08th March 2019

INTRODUCTION

For the longest of time, when there is a breach of contract, the innocent party cannot per se recover the Liquidated Ascertain Damages (“LAD”, also commonly known as “LD clause”, “damage clause” or “penalty clause”) stipulated in the contract simpliciter. The innocent party is only entitled to the actual damages/losses suffered and proven in court.

Recently, the Federal Court, i.e. the Malaysian Apex Court, had in the case of Cubic Electronics Sdn Bhd (In Liquidation) v Mars Telecommunication Sdn Bhd  [Appeal No. 02(f) – 64 – 09/2016 (W)] (“Cubic Electronic”) revisited the laws on Section 75 of Contracts Act 1950 and brought about drastic changes on the present state of law.

ISSUE

The stipulation of LAD is governed by Section 75 of Contracts Act 1950 which provides that:-

“When a contract has been broken, if a sum is named in the contract as the amount to be paid in case of such breach, or if the contract contains any other stipulation by way of penalty, the party complaining of the breach is entitled, whether or not actual damage or loss is proved to have been caused thereby, to receive from the party who has broken the contract reasonable compensation not exceeding the amount so named or, as the case may be, the penalty stipulated for.”

PRE-CUBIC ELECTRONIC

Previously, in the case of Selva Kumar Murugiah v Thiagarajah Retnasamy [1995] 1 MLJ 817, the Federal Court adopted a restrictive approach in interpreting Section 75 and held that the innocent party must prove the actual damage incurred or reasonable compensation in accordance with the settled legal principles. The only exception to this rule is when it is difficult to assess the actual damage suffered.

Of particular importance, the Federal Court in Selva Kumar held that the literal construction of Section 75 is undesirable as it would dispense with the need of proving actual losses / damages incurred:-

“In the first place, such a literal construction would seem to be beyond the object of the section in question, viz the abolition of the distinction between a penalty and liquidated damages; secondly, it will produce a most unreasonable result in that it will change the existing law which is that if a plaintiff seeks to recover damages for the actual damage caused, he ought to prove them, unless he is content with the symbolic award, eg of nominal damages, for any infraction of his rights under a contract. This even seems to be a rule of some antiquity.

 

We hold first, that the literal construction should not be strictly adhered to and the words in question should be given a restricted or limited construction though the language used in the words in question expresses really no circumscription of the area of operation.”

THE FEDERAL COURT DECISION IN CUBIC ELECTRONIC

Having considered the cases of Selva Kumar and Johor Coastal Development Sdn Bhd v Constrajaya Sdn. Bhd [2009] 4 CLJ 569 (which reaffirmed the position of Selva Kumar), the Federal Court found that there is no need to prove actual loss or damage incurred where there is a LAD clause in the contract:-

“65. With respect and for reasons we shall set out below, we are of the view that there is no necessity for proof of actual loss or damage in every case where the innocent party seeks to enforce a damages clause. Selva Kumar (supra) and Johor Coastal (supra) should not be interpreted (as what the subsequent decisions since then have done) as imposing a legal straightjacket in which proof of actual loss is the sole conclusive determinant of reasonable compensation. Reasonable compensation is not confined to actual loss, although evidence of that may be a useful starting point.”

Following therefrom, the court held that the onus that lies on the innocent party is merely to adduce evidence to show that there was, in fact, a breach of contract and the LAD clause would then be activated:-  

“70. We turn now to the issue on burden of proof. The initial onus lies on the party seeking to enforce a clause under section 75 of the Act to adduce evidence that firstly, there was a breach of contract and that secondly, the contract contains a clause specifying a sum to be paid upon breach. Once these two elements have been established, the innocent party is entitled to receive a sum not exceeding the amount stipulated in the contract irrespective of whether actual damage or loss is proven, subject always to the defaulting party proving the unreasonableness of the damages clause including the sum stated therein, if any.”

Having said that, the Federal Court nevertheless held that the breaching party is still able to defeat the LAD clause by proving that the sum stipulated therein is unreasonable or exorbitant:-

“71. If there is a dispute as to what constitutes reasonable compensation, the burden of proof falls on the defaulting party to show that the damages clause is unreasonable or to demonstrate from available evidence and under such circumstances what comprises reasonable compensation caused by the breach of contract. Failing to discharge that burden, or in the absence of cogent evidence suggesting exorbitance or unconscionability of the agreed damages clause, the parties who have equality of opportunity for understanding and insisting upon their rights must be taken to have freely, deliberately and mutually consented to the contractual clause seeking to pre-allocate damages and hence the compensation stipulated in the contract ought to be upheld.”

