9 February 1993
Judicial Committee of the Privy Council
Lord Templeman, Lord Goff of Chieveley, Lord Browne-Wilkinson, Lord Woolf, and Sir Christopher Slade
LORD WOOLF: This appeal, from the decision of the Court of Appeal of Hong Kong of 24 April 1991 [(1991) 58 BLR 112] with the leave of that court, raises the issue as to the approach which the courts should adopt in determining whether a clause in a commercial contract is unenforceable as being penal in effect
The decision was given in proceedings commenced by Philips Hong Kong Ltd ("Philips") by originating summons. The purpose was to obtain a ruling of the Hong Kong High Court upon the provisions contained in a contract which Philips had entered into with the Government of Hong Kong in connection with the construction of a highway project known as "Route 5" between Tsuen Wan and Sha Tin. The contract contained an arbitration clause and the present proceedings were initiated by Philips to obtain the ruling of the court on preliminary issues prior to arbitration. In the High Court Mayo J [(1990) 50 BLR 122] found in favour of Philips and on their application declared in effect that:
(i) the sums set out in an appendix to a contract made under seal dated 24 November 1986 between the plaintiff and the Government of Hong Kong, the reference of which is Contract No HY/85/09, (hereinafter referred to as "the Philips Contract") as the amount of liquidated damages for delay, when operated in conjunction with clause 29 of its Conditions were capable of operating as a penalty;
(ii) clause 29 was void for uncertainty and unenforceable;
(iii) the plaintiff was under no liability to pay or allow to the defendant any sum as liquidated damages for any part of the contract works.50
However, the Court of Appeal allowed the Government's appeal, quashed the declarations granted by Mayo J and gave Philips leave to appeal.
The nature of the Philips contract.
The contract works included the design, supply, testing, delivery, installation and commissioning of a processor based supervisory system for the approach roads and twin tube tunnels which were to be constructed under Smuggler's Ridge and Needle Hill Mountains in the New Territories as part of the Shing Mun Section of the project.
Instead of adopting the more usual course of employing a main contractor with overall responsibility for constructing the Shing Mun Section and allowing the main contractor to sub-contract portions of the contract, the Government entered directly into a total of seven separate contracts, the designated contracts, including the Philips contract. By dealing directly with the contractors the Government was seeking to exercise greater control over the whole project than would be possible under a single overall contract. The total value of the seven contracts was over HK$649 million while the Philips contract alone involved over HK$51 million. The Philips contract was contained in four books and included a substantial number of standard provisions used by the Government an other projects.
Apart from contract HY/85/07 which dealt with landscaping, each of the contracts, which were described as the designated contracts, contained its own individual programme for the progress of the work in the form of a flow chart. Each of the designated contracts also contained the flow charts setting out the programmes which the other contractors were required to meet. Each of the contractors should therefore have been aware of the activities on which the other contractors would be engaged at each stage of their work and the possible consequences of delay on the part of one contractor on the other contractors.
The flow charts identified as Key Dates interfaces with other contracts. Key Dates were dates which a contractor was under an obligation to meet so as to enable other contractors to continue with their work unimpeded. If those dates were not met by a contractor, then the contract specified a liability to pay liquidated damages to the Government at a daily rate. In addition the whole of the contract work was required to be completed within a specified time and, if this was not met, the contract provided that the contractor was required to pay additional liquidated damages also at a daily rate.
The Target Dates were those dates which a contractor should aim to meet in order to complete its contractual obligations on time.51
However if the Target Dates were not met no contractual liability would arise so long as the total works were completed on time.
In the case of the Philips contract, the works were to commence on the date to be notified by week 36 by the engineer and had to be completed by week 195 (a period of 160 weeks). The amount of liquidated damages which was payable for not completing the whole of the works within the specified time was $74,104 per day, a figure set out in the Appendix to the Form of Tender. That Appendix also specified the amount of the liquidated damages for delay in meeting Key Dates. The amount stated varied according to the section of the works to which they related, the sum increasing according to the number of other contractors who could be affected by the delay. Thus for the ten Key Dates identified in the flow chart the daily rate of liquidated damages was a figure which varied between HK$60,655 per day and HK$77,818 per day. The lowest figure, as would be expected, related to the first Key Date. The second lowest figure (HK$60,665) was payable in the case of six of the Key Dates where only one other contractor would be affected by delay. In the case of one Key Date two contractors could be affected and the sum payable was HK$62,568 per day; in the case of another Key Date three contractors would be affected and the rate was HK$73,017 per day. Finally there was one Key Date which would affect four contractors and the sum payable was HK$77,818 per day. While the flow charts were stated to be for "guidance only", the contract also included a schedule in Appendix 2 to the Particular Specification of the Contract which detailed the "parts of the Works that are required to be complete to a specified degree by either a Key or Target Date as indicated" (clause 1.11). The Particular Specification also expressly provided that Key Dates "are subject to liquidated damages in accordance with clause 29 of the Conditions of Contract" (clause 1.10(b)). That clause provides:
"29. LIQUIDATED DAMAGES FOR DELAY
29.1 If the Contractor shall fail to complete the Works or any Section thereof or shall fail to achieve a Specified Degree of Completion within the time prescribed by Clause 27 or extended time, or shall fail to complete or shall unduly delay the Tests on Completion then the Contractor shall pay to the Employer the sum or sums stated in the Appendix to the Form of Tender as liquidated damages for such default and not as a penalty for every day or part of a day which shall elapse between the time prescribed by Clause 27 or extended time, as the case may be, and the date of completion of the Works or the relevant Section thereof or the relevant Specified Degree of Completion.
