On November 21, 2018, the Malaysian Federal Court overturned a well-established decision on the effectiveness and enforceability of liquidated damages clauses in contracts.[1] Before this decision, the previous position had left many questioning the effectiveness of incorporating a liquidated damages clauses in their contracts.
BACKGROUND
The fundamental purpose of a liquidated damages clause is to enable the parties to negotiate and agree in their contract on the compensation payable for non-performance of contractual obligations.
Section 75 of the Contracts Act 1950 (“Section 75”) provides for compensation for a breach of contract in circumstances where the compensation clause has been clearly expressed as a penalty, whether or not actual damage or loss is proved to have been caused. However, in 1995, the Federal Court had decided in Selva Kumar Murugiah v Thiagarajah Retnasamy [1995] 1 MLJ 817 (“Selva Kumar”) that an innocent party cannot recover the sum fixed in a damages clause, regardless of whether it was stipulated as a penalty or liquidated damages clause. The innocent party must prove the actual loss and damage that it has suffered.
This has caused many to question what sense it would make to include a liquidated damages clause in a contract if it is not enforceable and actual damage still has to be proven. Indeed, the purpose of including such a clause would be defeated.
FEDERAL COURT DECISION
Recently, the Federal Court in Cubic Electronics Sdn Bhd (In liquidation) v Mars Telecommunications Sdn Bhd [2018] MLJU 1935 overturned the decision in Selva Kumar.
In this case, Mars Telecommunications Sdn Bhd (“Mars”) had offered to purchase a piece of land from Cubic Electronics Sdn Bhd (“Cubic”) when Cubic was in liquidation. Mars had offered to pay an initial earnest deposit of RM 1,000,000.00 so that the liquidators would not proceed with the open tender. The acceptance of Mars’s offer was subject to the condition that the sale and purchase agreement (“SPA”) had to be executed within 30 days from October 7, 2011, failing which the earnest deposit would be forfeited as agreed liquidated damages.
Mars failed to comply with the above term and was granted four extensions. During this period, Mars paid further earnest deposits. When granting all extensions of time, Cubic had informed Mars that if Mars failed to execute the SPA, the liquidated damages clause would also apply to these additional earnest payments.
Cubic finally terminated the sale when Mars had asked for its fifth extension. By then, Mars had already paid earnest deposit and non-refundable interest amounting to RM 3,040,000.00. Cubic informed Mars that this sum was forfeited. An action was then brought by Mars against Cubic for wrongful termination seeking a refund of the deposit and interest. Mars’s claim was dismissed by the High Court. However, the Court of Appeal ruled that the forfeiture was not allowed, relying on the case of Selva Kumar and the case landed before the Federal Court for determination.
The Federal Court decided that Section 75 allowed compensation as agreed by the parties in the liquidated damages clause, irrespective of whether actual loss or damage is proven, provided that the provision made is not extravagant, exorbitant or unconscionable and such liquidated damages claims are then enforceable.
The innocent party needs only to show that there was a breach of contract. The onus then lies on the defaulting party to prove that the sum stipulated in the liquidated damages clause is unreasonable.
KEY TAKEAWAYS
As a result of this shift, when drafting liquidated damages clauses, parties will need to pay close attention to the quantum stipulated in these clauses. It has to be reasonable and not extravagant, exorbitant or unconscionable. Otherwise, the liquidated damages would not be enforceable.
[1] Cubic Electronics Sdn Bhd (In liquidation) v Mars Telecommunications Sdn Bhd [2018] MLJU 1935.
