Federal Court Restates the Law on Deposits and Damages Clauses
30 April 2019
Loshini Ramarmuty and Siew Suet Mey analyse a recent landmark case on contract law.
In the recent decision of Cubic Electronics Sdn Bhd (in liquidation) v Mars Telecommunications Sdn Bhd  CLJ 723 (“Cubic Electronics”), the apex court of Malaysia revisited the principles on forfeiture of deposits and the treatment of liquidated damages clauses in contracts.
Cubic Electronics Sdn Bhd (“Cubic”) was the owner of a piece of land in Melaka together with the plant and machinery on the land (“properties”). When Cubic was wound up, the properties were put up for sale by way of an open tender exercise. Prior to the open tender exercise, Mars Telecommunications Sdn Bhd (“Mars”) offered to purchase the properties for RM90,000,000.00. Mars also offered an initial earnest deposit of RM1,000.000.00 which it paid to Cubic. The liquidators accepted Mars’s offer and did not proceed with the open tender exercise. The acceptance of Mars’s offer was subject to a term that the sale and purchase agreement (“SPA”) must be executed within 30 days from 7 October 2011, failing which the earnest deposit would be forfeited as liquidated damages and not by way of a penalty.
Forfeiture of Earnest Deposit
Mars was given a total of four extensions of time before Cubic terminated the sale. For the first and second extensions, Mars paid a further earnest deposit of RM500,000.00 each time bringing the total earnest deposit sum to RM2,000,000.00. Thereafter, Mars requested and obtained a third extension of time, subject to payment of a further earnest deposit of RM1,000,000.00 plus interest of RM40,000.00 due to the delay in making the earlier payment. When granting all extensions of time, Cubic informed Mars that if Mars fails to execute the SPA by the extended date, the earnest deposit would be forfeited as liquidated damages and not by way of a penalty. Mars was then granted a fourth and final extension of time. Mars’s request for another extension of time was refused by Cubic which then terminated the sale. Cubic further informed Mars that the sum of RM3,040,000.00 being earnest deposit and interest paid to date was forfeited. The property was subsequently sold to a third party.
High Court and Court of Appeal
Mars initiated a civil action seeking for, among others, a declaration that the termination of the sale by Cubic was wrongful and invalid. Mars further sought for the return of its deposit money and interest of RM3,040,000.00 or alternatively, RM2,040,000.00 less the first deposit of RM1,000,000.00. The High Court dismissed Mars’s claim.
The Court of Appeal ruled that the forfeiture of the RM3,040,000.00 was impermissible but allowed Cubic to forfeit RM1,000,000.00 of the earnest deposit.
Positions canvassed in the Federal Court
Cubic’s position in the Federal Court was that in the case of a deposit, section 75 of the Contracts Act 1950 (“Act”) did not apply and accordingly, it need not prove its loss before forfeiting the earnest deposit.
Mars contended that section 75 of the Act, as applied by the Federal Court in Selva Kumar a/l Murugiah v Thiagarajah a/l Retnasamay  2 CLJ 374 (“Selva Kumar”), disentitles Cubic from recovering simpliciter the sum fixed in the contract whether as penalty or liquidated damages and that Cubic must prove the damage suffered unless the sum named is a genuine pre-estimate of the loss.
The Federal Court’s Approach
In arriving at its decision, the Federal Court dealt with the primary issue of how deposits should be treated vis-à-vis section 75 of the Act. The Court went on to consider the treatment of provisions in a contract where a sum is payable on breach of contract, i.e. liquidated damages clauses.
Recovery of deposits
The Court noted that there is no statutory definition for a true deposit under the Act and therefore it was necessary for the Court to consider the principles of law applicable to forfeiture of deposits bearing in mind section 75 of the Act.
After analysing the position in various jurisdictions, the Court found that the Courts in the United Kingdom and India have held that the principles of law on damages clauses are equally applicable in relation to forfeiture of deposits and are not mutually exclusive. Therefore, the Court was of the view that the time had come for the Malaysian courts to adopt a similar approach.
As a starting point, the Court sought to distinguish between deposits that can be forfeited and those that are recoverable. A deposit which is not merely part payment but also a guarantee of performance is generally not recoverable whereas any money paid in advance of performance and as part-payment of the contract price is generally recoverable. Whether a payment is part payment of the price or a deposit is a question of interpretation that turns on the facts of the case and the usual principles of interpretation apply. Once it has been ascertained that the payment made is a deposit, the said sum is subject to section 75 of the Act. What this means is that, the next step is to determine whether the deposit sum is reasonable.
In determining whether or not the deposit is reasonable under section 75 of the Act, the concepts of “legitimate interest” and “proportionality” as enunciated in the joined cases of Cavendish Square Holding BV v Makdessi and ParkingEye v Beavis  UKSC 67 (“Cavendish”) are relevant. Once the innocent party has demonstrated that it has a legitimate interest to safeguard and that the said interest is proportionate to the interest identified, the onus then shifts to the defaulting party to show that the forfeited deposit is excessive. In short, the burden to demonstrate whether the forfeited deposit is reasonable or otherwise lies with the defaulting party.