WHEN WOULD A LAD CLAUSE BE UNREASONABLE, UNCONSCIONABLE OR EXORBITANT?

Having decided that the breaching party may defeat a LAD clause by showing that the LAD stipulated in the contract is unreasonable and exorbitance, the Federal Court proceeded to endorse the methodology propounded in the celebrated English case of Cavendish Square Holding BV v Talal El Makdessi [2015] UKSC 67.  

In essence, the court will first consider what is the ‘legitimate commercial interest’ the LAD clause seeks to protect from in the event of a breach. The Court will then compare and evaluate whether the LAD sum provided for is proportionate with the interest the LAD clause seeks to protect from:-

“57. Thus, under English law, the current approach is that in determining whether a damages clause in a contract amounts to a penalty, courts must first consider whether any “legitimate commercial interest” in performance extending beyond the prospect of pecuniary compensation flowing from the breach is served or protected by a damages clause and then evaluate whether the provision made for the interest is proportionate to the interest identified. And the overall common denominators that must be further identified by the courts are whether the damages clause:

 

(i) is a secondary obligation and not a primary obligation which would be enforceable per se;

(ii) which imposes a detriment on the contract-breaker; and

(iii) which is out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation.

               …

 

66. As for our reasons we begin by saying that in view of the legislative history of section 75 of the Act which need not be elaborated in this Judgment, we are of the considered opinion that there is nothing objectionable in holding that the concepts of “legitimate interest” and “proportionality” as enunciated in Cavendish (supra) are relevant in deciding what amounts to “reasonable compensation” as stipulated in section 75 of the Act. Ultimately, the central feature of both the Cavendish case (supra) and section 75 of the Act is the notion of reasonableness. Indeed, the ParkingEye v Beavis [2015] UKSC 67 judgment is replete with instances where the United Kingdom Supreme Court conflated “proportionality” with “reasonableness” (see: ParkingEye (supra) at paragraphs [98], [100], [108], [113] and [193]).

…

 

68. Consequently, regardless of whether the damage is quantifiable or otherwise, it is incumbent upon the court to adopt a common sense approach by taking into account the legitimate interest which an innocent party may have and the proportionality of a damages clause in determining reasonable compensation. This means that in a straightforward case, reasonable compensation can be deduced by comparing the amount that would be payable on breach with the loss that might be sustained if indeed the breach occurred (emphasis added). Thus, to derive reasonable compensation there must not be a significant difference between the level of damages spelt out in the contract and the level of loss or damage which is likely to be suffered by the innocent party.”

ISSUE OF FORFEITURE OF DEPOSIT

Corollary to the foregoing, the Federal Court further held that Section 75 applies to the forfeiture of deposits:-

“45. As such, the courts in the United Kingdom and India have held that presently the principles of law on damages clause are equally applicable in relation to forfeiture of deposits instead of the mutually exclusive approach. We are therefore inclined to hold that the time has come for our courts to adopt a similar approach. After all section 75 of the Act and section 74 of the Indian Contract Act 1872 are in pari material”.

Following thereto, a deposit which possesses the dual characteristic of earnest money and part payment, is subject to the same test discussed hereinabove.

EFFECT OF THE DECISION

Following the Federal Court’s decision, when there is a LAD clause or where the contract provides for a sum forfeitable in the event of a breach, the innocent party is merely required to prove there was a breach of contract.

On the other hand, in an attempt to defeat the LAD clause, the Federal Court decision imposes the onerous burden on the breaching party to show that the provision of the LAD is disproportionate with the commercial interest of the LAD clause that seeks to guarantee the performance of the contract.

Bearing in mind that the LAD sum was mutually agreed by the parties, the breaching party may face an uphill task to displace the LAD sum.

COMMENTARY

The decision of Cubic Electronics illustrates a shift in the judicial attitude where the court appears reluctant to interfere with the parties’ autonomy and freedom to contract save for exceptional circumstances where the damage clause / LAD clause is unconsciously high and exorbitant.

Having said the above, it ought to be pointed out that the Federal Court did not expressly overrule the case of Selva Kumar and Johor Coastal Development, and merely noted in passing that the decisions ought not be interpreted as a straightjacket requiring the actual loss to be proven.

It remains to be seen how the court will reconcile these two contrasting line of decisions and with the clear wording of Section 75 which provides that the amount named in the contract is merely a ceiling cap on the maximum recoverable amount.

Notwithstanding the above, an interesting point to note is that the introduction of Section 75 Contracts Act 1950 was intended to do away the complicated rules of penalty. With that in mind, has the decision of Cubic Electronics subtly reintroduced the rule of penalty back into the Malaysian jurisprudence, despite it being couched as a test of reasonableness/proportionality?

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