The rule against penalties – a primer
For well over a century, commercial parties have stipulated liquidated damages clauses (LD clauses) in contracts to avoid the cumbersome task of assessing damages payable upon the occurrence of an event, typically, a breach of contract. However, such clauses risk being unenforceable if they flout the rule against penalties. The courts in most Commonwealth jurisdictions (including Singapore) have traditionally regarded LD clauses as penalties that are unenforceable if they do not represent a genuine pre-estimate of loss, and go beyond compensating a party for its loss.
This approach reflects a judicial policy of ensuring that parties do not ‘overreach’, and has its roots in Lord Dunedin’s judgment in Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd  UKHL 1 (Dunlop), a seminal decision so entrenched in law that it has been described by a leading commentator as “holy writ” (see Seddon & Bigwood, Cheshire & Fifoot Law of Contract (11th Australian Edition) at p 1230).
This seemingly settled position has been upended in recent years. Following a tide of fairly recent decisions from the highest courts in various Commonwealth jurisdictions that have adopted a wider and more flexible “legitimate interests” test in determining whether LD clauses are penalties (see for example, the UK Supreme Court’s decision in Cavendish Square Holdings BV v Makdessi  UKSC 67 (Cavendish) and the High Court of Australia’s decision in Paciocco v Australia & New Zealand Banking Group Ltd  HCA 28). Under this test, the courts will examine whether a LD clause imposes a detriment on a contract breaker that is out of all proportion to any legitimate interest that the innocent party has. Such “legitimate interest” need not be an interest in compensation only and could include wider commercial interests.
Following these developments, Singapore law existed in a state of flux because there was some ambiguity as to the appropriate test. Some judgments have applied the test in Dunlop and declined to apply the legitimate interests test (see for example Hon Chin Kong v Yip Fook Mun  3 SLR 534), some others applied the legitimate interests test (see for example, Nanyang Medical Investments Pte Ltd v Kuek Bak Kim Leslie  SGHC 263), and certain cases applied both (see for example, Leiman Ricardo v Noble Resources Ltd  2 SLR 386).
Recently, a five-judge coram of the Singapore Court of Appeal (SGCA) (Singapore’s highest court) in Denka Advantech Pte Ltd v Seraya Energy Pte Ltd  SGCA 119 (Denka v Seraya) has clarified that the correct test to determine whether a LD clause is a penalty is that in Dunlop. This article analyses the SGCA’s reasoning and provides some key takeaways.
Denka v Seraya
The case concerns an alleged breach by Denka Advantech Pte Ltd and Denka Singapore Pte Ltd (collectively, Denka) of their obligation under electricity retail agreements (ERAs) to purchase electricity from Seraya Energy Pte Ltd (Seraya). Seraya sought to recover liquidated damages under the LD clauses in the ERAs. However, Denka contended that the LD clauses in the ERAs were unenforceable because they were penalty clauses.
In determining whether the LD clauses amounted to penalties, the SGCA engaged in an extensive review of the principles relating to the rule on penalties (including its recent developments in the Commonwealth which showed that there was some variance in the approaches adopted across jurisdictions), and focused on two main issues:-
- When does the rule against penalties apply; and
- The test to determine whether a LD clause is a penalty.
When does the rule on penalties apply?
The SGCA declined to extend the rule against penalties to situations outside of breach of contract, contrary to the present position in Australia as set out in the High Court of Australia’s decision in Andrews v Australia and New Zealand Banking Group Ltd (2012) 247 CLR 205 (Andrews).
In Andrews, the High Court of Australia held that the rule against penalties applies to any term in the nature of a security or collateral to ensure the fulfilment of some primary stipulation, which need not be a strict contractual obligation. This was because the rule against penalties, as it was originally developed in equity, was never limited to situations involving a breach of contract.
The SGCA explained that extending the rule against penalties to situations outside of a breach of contract was undesirable because:-
- Although the removal of the breach requirement appeared attractive, the rule against penalties was developed in response to a very specific situation concerning the enforcement of penal bonds. There was no reason why that form of the rule against penalties should be extended to apply in the same manner to all modern contracts. On the contrary, any extension of the rule against penalties would vest in the courts a discretion that was both wide and uncertain, in that it would permit the courts to review a wide range of clauses on substantive grounds, which would constitute a significant intrusion into the parties’ freedom of contract.
- There were persuasive reasons in logic and principle as to why the prerequisite of a breach of contract should be preferred. Requiring a breach of contract would ensure that the rule against penalties applies only to secondary obligations (i.e., the obligation to pay damages upon breach), and would not interfere with the parties’ primary obligations. Apart from being a practically enforceable limit on the rule against penalties, the breach of contract requirement is also normatively sensible given a common law court’s reluctance to interfere with the content of the parties’ contractual bargain.
Thus, the SGCA has clarified that under Singapore law, the rule against penalties applies only where there has been a breach of contract.