Liquidated damages clauses
Having dealt with deposits, the Court went on to clarify the position in law in relation to the enforceability of damages clauses. The Federal Court relied heavily on the English position on liquidated damages in restating the law on liquidated damages in Malaysia.
The Cavendish Approach
In the UK, the traditional common law approach of enforcing liquidated damages clauses is as set out in Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd  AC 79 in which the House of Lords held that a liquidated damages provision would be enforceable only if the amount of liquidated damages was a reasonable estimate of the actual damage suffered by the innocent party (i.e. a genuine pre-estimate of loss). A liquidated damages clause that seeks to compensate the innocent party for a sum greater than the sum which ought to have been paid, that is, not a genuine pre-estimate of loss, would necessarily be penal and unenforceable.
Subsequently, the UK Supreme Court in Cavendish reformulated the approach to the penalty doctrine. The court distinguished between primary obligations and secondary obligations. Primary obligations are the legal obligations imposed upon each party to a contract to do what he promised would be done. A breach of the primary obligation would then lead to the secondary obligation to pay monetary compensation for the loss sustained by the innocent party. The distinction is important as the penalty doctrine does not apply to primary obligations.
The court went on to consider the concept of ‘legitimate interests’ of the innocent party. This would mean that in determining whether or not a clause is a penalty, the court is entitled to look at whether the innocent party’s ‘interests’, i.e. losses that go beyond financial losses, have been taken into account. Ultimately, the test is whether the sum or remedy stipulated is proportionate and not ‘extravagant, exorbitant or unconscionable’ having regard to the innocent party’s legitimate interest that it was designed to protect.
Restating the position in Malaysia
The Federal Court noted that section 75 of the Act had done away with the distinction between liquidated damages and penalties. Therefore, an innocent party in a contract that has been breached cannot recover simpliciter the sum fixed in a damages clause whether as penalty or liquidated damages. He must prove the actual damage he has suffered unless his case falls under the situation where it is difficult to assess actual damage or loss as enunciated in Selva Kumar. In doing so, the innocent party must prove actual damage or reasonable compensation in accordance with the principles set out in Hadley v Baxendale (1854) 9 Exch 341.
Having set out the existing legal position, the Court was of the view that there is, however, no necessity for proof of actual loss or damage in every case where the innocent party seeking to enforce a damages clause. Therefore, as a starting point for recovery, the Court noted that section 75 of the Act allows reasonable compensation to be awarded irrespective of whether actual loss or damage is proven. In making this pronouncement, the Court cautioned that Selva Kumar should not be interpreted as imposing a requirement that proof of actual loss is the sole conclusive determinant of reasonable compensation.
As to what amounts to “reasonable compensation” as stipulated in section 75 of the Act, the Court noted that the central feature of Cavendish and section 75 is the notion of reasonableness, and accordingly there was nothing objectionable in holding that the concepts of “legitimate interest” and “proportionality” as enunciated in Cavendish are relevant in deciding what amounts to “reasonable compensation”. The Court explained 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. In deriving a reasonable compensation, there must not be a significant difference between the level of damages expressed in the contract and the level of loss likely to be suffered.
Burden of Proof
Having restated the position in relation to the enforcement of a damages clause, the Court went on to address the issue of burden of proof. The Court stated that the first step is that it is the onus of the party seeking to enforce a damages clause 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 the innocent party has established these two elements, the innocent party is entitled to the sum stipulated in the damages clause.
If the defaulting party disputes the sum stated in the damages clause, the burden is on the defaulting party to show that the damages clause is unreasonable (i.e. by showing that the sum stipulated in the contract is extravagant and unconscionable in amount in comparison with the highest conceivable loss which could possibly flow from the breach) or to demonstrate from available evidence and under such circumstances what ought to be the reasonable compensation caused by the breach of contract.
Distilling the Principles
The Federal Court then distilled the principles that it had laid down into the following propositions:
- If there is a breach of contract, any money paid in advance of performance and as part payment is generally recoverable by the payer. A deposit paid which is not merely part payment but also a guarantee of performance is generally not recoverable.
- Whether a payment is part payment of the price or a deposit is a question of interpretation that turns on the facts of a case.
- A deposit is subject to section 75 of the Act.
- In determining what amounts to “reasonable compensation” under section 75 of the Act, the concepts of “legitimate interest” and “proportionality” as enunciated in Cavendish are relevant.
- A sum payable in breach of contract will be held to be unreasonable compensation if it is extravagant and unconscionable in comparison with the highest conceivable loss which could possibly flow from the breach.
- Section 75 of the Act allows reasonable compensation to be awarded irrespective of whether actual loss or damage is proven.
- The initial onus lies on the party seeking to enforce a damages clause under section 75 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 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.
- 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, including the sum stated therein, is unreasonable.
Decision of the Federal Court
The Court, applying the principles laid down in this case, held that it was evident from the correspondence that Mars had agreed that the additional RM2,000,000.00 paid for the three extensions would form part of the earnest deposit guaranteeing its performance in the execution of the SPA. As such, the Court found that the additional payments bore the characteristics of a deposit and therefore subject to the same test of reasonableness applicable to a damages clause.