29.2 The employer may without any prejudice to any other method of52
recovery, deduct the amount of such damages from any monies due or which may become due to the Contractor whether under this or any other Contract with the Employer.
29.3 The payment or deduction of such damages shall not relieve the Contractor from his obligation to complete the Works or from any other of his obligations and liabilities under the Contract.
29.4 If before completion of the Works, any Section of the Works is required by the Employer and capable of occupation or use by the Employer and has been confirmed by the Engineer as completed pursuant to Clause 31 (Taking Over), the liquidated damages (if any) prescribed for delay to the whole of the Works shall for any period of delay after such certification be reduced in the proportion which the value of the Section so certified bears to the whole of the Works:
Provided that - ...
Notwithstanding any provisions of this Clause or of the Contract providing for the reduction in liquidated damages for the early completion of any Section of the Works the resulting amount of liquidated damages shall not be less than the minimum amount of liquidated damages as stated is [sic] the Form of Tender."
The court's approach to liquidated damages provisions in contracts
Although there is a good deal of disagreement as to how the penalty jurisdiction grew up (see the Law Commission Working Paper No 61, Penalty Clauses and Forfeiture of Monies Paid) it is recorded in the judgment of Kay LJ in Law v Local Board of Redditch [ 1892] 1 QB 127 at page 133 that originally it was by the Courts of Equity that relief was granted. They did so where a sum of money was agreed to be paid as a penalty for non-performance of a collateral contract where the actual damage which would be sustained could be estimated. In such circumstances the Courts would limit the sum recoverable to the actual loss suffered. The principle would be applied in particular where the penalty was agreed to be paid for the non-payment of a sum of money under a bond. This limited application of the principle was subsequently extended to other situations by the courts of common law, but the principle was always recognised as being subject to fairly narrow constraints and the courts have always avoided claiming that they have any general jurisdiction to rewrite the contracts that the parties have made.56
Guidance as to what are the constraints is authoritatively set out in the speech of Lord Dunedin in Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co  AC 79, at page 86, when he said:
"... I shall content myself with stating succinctly the various propositions which I think are deducible from the decisions which rank as authoritative:
1. Though the parties to a contract who use the words 'penalty' or 'liquidated damages' may prima facie be supposed to mean what they say, yet the expression used is not conclusive. The Court must find out whether the payment stipulated is in truth a penalty or liquidated damages. This doctrine may be said to be found passim in nearly every case.
2. The essence of a penalty is a payment of money stipulated as in terrorem of the offending party; the essence of liquidated damages is a genuine covenanted pre-estimate of damage (Clydebank Engineering and Shipbuilding Co v Don José Ramos Yzquierdo y Castaneda  AC 6.)
3. The question whether a sum stipulated is penalty or liquidated damages is a question of construction to be decided upon the terms and inherent circumstances of each particular contract, judged of as at the time of the making of the contract, not as at the time of the breach (Public Works Commissioner v Hills  AC 368 and Webster v Bosanquet  AC 394).
4. To assist this task of construction various tests have been suggested, which if applicable to the case under consideration may prove helpful, or even conclusive. Such are:
(a) It will be held to be penalty if the sum stipulated for is extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved to have followed from the breach. (Illustration given by Lord Halsbury in Clydebank case [ 1905] AC 6).
(b) It will be held to be a penalty if the breach consists only in not paying a sum of money, and the sum stipulated is a sum greater than the sum which ought to have been paid (Kemble v Farren (1829) 6 Bing 141)...
(c) There is a presumption (but no more) that it is penalty when 'a single lump sum is made payable by way of compensation, on the occurrence of one or more or all of several events, some of which may occasion serious and others but trifling damage' (Lord Watson in Lord Elphinstone v Monkland Iron and Coal Co (1886) 11 App Cas 332).
On the other hand:57
(d) It is no obstacle to the sum stipulated being a genuine pre--estimate of damage, that the consequences of the breach are such as to make precise pre-estimation almost an impossibility. On the contrary, that is just the situation when it is probable that pre--estimated damage was the true bargain between the parties (Clydebank case  AC 6 per Lord Halsbury at page 11; Webster v Bosanquet, per Lord Mersey at "page 398)."
Lord Denning did criticise this restricted view of the application of the principle in Bridge v Campbell Discount Co  AC 600 at page 629, but his views were not shared by the other members of the House. Furthermore although Lord Denning stressed the equitable nature of the courts' powers, the main subject of his strictures was the conclusion that, if a hirer under a hire purchase agreement lawfully terminated the agreement, he would not be able to say the sum then payable by him according to the terms of the agreement was a penalty, but he would be able to do so in respect of the very same term if the agreement was terminated in consequence of his breach of contract. This he understandably described as the "absurd paradox".
