A recent court of appeal decision has definitively clarified the test for assessing the enforceability of liquidated damages clauses in Singapore. Contracting parties intending to incorporate liquidated damages clauses must be mindful of the type of damages that may be recovered in the event of default, especially when exercising a contractual right to terminate the contract. 

For over a century, commercial parties avoided difficulties in quantifying losses by using liquidated damages clauses to stipulate the sum payable if a party breached terms of a contract. However, such clauses can be unenforceable if they are found in law to be a penalty (the “Penalty Rule”). Fundamentally, a liquidated damages clause would be a penalty if it was not a genuine pre-estimate of damages.  This was established in the House of Lord’s decision of Dunlop which became the decisive case that all lawyers referred to.

This was upended in recent years, following the UK Supreme Court’s 2015 decision of Cavendish[1]. The genuine pre-estimate test was replaced with a wider, more flexible “legitimate interest” test.  This created some uncertainty incommon law jurisdictions such as Malaysia, Australia and New Zealand as they considered whether to follow or differ from the UK restatement.

The question finally reached Singapore’s Court of Appeal in Denka Advantech Pte Ltd v Seraya Energy Pte Ltd [2020] SGCA 119 (“Seraya”). The Court of Appeal has decided that Singapore will continue to follow the century-old conventional wisdom articulated in Dunlop and depart from the UK regime.

The Court of Appeal also took the opportunity to flesh out the legal principles underpinning the Penalty Rule. We discuss here some of the key nuances that commercial parties should be cognizant of, to ensure their contract will be upheld in Court.

Background

TSMP acted for Seraya Energy Pte Ltd (“SEPL”), electricity retailer and a wholly owned subsidiary of electricity generator YTL PowerSeraya Pte Ltd, as Plaintiff in a series of suits, appeals and cross-appeals that led to the Court of Appeal decision in Seraya.

The Defendants were customers of SEPL under three electricity retail agreements (“ERAs”) which required the Defendants to purchase electricity at agreed fixed rates. With decreasing electricity prices, the Defendants repudiated the three ERAs, intending to purchase electricity from the market at a lower rate. SEPL commenced the Suits against the Defendants, claiming liquidated damages and alternatively, common law damages.

Notable Legal Principles

While the Seraya decision traversed a broad spectrum of legal doctrines which we cannot do justice to in a summary, we highlight three legal principles worth knowing.

First, the Court of Appeal took the opportunity to clarify the nuanced differences between primary and secondary obligations.

A primary obligation is a contractual obligation – for instance to pay a stipulated sum upon an event. The obligation to pay damages is a secondary obligation – as it is an obligation triggered upon the failure to fulfil a primary obligation.

Seraya affirms the distinction between primary and secondary obligations, and held that the Penalty Rule is only applicable to secondary obligations, consistent with the UK position: i.e. only clauses which seek to regulate the quantum of damages payable on breach of a term of contract can be held unenforceable pursuant to the Penalty Rule.

This demonstrates Singapore’s commitment to contractual autonomy, which means that the Court will avoid interfering too much in the parties’ underlying bargain, or protect a party from a bad bargain. This stands in contrast to countries such as Australia, where the Penalty Rule operates regardless of whether the clause in question is a primary or secondary obligation.

Second, Seraya reaffirmed Dunlop principles: liquidated damages clauses must be a genuine pre-estimate of the loss that the innocent party would suffer pursuant to the breach, if not, they will likely be deemed a penalty, and unenforceable in Court.

In contrast, UK’s 2015 decision of Cavendish reframed the substantive criteria for the Penalty Rule: a clause imposing a detriment on the contract-breaker out of all proportion to any legitimate interest of the innocent party would be an unenforceable penalty. Such “legitimate interests” were much broader and less predictable, and could include commercial interests beyond compensation, which had traditionally been the only interest considered by the Penalty Rule. This “legitimate interest” test has also been applied and/or considered in other common law countries including Australia, Malaysia and New Zealand.

Third, the Court of Appeal clarified when a party is entitled to loss of bargain damages.

Faced with a breaching counterparty, the innocent party often seeks to terminate under an express term, as opposed to treating the breach as a repudiation and accepting the same, due to the apparent certainty that the former provides.

However, the decision in Seraya sounds a note of caution for such an approach. The Court of Appeal reviewed and affirmed the English position in Financings[2] that, where one party breaches the contract and the innocent party terminates the contract under an express term, the innocent party’s ability to claim loss of bargain damages (i.e. future profits) is dependent on whether it had a concurrent right to terminate the contract under common law, independent of its express contractual right of termination.

For completeness, the principle in Financings was not in issue, and the Court of Appeal was content to proceed on this basis.  Whether the Court of Appeal will entertain a future challenge to the principle in Financings remains to be seen.

Key Takeaways

In practical terms, the decision in Seraya is significant when negotiating or drafting contracts, especially when dealing with termination rights and liquidated damages.

First, a clause requiring payment that is triggered by a non-breaching event is not subject to the Penalty Rule. Strictly speaking, such a clause would not provide for liquidated “damages”, since there is no breach involved.

Second, if the parties intend that the contract can be terminated by certain breaches, the parties should ensure that the underlying obligations relating to such breaches are incorporated as true conditions, as opposed to merely providing the strict right to terminate should a specified event occur. This would go some way in ensuring that the innocent party would have an express right to terminate as well as a concurrent right to terminate for breach of condition, allowing it to claim for loss of bargain damages.

Third, to avoid falling foul of the Penalty Rule, and to ensure liquidated damages clauses are upheld when challenged, parties should:

1. attempt to calculate the losses or range of losses that the innocent party might suffer from a particular breach of contract, and ensure that the liquidated damages clause provides for a sum that is not “extravagant and unconscionable” in comparison with the greatest loss in the said range;
2. where the liquidated damages clause is triggered by a breach involving only non-payment of money, ensure that the clause does not provide for a sum larger than the amount unpaid; and
3. take into account the possibility of different events and circumstances that might trigger the liquidated damages clause, and avoid fixed lump sum payments regardless of the nature of the breach.
   
   

Additionally, the following factors should also be considered:

1. whether parties were of equal bargaining power and had legal representation; and
2. the purpose of the underlying transaction and the particular primary obligation that has been breached.
   
   

Parties should be aware of the potential differences between Singapore and other common law jurisdictions in relation to the Penalty Rule, especially in their choice of applicable laws, and special care must be taken if clauses are being adopted from templates of other jurisdictions. Seraya confirms that the goal of liquidated damages clauses in Singapore is limited to providing compensation for damage, which means that as things stand, Singapore law provides greater certainty and predictability for commercial contracting parties.

A copy of the decision may be obtained from the Singapore Law Watch website.

Disclaimer: The information provided herein does not and is not intended to constitute legal or professional advice and should not be relied upon as such.