Singapore Court of Appeal affirms long-standing Dunlop test for contractual penalties

28 January 2021

Denka Advantech Pte Ltd & Anor v Seraya Energy Pte Ltd & Anor and other appeals [2020] SGCA 119

In Denka Advantech Pte Ltd & Anor v Seraya Energy Pte Ltd & Anor, the Singapore Court of Appeal affirmed that the test for what amounts to a penalty clause (“Penalty Test”) remains as that formulated in Dunlop Pneumatic Tyre Company, Limited v New Garage and Motor Company, Limited [1915] AC 79 (“Dunlop”), i.e. whether the clause concerned provides a genuine pre-estimate of the likely loss as assessed at the time of contracting. In so holding, the Court of Appeal declined to adopt the wider legitimate interest standard developed by the UK Supreme Court in Cavendish Square Holding BV v Makdessi [2016] AC 1172 (“Cavendish”). The Court of Appeal also held that the Penalty Test applies only in the context of a breach of contract.

Background

The dispute centred mainly on alleged repudiatory breaches by Denka Advantech Pte Ltd (“DAPL”) or Denka Singapore Pte Ltd (“DSPL”) (collectively, “Denka”) of three electricity retail agreements (“ERAs”) entered into between Seraya Energy Pte Ltd (“Seraya”) on the one hand and DAPL or DSPL on the other, pursuant to which Seraya supplied electricity to Denka’s premises. Each ERA contained a liquidated damages (“LD”) clause, which was tied, among other things, to Seraya’s express contractual right to terminate the ERAs under various scenarios, but most notably for any breach by Denka of its obligations under the ERAs. The formula in the LD clauses stipulated a payment of 40% of the remaining contract value as determined by the average monthly payments around the time of termination.

Seraya began supplying electricity under the ERAs on 1 September 2012. The ERAs were due to expire on 31 January 2021. However, in August 2014, Denka indicated that it no longer wished to purchase electricity under the ERAs. Seraya thus terminated the ERAs and in December 2014, Seraya commenced action against DAPL and DSPL for breaches of their respective ERAs, and sought LD or common law damages in the alternative.

At first instance, the High Court applied the Dunlop test and rejected Seraya’s claims under the LD clauses on the basis that the LD clauses were not a genuine pre-estimate of Seraya’s damage. Thus, the High Court decided that the LD clauses were unenforceable penalty clauses (although Seraya was awarded common law damages). Seraya appealed to the Court of Appeal, contending among other things that the LD clauses were enforceable.

Decision of the Court of Appeal

Denka’s main argument was that the LD clauses were unenforceable penalty clauses. To determine the issue, the Court of Appeal embarked on a survey of the legal principles governing the Penalty Test in major Commonwealth jurisdictions, focusing on (a) the scope of the Penalty Test, and (b) the substance of the Penalty Test.

The Court of Appeal noted that until recently, Dunlop had been the seminal case on the Penalty Test across the common law world. In 2012, however, the High Court of Australia in Andrews & Ors v Australia and New Zealand Banking Group Limited (2012) 247 CLR 205 (“Andrews”) held that the scope of the Penalty Test was not limited to clauses operating only upon a breach of contract, but also applied to any term being in the nature of a security or collateral to ensure the fulfilment of some primary stipulation. Shortly thereafter, in 2015, the UK Supreme Court in Cavendish reformulated the substance of the Penalty Test such that a clause was a penalty only if it was a secondary obligation imposing a detriment on the contract breaker “out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation”. Significantly, such “legitimate interest” need not be an interest in compensation only and could include wider “commercial interests”.

Scope of Penalty Test

The Court of Appeal declined to follow Andrews, reasoning that the Penalty Test had been developed in relation to a very specific situation relating to the enforcement of penal bonds and that an extension of the Penalty Test to all modern contracts would vest in the courts a wide and uncertain discretion. Moreover, such a discretion would permit the courts to review a wide range of clauses on substantive grounds, thus constituting a general, uncertain and significant legal incursion into the freedom of contract. The Court of Appeal preferred to limit the Penalty Test to situations involving a breach of contract because this would confine the Penalty Test to the sphere of secondary obligations only, specifically, the defendant’s obligation to pay damages to the plaintiff. In this regard, the parties’ primary obligations would not be interfered with at all.

Substance of Penalty Test

The Court of Appeal declined to follow the legitimate interest approach in Cavendish and endorsed the statement of principles set out in Dunlop on the basis that the test as to whether the contractual provision concerned provided a genuine pre-estimate of the likely loss is wholly consistent with the fact that the focus is on the secondary obligation on the part of the defendant to pay damages by way of compensation. Furthermore, the concept of “legitimate interest” was a very general concept that could be used too flexibly, leading to much uncertainty both before the entry into the contract concerned as well as with regard to the specific result arrived at by the court thereafter.

Application to the facts

Having found that Denka had breached the ERAs, the Court of Appeal proceeded to consider whether the LD clauses in the ERAs were indeed penalties. On the facts, the LD clauses in the ERAs were secondary obligations. The Penalty Test was thus appropriately applied in the circumstances.

Applying Dunlop, the Court of Appeal found that the sum stipulated for in the LD clauses was not “extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved to have followed from the breach”.

Although the LD clauses appeared to violate the single lump test because they applied to a variety of situations of differing importance and consequence, this only gave rise to a rebuttable presumption that the LD clauses were penalties. The Court of Appeal was satisfied that this presumption was rebutted as the LD formula was expressed as a proportion of the contract sum which Seraya would have received had the ERAs been fulfilled, and the 40% multiplier was a reasonable one on the expert evidence.