legitimate interests” test in Cavendish.

In clarifying its approach towards these issues, the SGCA formulated 2 questions:

1. Whether the Penalty Rule should be confined to situations involving a breach of contract; and
2. What are the applicable legal criteria for the Penalty Rule?

On the first question, the SGCA declined to extend the Penalty Rule to situations outside of a breach of contract. This is in contrast to the approach of the Australian High Court in Andrews v Australia and New Zealand Banking Group Limited (2012) 247 CLR 205 (“Andrews”), which extended the scope of the Penalty Rule to include clauses dealing with situations not involving breach of contract.

The SGCA found that any extension of the Penalty Rule to situations outside of a breach of contract vests in the Court a discretion that is both wide and uncertain. An extension of the Penalty Rule to include such situations (and therefore not relating purely to damages), could create a situation where the Court is forced to determine whether a contractual bargain is fair, as opposed to whether the stipulated compensation is fair. Such a discretion would inadvertently require the Court to review clauses on substantive (as opposed to procedural) grounds, impugning upon the parties’ freedom to contract. Limiting the application of the Penalty Rule to instances where a breach of contract has occurred creates a practical limit to the Court’s discretion.

On the second question, the SGCA rejected the “legitimate interests” test as a step too far from the fundamental purpose of LD clauses, to provide compensation for the damages suffered by the aggrieved party.

The SGCA instead affirmed the Dunlop principles primarily on the basis that requiring the clause to be a genuine pre-estimate of loss was consistent with the compensatory nature of LD clauses. On the other hand, accounting for “legitimate interests” on top of the pre-estimate of loss would necessarily be penal as opposed to compensatory. Therefore, a rejection of the Cavendish test would conform with prior cases which held that, as a general rule, punitive damages cannot be awarded for breach of contract. Additionally, the SGCA also found that the vast majority of cases would reach the same conclusion applying the Dunlop principles as it would applying the “legitimate interests” test in Cavendish, obviating the need for such a distinction.

Furthermore, it was held that the concept of “legitimate interests” was too general a concept that lends itself to several interpretations. The inability to pin down a defined meaning for the concept of “legitimate interests” would allow it to be utilised too flexibly, causing uncertainty both during the contracting phase and the specific result that would be reached by the Court in a subsequent dispute.

However, the Court noted that the key elements used in Cavendish to determine “legitimate interests” (such as commercial interests and the relative bargaining power between the contracting parties) were still relevant insofar as they helped the Court to determine if the clause was penal based on the Dunlop principles.

Application to the present case

On the facts, the SGCA found that Denka had wrongfully repudiated the ERAs. Therefore, the LD clauses were engaged. Although the LD clauses essentially provided a “single lump sum” amount for several possible breaches (with varying degrees of severity), this only led to the rebuttable presumption that the LD clauses were penal. Applying the greatest loss principle, the SGCA determined that the LD amount was not extravagant and unconscionable in amount in comparison with the greatest loss that could have resulted. It was therefore a genuine pre-estimate of loss and not penal. This conclusion was further supported by the fact that the parties were sophisticated commercial entities, who would be expected to look after their own interests at the time of contract.

The SGCA therefore affirmed the enforceability of the LD clauses, and awarded Seraya damages amounting to $30.8M on that basis, substantially greater than the amount determined in the SGHC.

F. Commentary

This decision provides clarity on two issues relating to penalty clauses.

Firstly, the Penalty Rule in Singapore is applicable only to situations involving a breach of contract. Respectfully, the decision of the Australian High Court in Andrews to expand the scope of the Penalty Rule creates a wide and uncertain discretion for the Court, and allows (or even compels) the Court to review clauses on substantive (and not procedural) grounds. Taken to its logical extreme, the Court could be forced to review the fairness of the contractual bargain between the parties as opposed to the fairness of the compensation amount, going against the Court’s reluctance to intervene in parties’ freedom to contract.

Secondly, Dunlop remains the leading authority in Singapore for the rule against penalties. This is a principled decision. It is clear that the purpose of LD clauses is compensatory in nature, which is wholly consistent with Dunlop’s requirement that the clause must be a genuine pre-estimate of loss. Conversely, an LD clause that accounts for “legitimate interests” on top of such genuine pre-estimate(s) of loss will undoubtably be penal.

This decision is largely welcomed as a source of relief for contracting parties, particularly in a market already familiar with the Dunlop principles. With respect, the Cavendish test would have created a great deal of uncertainty regarding the interpretation and enforceability of LD clauses in the market, given the protean nature of “legitimate interests”. The affirmation of the Dunlop principles is also a warning to parties not to draft their LD provisions too widely, and to be mindful of how they arrive at the stipulated sum or damages under the contract. Parties unable to justify their LD provisions as a genuine pre-estimate of loss will likely find the Courts unwilling to enforce them.

Article co-authored by Lee Kwang Chian.