That "paradox" does not arise for consideration on this appeal. It was however considered by the High Court of Australia in AMEV UDC Finance Ltd v Austin (1986) 162 CLR 170, a case to which reference is made, not for its treatment of that subject but for the general approach which was adopted as to what should be the approach of the court to alleged penalties. It was a case in which a finance company tried unsuccessfully to rely on general equitable principles relating to relief against penalties as against guarantors of a hirer when the finance company had determined a hiring agreement. Mason and Wilson JJ in a joint judgment, having admirably surveyed the decisions as to penalties decided both in this country and in other Commonwealth countries, referred to the advantages of allowing the parties to contracts greater latitude to determine for themselves the consequences of breaches or the termination of their contracts, and then went on to say (page 193):
"But equity and the common law have long maintained a supervisory jurisdiction, not to rewrite contracts imprudently made, but to relieve against provisions which are so unconscionable or oppressive that their nature is penal rather than compensatory. The test to be applied in drawing that distinction is one of degree and will depend on a number of circumstances, including (1) the degree of disproportion between the stipulated sum and the loss likely to be suffered by the plaintiff, a factor relevant to the oppressiveness of the term to the defendant, and (2) the nature of the relationship between the contracting parties, a factor relevant to the unconscionability of the58
plaintiff's conduct in seeking to enforce the term. The courts should not, however, be too ready to find the requisite degree of disproportion lest they impinge on the parties' freedom to settle for themselves the rights and liabilities following a breach of contract. The doctrine of penalties answers, in situations of the present kind, an important aspect of the criticism often levelled against unqualified freedom of contract, namely the possible inequality of bargaining power. In this way the courts strike a balance between the competing interests of freedom of contract and protection of weak contracting parties: see generally Atiyah, The Rise and Fall of Freedom of Contract (1979), especially Chapter 22."
It should not be assumed that, in this passage of their judgment, Mason and Wilson JJ were setting out some broader discretionary approach than that indicated as being appropriate by Lord Dunedin. On the contrary, earlier in their judgment they had noted that the "Dunlop approach" had been eroded by recent decisions and they stated that there was much to be said for the view that the courts should return to that approach. This is confirmed by the later decision of the Australian High Court in Esanda Finance Corporation Ltd v Plessnig  ALJ 238. In that case, it should be noted that, according to the headnote, the first holding was that, as "it had not been shown that the amount claimed ... was out of all proportion to, or extravagant or unconscionable in comparison with, the greatest loss that could conceivably be proved to have followed from the breach, a basic test for the existence of a penalty had not been satisfied". Wilson J, in giving the first judgment with Toohey J, cited, with implicit approval, the view of Dickson J in the Supreme Court of Canada in Elsey v J G Collins Insurance Agencies Ltd (1978) 83 DLR at page 15 where he said:
"It is now evident that the power to strike down a penalty clause is a blatant interference with freedom of contract and is designed for the sole purpose of providing relief against oppression for the party having to pay the stipulated sum. It has no place where there is no oppression."
Such views are in accord with those expressed by Lord Justice Diplock in Robophone Facilities Ltd v Blank [ 1966] 1 WLR 1428. He said (at page 1447) that the "court should not be astute to descry a 'penalty clause"'. These statements assist by making it clear that the court should not adopt an approach to provisions as to liquidated damages which could, as indicated earlier, defeat their purpose.
Except possibly in the case of situations where one of the parties to the contract is able to dominate the other as to the choice of the terms of a contract, it will normally be insufficient to establish that a59
provision is objectionably penal to identify situations where the application of the provision could result in a larger sum being recovered by the injured party than his actual loss. Even in such situations so long as the sum payable in the event of non-compliance with the contract is not extravagant, having regard to the range of losses that it could reasonably be anticipated it would have to cover at the time the contract was made, it can still be a genuine preestimate of the loss that would be suffered and so a perfectly valid liquidated damage provision. The use in argument of unlikely illustrations should therefore not assist a party to defeat a provision as to liquidated damages. As the Law Commission stated in Working Paper No 61 (page 30):
"The fact that in certain circumstances a party to a contract might derive a benefit in excess of his loss does not . . . outweigh the very definite practical advantages of the present rule upholding a genuine estimate, formed at the time the contract was made of the probable loss."
A difficulty can arise where the range of possible loss is broad. Where it should be obvious that, in relation to part of the range, the liquidated damages are totally out of proportion to certain of the losses which may be incurred, the failure to make special provision for those losses may result in the "liquidated damages" not being recoverable. (See the decision of the Court of Appeal on very special facts in Ariston SRL v Charly Records Ltd (1990) The Independent 13 April 1990.) However, the court has to be careful not to set too stringent a standard and bear in mind that what the parties have agreed should normally be upheld. Any other approach will lead to undesirable uncertainty especially in commercial contracts.