In June 2022, the Court of First Instance handed down a judgment arising out of a two-year salary payment compensation clause in an employment contract. The judgment clarifies the difference between a liquidated damages clause and a penalty clause and confirms that, when properly drafted, a liquidated damages clause in an employment contract can be enforced.

In Ng Yan Kit Alfred & Or v Ever Honest Industries Limited & Or,¹ the claimant, Mr Ng, signed a letter of employment with his employer which contained a 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.”

Mr Ng was first employed by another company affiliated with the defendants from 1 August 2014. He subsequently signed new employment letters with the first defendant in March 2015 and then again in January 2016. Recognising his contribution to the group, particularly during difficult times including suspension of trading of its stocks, restructuring of debts and resumption of trading, the first defendant indicated that it hoped Mr Ng would work for the company for at least three years and therefore included the above clause in his new employment letter signed in January 2016. In April 2016, the first defendant terminated Mr Ng’s employment and only paid him three months’ salary as payment in lieu. Mr Ng sued for 24 months’ salary as contractually agreed.

At the Labour Tribunal, the Presiding Officer dismissed Mr Ng’s claim but he appealed. The court found that the Presiding Officer erred in applying the legal test but that the claim must be remitted back to the Labour Tribunal for further fact-finding. The focus of the court’s judgment was on whether the relevant clause constituted a penalty clause, or whether it was a liquidated damages clause. The key principles to note are as follows:

• in the employment context, parties can agree to include a liquidated damages clause;²
• in a claim for liquidated damages, a claimant is not legally required to mitigate his loss. The object of a liquidated damages clause is to fix a certain sum to be paid irrespective of the actual damage suffered by reason of a breach;³ and
• in order to determine whether a clause is in fact a liquidated damages clause or a penalty clause, reference should be made to the principles established by the landmark decisions in Cavendish Square Holding BV v Makdessi and ParkingEye Ltd v Beavis,⁴ which were recently applied by the Hong Kong Court of Appeal in Law Ting Pong Secondary School v Chen Wai Wah and which represents the current law in Hong Kong reflecting the modern judicial approach in considering the application of the penalty rule.

The court clarified that the modern approach to determine whether a clause should be regarded as a liquidated damages clause or penalty clause involves a two-step enquiry, as follows:⁵

• first, the court has to construe the relevant clause in the contract to determine whether it is a contractually agreed method of lawful termination of the contract, or whether the sum stipulated is in the nature of damages for breach of contract. In the case of the former, it is a primary obligation to pay rather than a secondary obligation arising upon the breach of a primary obligation of performance, which is the case for the latter. This is ultimately a matter of construction; and
• second, in the event the payment is a secondary obligation arising upon the breach of a primary obligation of performance, the next step requires the court 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. This inquiry requires the court to 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 court found that the Presiding Officer below had applied the wrong test in dealing with Mr Ng’s claim but that, since there was no proper inquiry about the true nature of the “compensation” as agreed between Mr Ng and the first defendant, and the investigation of facts can only be conducted by the tribunal and not the appellate court, the court had no choice but to remit the case back to the tribunal for reconsideration of the claim following the correct approach.

Retaining talent has become increasingly difficult in Hong Kong since the COVID-19 pandemic. There have been numerous media reports of the “brain drain” caused by the exodus of talent from Hong Kong to other countries, and having a stable workforce is now becoming a priority for employers in Hong Kong. A properly drafted liquidated damages clause in an employment contract can serve to protect a workforce and deter key employees from premature departure which can have a significant impact on a business.

1. [2022] HKCFI 1834, 17 June 2022.
2. Murray v Leisureplay Plc [2005] EWCA 963, cited in the judgment.
3. Abrahams v Performing Right Society Ltd [1995] ICR 1028, cited in the judgment.
4. [2016] AC 1172, cited in the judgment.
5. See § 43 to 47 of the judgment.