The test to determine whether a LD clause is a penalty
The SGCA declined to follow the legitimate interests test in Cavendish and endorsed the statement of principles set out by Lord Dunedin in Dunlop as representing the correct position under Singapore law.
Under Dunlop, the main inquiry is whether the amount to be paid as liquidated damages represents a genuine pre-estimate of loss. The following tests may be helpful, or even conclusive:-
- A clause is a penalty if the sum stipulated is extravagant or unconscionable in comparison with the greatest loss that could conceivably be proved to have followed from the breach.
- A clause is a penalty if the breach consists only in the non-payment of money and it provides for a larger sum that ought to be paid.
- There is a rebuttable presumption that the clause is a penalty if the same sum is payable on a number of events of varying gravity.
- A sum may be a genuine pre-estimate of loss even if the consequences of the breach are such as to make the precise pre-estimation of loss almost an impossibility.
In applying the above principles, much will depend on the precise facts and circumstances of the case itself.
The SGCA declined to adopt the legitimate interests test because:-
- The test in Dunlop as to whether the LD clause concerned provided a genuine pre-estimate of the likely loss is wholly consistent with the position under Singapore law that damages ought to be compensatory, rather than punitive (barring exceptional cases). This is in line with the SGCA’s earlier decision in PH Hydraulics & Engineering Pte Ltd v Airtrust (Hong Kong) Ltd  2 SLR 129 which held that, as a general rule, punitive damages cannot be awarded for breach of contract.
- In contrast, the approach in Cavendish was inconsistent with this because it would permit the enforcement of LD clauses that operate upon a breach and are not a genuine pre-estimate of likely loss, but are nonetheless commercially justifiable.
- Moreover, the manner in which the concept of “legitimate interests” was framed in Cavendish had a protean character that allowed it to be used too flexibly, which would result in too much uncertainty.
While the SGCA rejected the legitimate interests test in Cavendish, it has made clear that factors such as commercial interests, the bargaining power of the parties, and the parties’ purpose for entering into the contract, may be relevant and taken into consideration by the Singapore courts to determine whether a LD clause is penal in nature. However, these have to be viewed with a focus on whether the LD clause provided a genuine pre-estimate of the likely loss.
The SGCA’s decision in Denka v Seraya is highly significant as it lays to rest important issues in relation to the rule against penalties in Singapore. It is now clear that under Singapore law:-
- The rule against penalties applies only where there has been a breach of contract; and
- The rule against penalties remains that of the statement of principles articulated by Lord Dunedin in Dunlop, where the focus is on whether a LD clause provides a genuine pre-estimate of a party’s likely loss. In this regard, the only legitimate interest which the rule against penalties is concerned with is that of compensation.
These holdings are especially weighty as Denka v Seraya has been heard and determined by five judges of the SGCA, instead of the usual three.
If a party terminates a contract pursuant to an express right of termination, there is a possibility that it may be unable to contend that a LD clause is unenforceable for being a penalty, because of the SGCA’s pronouncement that the rule against penalties takes effect only upon a breach of contract.
This ruling could be significant in a number of contexts, such as contracts involving fees charged by a bank for a customer being overdrawn (as it may not be a breach of contract to be overdrawn), contracts involving fees for extending the time for repayment (as the possibility for an extension of time may have been agreed between the parties), and energy / oil & gas supply contracts with ‘take or pay’ provisions (as the failure to take a certain amount of energy may not constitute a breach of contract). To this end, it is important to carefully examine the exact wording of the contracts in question and the precise facts to determine the substance of the obligation involved. It remains to be seen how the principles in Denka v Seraya will be fully developed in these contexts.
Parties should be especially careful when drafting LD clauses – the sum stipulated as liquidated damages cannot be extravagant in comparison to the range of losses that could have been reasonably anticipated. Otherwise, there would be a considerable risk that the LD clause will be held to be unenforceable for flouting the rule against penalties. The question of what is extravagant will ultimately depend on the facts of each case.
A party seeking to rely on a LD clause may wish to obtain the written consent or acknowledgment that the amount of damages specified in the clause is reasonable, and represents a genuine pre-estimate of loss. To this end, it should endeavour to furnish information or calculations setting out its expected losses in the event of a breach of contract. Such correspondence could be vital and may reduce disputes over whether the LD clause is a penalty or not.
Care must also be taken when adapting clauses found in template documentation. Parties should not slavishly adopt templates, and should have due regard to the governing law, given the variance in approaches on how the rule against penalties applies across jurisdictions. It is imperative to seek appropriate legal advice or the consequences could well be dire.
Not infrequently, one begins by swimming against the tide, only to find that the tide has turned. The SGCA’s approach will no doubt give the courts in other jurisdictions occasion to pause, and reconsider their respective approaches in applying and refining the principles governing the rule against penalties.
Dentons Rodyk thanks and acknowledges Practice Trainee Rebecca Goh for her contributions to this article.