Liquidation damage laws for Mainland China, HK

Under different legal systems, mainland China and Hong Kong have different priorities when it comes to liquidated damages.

Both China’s civil law and Hong Kong’s common law systems place contractual limits on the portion of liquidated damages that exceed the loss, choosing either to not enforce or reduce the penalty.

Common law traditionally enforces damages provided for beforehand, but refuses to enforce punitive damages. In contrast, civil law tends to enforce punitive clauses in contracts, but lower the punitive degree.

Accordingly, when an enterprise executes a contract in the Greater Bay Area embracing neighbouring Guangdong, Hong Kong and Macau, it should be particularly aware of differences in the laws of Hong Kong and mainland China in discretionary reduction of liquidated damages – and select the appropriate governing law.

HONG KONG LAW

When contracting parties include a liquidated damages clause in their contract, requiring a party to pay a specific sum to the non-breaching party in the event of a breach, the amount specified in such clause must be a genuine pre-estimate of the loss made by the parties, instead of one provided just for deterrence purposes. Otherwise, such a clause will be deemed unenforceable.

CHINESE LAW

According to article 585 of the Civil Code: “Parties may provide that, upon breach by one party, a certain amount in liquidated damages, consistent with the circumstances of the breach, shall be paid to the other party or, alternatively, the parties may specify the method of calculating damages arising from the breach.”

Where the liquidated damages specified are excessively higher than the loss caused, the people’s court or arbitration institution “may reduce the amount appropriately if requested”.

Article 50 of the Minutes of the National Work Conference on Civil and Commercial Adjudication by Courts, issued by the Supreme People’s Court in 2019, provides that when determining whether the liquidated damages specified are excessively high, they should generally be based on loss as specified in article 113 of the Contract Law. Such loss includes benefits that could have been derived had the contract been performed.

In bilateral contracts, other than loan contracts, the upper limit on the interest rate on private loans as protected by law may not serve as the criterion for determining whether the liquidated damages for a debt involving payment of a price or remuneration as consideration – but not a repayment obligation under the loan contract – are excessively high.

Instead, it should be comprehensively assessed by taking into account the performance of the contract and degree of fault of the parties, as well as the anticipated benefits. The breaching party claiming that the liquidated damages are excessively high bears the burden of proof.

The Minutes of the National Work Conference on the Thorough Implementation of the Civil Code by Courts, issued by the Supreme People’s Court in April 2021, further clarifies that “scope of loss” specified in the second paragraph of article 585 of the Civil Code shall be determined in accordance with article 584, “including the benefits that could be derived after the contract is performed, but may not exceed the loss that the party in breach foresaw or ought to have foreseen, at the time it entered into the contract, could be caused by a breach of contract”.

Where a party requests that the court reduce the liquidated damages, the court shall “comprehensively take into account the performance of the contract, the degree of fault of the parties and other factors, with the loss under article 584 as a basis, and render its decision in accordance with the principles of fairness and good faith”.

Where the liquidated damages specified exceed the loss determined, pursuant to article 584, by 30%, it may, in general, be found that they are “excessively higher than the loss caused”, as provided in the second paragraph of article 585.

Where a party claims that the liquidated damages specified are excessively high and requests that they be appropriately reduced, “such party shall bear the burden of proof”. Where the other party claims that such damages are reasonable, it likewise shall “provide the requisite evidence”.

CHOOSING BETWEEN THE TWO

In Hong Kong’s common law system, a liquidated damages clause – in the event of a breach – can only be enforced if it reflects a genuine pre-estimate of the loss of the non-breaching party.

In contrast, under the rules for discretionary reduction in mainland Chinese law, liquidated damages are not mandatorily reduced when exceeding the loss. Instead they are left to the discretion of the adjudicating body when they are “excessively” higher than the loss – and such reduction is required to be “appropriate”.

SHIFTING PERSPECTIVES

Recently, however, common law jurisdictions including Hong Kong have perhaps begun to shift their perspectives.

First, penalty may be considered a security provided by the breaching party in the form of written insurance, particularly in terms of anticipated value, which is subjective and difficult to accurately measure. Second, such clauses reflect on the reliability and performance capacity of the contracting parties and reduce transaction costs.

UK courts are shifting their position on liquidated damage clauses, and Hong Kong courts have also begun to apply the testing method of the Supreme Court of the UK, in Cavendish Square v Talal El Makdessi (2015), and companion landmark contract law case ParkingEye v Beavis.

The Hong Kong Court of Appeal ruled, in Law Ting Pong Secondary School v Chen Wai Wah (2021), that a penalty clause applies only when involving secondary liability.

In China Great Wall AMC (International) v Royal Bond Investment (2021), the Hong Kong Court of First Instance indicated that it would no longer focus on the distinction between a penalty and a genuine pre-estimate of loss. Rather, it would first consider the lawful rights and interests of the non-breaching party protected by the relevant clause, followed by the circumstances of entering into the contract – and assess whether the clause was disproportionate to the lawful interests.

Judging from these cases, Hong Kong’s common law system is beginning to consider benefits beyond compensation, and thus justifies imposing additional economic burden on the breaching parties.

Mo Xinying is a senior associate at ETR Law Firm