The Court was of the view that when the three extensions of time were granted, the primary obligation on Mars’s part was to ensure that the SPA was completed by the new deadline. Its failure to perform this primary obligation resulted in it having to fulfil its secondary obligation to forfeit the agreed sums.
The Court was satisfied that Cubic had various legitimate interests to safeguard. These included the duty to maximize the amount available to its creditors, the additional expenditure incurred and the depreciation in value of the moveable assets due to Mars’s delay in completing the SPA, and the loss of opportunity to negotiate with a third party.
The Court considered that the RM2,000,000.00 was not too large an amount as to be disproportionate when compared against the total purchase price of RM90,000.000.00. The total deposit of RM3,000,000.00 represented only 3.33% of the purchase price.
In view of the foregoing, the onus had shifted to Mars to show that the forfeiture was excessive. Mars had not adduced any proof to show that the forfeited payments were exorbitant or unreasonable. Instead, it only argued that Cubic had not proved actual loss or damage. Consequently, the Court ruled that the additional RM2,000,000.00 amounted to reasonable compensation.
As for the RM40,000.00 paid by Mars by way of interest, the Court was satisfied that this amount was calculated at an agreed rate and was paid because of Mars’s delay in paying the balance of the deposit. It did not constitute part payment for the properties and was not refundable regardless of whether the sale was completed. It was payable regardless of any breach and fell outside the scope of section 75 of the Act.
For the aforesaid reasons, the Court upheld Cubic’s forfeiture of the RM2,000,000.00 (in addition to the initial deposit of RM1,000,000.00) and held that the RM40,000.00 was not refundable to Mars.
Cubic Electronics is a significant decision as it restates the law regarding deposits and damages clauses in Malaysia. The decision makes it clear that both areas are subject to section 75 of the Act and lays down the burden of proof under section 75 in a manner that is fair and logical.
The case lays to rest the perception that arose from Selva Kumar that there is, in general, a legal requirement for an innocent party to prove actual loss in order to determine what amounts to reasonable compensation.
Cubic Electronics also aligns the legal position in Malaysia to the current position in England and India.
It is also useful to note the approach taken by other jurisdictions in light of Cavendish.
Singapore follows the traditional common law approach in its enforcement of liquidated damages clauses as set out in Dunlop, though there has been a recent trend to adopt the Cavendish approach at the High Court level in recent years. The Singapore High Court did this most recently in Seraya Energy Pte Ltd v Denka Advantech Pte Ltd and another suit (YTL PowerSeraya Pte Ltd, third party)  SGHC 2.
The plaintiff in Seraya commenced two actions against the defendants for liquidated damages pursuant to three electricity retail agreements (“ERAs”) as it had terminated the ERAs due to the defendant’s alleged wrongful conduct. Applying Dunlop, the court was of the view that each provision for liquidated damages under the ERAs was a penalty and therefore not enforceable as there was no evidence that the liquidated damages sum was a genuine pre-estimate of the losses likely to be suffered by the plaintiff on the termination of the ERAs. In doing so, the court considered the fact that the same formula was included in each ERA, regardless of the terms or duration of the particular ERA or the severity of the breach, potentially enabling the plaintiff to terminate the ERA and claim liquidated damages even for minor breaches. The court considered but declined to follow Cavendish as it could not see any legitimate interest that would justify imposing liquidated damages on termination at the proposed rate as the plaintiff failed to prove that it had some legitimate interest in claiming the liquidated damages sum, other than financial loss.
To date, the Singapore Court of Appeal has yet to have the opportunity to consider the Cavendish approach.
The Australian courts’ approach to the penalty doctrine is also consistent with the approach in Dunlop (see the High Court decision of Ringrow Pty Ltd v BP Australia Pty Ltd (2005) 222 ALR 305) and was well-settled until the High Court of Australia’s decision in Andrews v Australia and New Zealand Banking Group Pty Ltd  HCA 30 where it was held that ‘there subsisted, independently of the common law rule, an equitable jurisdiction to relieve against any sufficiently onerous provisions which was conditional upon a failure to observe some other provision, whether or not that failure was a breach of contract’. The extension of the penalty doctrine in Andrews (that breach is not an essential aspect of the doctrine) was not considered favourably by the Supreme Court in Cavendish. Rather it was viewed as a ‘radical departure’ from the existing law.
The penalty doctrine was subsequently revisited in Paciocco & Anor v Australia and New Zealand Banking Group Limited  FCAFC 50, where the Australian High Court ruled that a contractual obligation to pay a specified sum of money upon breach of contract will be enforceable as long as the amount payable is not ‘all out of proportion’ to the party’s interest in ensuring compliance with the relevant obligation. The relevant ‘interest’ may include financial interests such as the cost associated with making accounting provisions and therefore may extend beyond the costs recoverable by way of damages in litigation.
You may view the full issue of Skrine’s Legal Insights Issue 1/2019 here