A discussion of Hon Chin Kong v Yip Fook Mun and another
The Singapore High Court recently had to consider whether the penalty rule applies to deposits in its decision in the case of Hon Chin Kong v Yip Fook Mun and another.
The two tests
The Dunlop Formulation
In Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd ("Dunlop"), the UK House of Lords confirmed that a penalty (as opposed to liquidated damages which are a genuine pre-estimate of loss), is essentially a sum of money so extravagant or unconscionable in comparison with the greatest loss that could possibly result from the breach of contract1. The Dunlop formulation is predicated on the idea that the sole purpose of a liquidated damages clause is to compensate an innocent party for losses arising from a breach of contract. Hence, a liquidated damages clause that seeks to compensate the innocent party for a sum greater than the sum which ought to have been paid (i.e. not a genuine pre-estimate of loss) would necessarily be penal and correspondingly, unenforceable.
The Cavendish Formulation
On the other hand, the UK Supreme Court in Cavendish Square Holding BV v Talal El Makdessi ("Cavendish") reformulated the Dunlop formulation. According to Cavendish, a distinction must first be made between:-
(1) Primary obligations, (i.e. obligations to imposed on each party to procure whatever he has promised to do); and
(2) Secondary obligations (i.e. obligations to pay monetary compensation for losses sustained in consequence of a breach of contract).
According to Cavendish, a provision is penal if it is a secondary obligation which imposes a detriment on the contract-breaker out of all proportion to any "legitimate interests" of the innocent party. The Cavendish formulation is wider than the Dunlop formulation given that it allows for consideration of contractual purposes beyond the desire to recover compensation for a breach (including but not limited to considerations of "commercial interests")2, as opposed to Dunlop formulation, which only considers the compensatory nature of the clause.
Hon Chin Kong v Yip Fook Mun and another ("Hon Chin Kong")
The Plaintiff sought to acquire from the Defendants their shares in a company (the "Shares"). The Plaintiff proposed to make payment to the Defendants for the Shares in three tranches. The Defendants agreed to the Plaintiff's proposed payment arrangement, stipulating, inter alia, that the first tranche payment is to be paid as a "down payment deposit". Eventually, the Plaintiffs only made payment of the first tranche payment, and when the contemplated sale of the Shares fell through, the Plaintiff commenced the suit to demand for the return of the first tranche payment.
The High Court noted that where a plaintiff (i.e. the purchaser) sued for the return of a deposit, the following analysis must be taken:-
(1) The first question was whether the Defendant (i.e. the vendor) was contractually entitled to forfeit the "deposit";
(2) If there was no contractual right to forfeit, the Plaintiff (i.e. the purchaser) could sue to recover the sum in unjust enrichment, subject to a right of set-off for damages.
(3) If there was a contractual right to forfeit, the next question was whether the sum was a true deposit (i.e. whether the sum was reasonable and can be objectively justified as a signal of serious intent on the purchaser's part).
On the facts of Hon Chin Kong, the High Court held that:-
(1) There was a contractual right to forfeit the first tranche payment in the event of the Plaintiff's repudiation; and
(2) The first tranche payment was a true deposit.
Accordingly, the High Court had to assess whether the penalty rule applies to true deposits. In this regard, the High Court made the following observations / holdings:-
(1) The High Court remained bound by the Singapore Court of Appeal's endorsements of the Dunlop formulation in the previous case of Xia Zhengyan v Geng Changqing. Accordingly, the Dunlop formulation remained the applicable test for penalties in Singapore.
(2) The Dunlop formulation does not apply to a true deposit because:-
(a) Unlike a liquidated damages clause which is remedial and serves to predetermine damages paid in event of breach, a deposit serves a different purpose of signalling the purchaser's attitude towards the purchase.
(b) The public policy reasons that apply to a liquidated damages clause (i.e. saddling the contract-breaker with payment of an unconscionable sum of money would be too oppressive and punitive and should accordingly justify departing from the parties' pre-agreed sum stipulated in the liquidated damages clause) do not apply to forfeiture of deposits upon breach (provided that it is customary or moderate). In fact, the forfeiture of deposits allows the purchasers to escape from his previous communication to the seller of his ability to fulfil the contractual obligations.
(3) Accordingly, if the sum was a true deposit, it could be forfeited regardless of whether the deposit was proportionate to the vendor's loss.
The High Court further observed that its analysis was made in the context that the Dunlop formulation (which is narrower than the Cavendish formulation) remained the applicable law in Singapore. To the extent that it is suggested that the Cavendish formulation applies to true deposits, the applicability of the penalty rules to true deposits may need to be re-visited if the Cavendish formulation is subsequently adopted by the Singapore Court of Appeal.
Hon Chin Kong is interesting because:-
(1) The Singapore Court of Appeal has not had a chance to consider the Cavendish formulation;
(2) However, prior to Hon Chin Kong, the High Court had in other instances3 considered and applied the Cavendish formulation. Hon Chin Kong marks an arguably sudden departure from the aforementioned trend of applying the Cavendish formulation in relation to the law of penalties.
(3) According to Hon Chin Kong, the law of penalties (i.e. the Dunlop formulation) does not apply to true deposits. This observation was made even though it has been suggested that the Cavendish formulation may be wide enough to apply to true deposits.
It remains to be seen whether the Singapore Court of Appeal would adopt the Cavendish formulation as the applicable test for penalties and correspondingly whether the penalty rules will apply to true deposits. In the event that the Cavendish formulation is adopted, it may well mean that a deposit so large such that it imposes a detriment on the contract breaker out of all proportion to any "legitimate interests" of the innocent party may be considered penal and therefore cannot be forfeited.