Legal update: The Hong Kong Court of First Instance confirms penalty rule in an employment contract following decision in Law Ting Pong Secondary School v. Chen Wai Wah  CA 87304May2023
Many employers may want to bind an employee for a certain period of time, by including a clause in employment contacts that requires the employee to pay wages for the balance of the fixed term should they terminate employment before the fixed term ends. However, such a clause may risk being challenged as a penalty clause and hence being struck down.
The recent Court of First Instance (“CFI”) case of Ng Yan Kit Alfred and Another v. Ever Honest Industries Ltd and Another  HKCFI 1834 applied, in an employment contract context, the principles established in the Court of Appeal in Law Ting Pong Secondary School v. Chen Wai Wah  CA 873 reflecting the modern judicial approach in the application of the penalty rule.
In Ng, the claimant, Mr. Ng, was a vice president and director of the defendant companies. In January 2016, he signed a letter of employment with the first defendant which contained a clause (“Subject Clause”) stating:
“The Group cannot dismiss you within three years upon the commencement of this employment agreement. If the Group dismisses you within three years after this employment agreement commences, you will be paid two whole years’ salary as compensation. If this employment is terminated by you within three years, one month’s written notice or one month’s salary in lieu of notice is required, and after resignation, you will not be allowed to work in an organisation that is in the same or relevant industry, or the compensation of two whole years’ salary will not be granted.”
In the Subject Clause, the employee potentially benefitted from the liquidated damages provision, not vice versa. However, the principles are applicable to either party.
Mr Ng was dismissed by the first defendant on 1 April 2016, and upon the termination of his employment, only three months’ salary was paid to him as payment in lieu of notice. Mr Ng subsequently brought a claim in the Labour Tribunal (“LT”) for a sum equivalent to 24 months’ salary on the basis of the Subject Clause.
Mr Ng’s case was dismissed at the LT, so he appealed to the CFI. The issue before the CFI was whether the Subject Clause was a valid liquidated damages clause or void as an unenforceable penalty clause.
In terms of determining the nature of the Subject Clause, the CFI has confirmed the two-step inquiry approach in Law.
- Is the Subject Clause a contractually agreed method of lawful termination of the contract constituting a primary obligation to pay, or a secondary obligation to pay arising upon the breach of a primary obligation of performance?
The penalty rule is only engaged when there had been a secondary obligation to pay arising from a breach of contract. It is not applicable to contractual provision which stipulates an obligation to pay a certain amount of money, in certain agreed circumstances, by way of a primary obligation.
- In the event that the payment is a secondary obligation, the court should move on to identify the legitimate interest of the innocent party that is being protected by the clause, and then assess whether the clause is out of proportion to such legitimate interest by considering the circumstances in which the contract was made.
The court should look at all the circumstances of the case, including the background, the reason and the purpose as to why the parties agreed on the terms in the relevant provision.
The CFI decided that
- LT had concluded the case by purely relying on the fact that there was no attempt by the parties to make a genuine pre-estimate of the loss. She had not applied the correct test in determining the nature of the Subject Clause as a penalty clause.
- LT had not conducted a proper inquiry regarding the true nature of “compensation” as agreed between the first defendant and Mr. Ng. The CFI could not make a final determination based on the available materials. The case was therefore remitted back to the LT for reconsideration.
Conclusion and Lessons
In light of Ng, employers:
- should be cautious when drafting clauses in relation to the payment of money, in particular, whether the payment is a primary obligation i.e., one of the commercial terms of the agreement or a secondary obligation relating to damages arising from a breach of contract.
- may also consider entering into a fixed-term employment contract containing a provision on early termination or for liquidated damages. If the latter, and if this arises in the event of a breach, evidence of some assessment of potential loss would assist in proving the enforceability of the clause.
- should consider achieving a similar result to a fixed term by having a longer and reducing notice period (in effect a minimum term), rather than a fixed term with “liquidated damages”, as then a breach and early termination is covered by statutory liquidated damages applicable to notice periods under sections 7 and 8A Employment Ordinance (Cap. 57), equal to the payment in lieu of notice, which does not require proof of loss and is not subject to a duty to mitigate your loss.
In order to mitigate the risk of legal disputes, employers should seek legal advice when drafting liquidated damages clauses or provisions that involve compensation or payments in circumstances of early termination.
Russell Bennett and Abby Wong
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Disclaimer: This publication is general in nature and is not intended to constitute legal advice. You should seek professional advice before taking any action in relation to the matters dealt with in this publication.