Zoe Chan So Yuen FCS, FCIS, LLM, MCIArb, Solicitor, argues that a Supreme Court judgment in the UK will have a significant impact on contractual risk management in Hong Kong.

Corporations build up a number of contracts on a daily basis with investors, directors, shareholders, suppliers, employees, sub-contractors and vendors. Very often company secretaries play an important role in corporate contract management and are responsible for ensuring that the board is fully updated on the law. This article provides some practical tips for practitioners, focusing particularly on the Supreme Court’s consolidated decisions of Cavendish Square Holding BV v Talal El Makdessi (Cavendish) and ParkingEye Ltd v Beavis [2015] UKSC 67 (Parking Eye) on the validity of the penalty and payment clauses. The judgment has significant practical lessons for those negotiating commercial contracts or attempting to impose charges for defaults in consumer arrangements. Company secretaries and contract administrators are recommended to review their contract management practices in the light of these rulings.

The rules on penalties 

The UK Supreme Court judgment concerned two appeals; the first appeal (Cavendish) was a complex dispute between sophisticated commercial parties, and the second (Parking Eye) was a consumer contract claim of a modest car parking charge in Britain.

The classic test in Dunlop Pneumatic Tyre Co Ltd (Dunlop) [1915] AC79, provides that a penalty payment for a specified sum is generally unenforceable. Cavendish involved the breach of a multi-million dollar commercial contract for the sale of shares in the largest advertising and marketing communications group in the Middle East. Both parties retained teams of experienced lawyers. As part of the sale, the defendant (seller) had contracted with a number of restrictive covenants preventing him from competing against the interests of the group. But he breached those covenants and Cavendish withheld further payments under the contract with a forced transfer for no consideration or at undervalue. The defendant contended those clauses amount to an unenforceable penalty.

But the Supreme Court ruled that the clauses were constructed as the ‘conditional primary obligations’ and so they did not engage the penalty rule. It was concluded that ‘the buyer had a legitimate interest in enforcing the covenants, in order to protect the goodwill of the business, and the parties themselves were the best judges of how that interest should be reflected in the agreement’.

In Parking Eye, the defendant disputed a parking charge of £85 for overstaying in a car park. This case did engage the penalty clause as the Supreme Court unanimously ruled that the parking charge did not infringe the rule against penalties and unfair terms for consumer transactions. First, it was ‘not out of all proportion to the legitimate social and economic interest’ which the car park operator had in preventing long over-stays in the car park. It facilitated an efficient use of the car park in the interests of retailers and their customers by deterring long-stay commuters. Second, it generated income for Parking Eye in return for running the scheme smoothly.

Impact on commercial transactions

The current approach after the judgments discussed above has apparently widened the tasks of courts, thus making litigation on penalty charges more costly and lengthy. It seems that more court time is needed to determine issues such as whether the clause is out of all proportion to the innocent party’s legitimate interest in enforcing the counterparty’s obligations under the contract. If so it will be unenforceable, but whether a clause is out of proportion to that interest may be open to debate in many cases.

Practical contractual risk management implications for company secretaries  

The landmark judgment of the Supreme Court discussed above is likely to expand the standard and scope of Dunlop’s test to establish whether a sum payable on breach constitutes an unenforceable penalty or not. The sums constituting a ‘genuine pre-estimate of loss’ seem to have been expanded by new factors, namely, the primary and secondary obligations of the contract.

It has now become important to consider documenting and inserting clauses to justify the commercial rationale for certain provisions on legitimate interest to perform the contract. Company secretaries would be in the best position to document those terms, either in the clauses or recitals, or by keeping a record of the negotiations and minutes of meetings.

Since the courts may now consider the wider commercial context of a transaction, company secretaries may need to take a more proactive role in documenting contractual negotiations Even if the amount required by a clause bears no direct relationship to the loss actually attributable to the breach, it would not necessarily be a penalty if it can be shown that there is a legitimate reason why compensation for the actual loss suffered would not be sufficient.

The courts appear to prefer not to uphold payment provisions where the alleged amount to be paid would be ‘disproportionate to the loss attributable to the breach’.

Proactive contract management

Company secretaries should consider regular reviews of their payment terms stated in corporate contracts and contractual manuals. Company secretaries can play a significant role in:

  • effectively administering contracts and arranging a regular contractual compliance audit
  • alerting boards to update contracts as necessary to reflect the revised/updated approach to protecting corporate legitimate interests as stated above, and
  • seeking professional advice to identify any possible contractual risks or loopholes that may result from the new approach of the courts.

Emphasising legitimate interests in the drafting of relevant clauses has become more important. This is obvious particularly in the situation of where the interests, and the sanction for breach, go beyond straightforward damages for (in effect) direct losses. An insertion of a rider clause will also help building in any material information (for example the legitimate interest to protect the target’s goodwill in M&As) proving that, even where there is a legitimate interest, the remedy stipulated is not, in the circumstances, extravagant or unconscionable.

Increased role of company secretaries 

The above Supreme Court judgment will have a significant impact on the formation of contracts and the remedies available on breach of contracts in Hong Kong. Since Hong Kong’s law has a strong link with the common law framework, the judgment will be highly persuasive and will be likely to be followed in Hong Kong. It will be interesting to see whether any forthcoming local court decision will accept the arguments and endorse the findings of Cavendish and Parking Eye. Such an endorsement would be a welcome development in the contract law of penalties in Hong Kong, thus resulting in a more realistic commercial
and practical financial context. No doubt, Hong Kong company secretaries and contract administrators will play a key role in contract management, thus maintaining Hong Kong as a world class financial centre.

Zoe Chan So Yuen FCS, FCIS, LLM, MCIArb