Contract Law – Case Analysis – The Enforceability of Liquidated and Ascertained Damages (“LAD”) Clauses

The Federal Court case of Cubic Electronics Sdn Bhd (in liquidation) v Mars Telecommunications Sdn Bhd¹ has brought about significant changes in the law on the enforceability of Liquidated and Ascertained Damages (“LAD”) clauses in contracts.

LAD clauses are provisions which stipulate a pre-determined sum of money that must be paid as damages for failure to perform under a contract. Such clauses are especially common in the following:

• The sale and purchase of property within a new development, between a developer and a purchaser, where in the event of delay in handover of the property (or breach on the timelines of handover), the developer may be liable to pay LAD to the purchaser; and
• In the construction industry, where delays in completion of work, outside of the expected timeline, has a resulted in a breach of contract and may cause a party to pay LAD as a consequence of the delay.

The Cubic Electronics case concerned the purchase of land and machinery as part of a distressed asset acquisition exercise conducted by the liquidators of the Appellant (Cubic Electronics Sdn Bhd (in liquidation) for the purpose of recovering funds to repay creditors. The Respondent (Mars Telecommunications Sdn Bhd) paid a total of RM3,040,000.00 as earnest deposit and interest towards the purchase of the assets, but had not executed a sale and purchase agreement at the time and had sought several extensions of time to execute. The Appellant (through the liquidators) proceeded to terminate the sale and forfeit the earnest deposits paid. The Respondent subsequently brought an action for, amongst others, the refund of the earnest deposits as well as a claim for damages for consequential losses arising from the termination of the sale.

In considering the primary issues on forfeiture of deposit and interest, the Federal Court delved into the principle that an innocent party (to a breach of contract) must prove the actual damage or loss suffered.

The Previous Position Of Malaysian Courts On Lad Clauses
It has long been the case in Malaysia’s common law² that if a clause for LAD has been included in a contract for late completion / late delivery, the non-defaulting party would not be entitled simpliciter the sum calculated as per the contractual LAD clause even where liability has been successfully established. This was due to a restrictive interpretation of section 75 of the Contracts Act 1950 (”S. 75”)³.

S. 75 states:

Compensation for breach of contract where penalty stipulated for

When a contract has been broken, if a sum is named in the contract as the amount to be paid in case of such breach, or if the contract contains any other stipulation by way of penalty, the party complaining of the breach is entitled, whether or not actual damage or loss is proved to have been caused thereby, to receive from the party who has broken the contract reasonable compensation not exceeding the amount so named or, as the case may be, the penalty stipulated for. (emphasis added)

Since 1995, the common law position has followed the Federal Court case of Selva Kumar Murugiah v Thiagaraja Retnasamy, wherein the Court primarily held that the words in the provision whether or not actual damage or loss is proved to have been caused thereby’ must be given a restricted construction.

Further, notwithstanding any LAD clause, any innocent party seeking to rely on an LAD clause would still have to prove the actual damage that was suffered unless the case falls within a limited category of cases where it is difficult to assess actual damage or loss.

As such, our courts have previously insisted that actual damage or reasonable compensation be proved in accordance with the principles set out in the English case of Hadley v Baxendale i.e. that the damage must not be too remote⁴. Any failure of the innocent party in proving his loss would have resulted in the refusal of the court to award such damages⁵.

The Federal Court in Johor Coastal⁶ affirmed the position in Selva Kumar and held that S. 75 provides that in every case, the court must determine what is reasonable compensation.

As a result of this, the court would have to be satisfied that the innocent party has proven his loss or damage before awarding him the sum (or a part thereof) provided for in the LAD clause.

The resulting effect is that innocent parties were often left without an adequate recourse or remedy even when the contract has been clearly breached simply because they could not prove their loss, effectively undermining the purpose of having such a clause in the contract in the first place.

The Current Position On LAD Clauses Post Cubic Electronics

Following the judgment in Cubic Electronics, the current position of the law on both LAD clauses and the forfeiture of deposit can be summarized⁷ as follows:-

• The innocent party seeking to enforce the liquidated damages clause must first show that:
  • there was a breach of contract; and
  • the contract contains a clause specifying a sum to be paid upon such breach.

  Once these two requirements are met, the innocent party can receive a sum not exceeding the amount stipulated in the contract irrespective of whether actual damage or loss is proven, subject to the following point.

• The burden will then shift onto the defaulting party to prove that the liquidated damages clause, including the sum stated in the clause, is unreasonable.
• A sum payable on breach of contract will be held to be unreasonable if it is extravagant and unconscionable in amount in comparison with the highest conceivable loss which could possibly flow from the breach. In the absence of proper justification, there should not be a significant difference between the level of damages spelt out in the contract and the level of damage which is likely to be suffered by the innocent party.

Accordingly, proof of actual loss is no longer mandatory, and the enforceability of LAD clauses have been widened. Unlike before, the burden now largely lies on the defaulting party to prove the unreasonableness of the pre-determined damages.

Effect of the changes in the law

This decision is largely seen to be a favourable one as it upholds the ‘sanctity of contracts’ doctrine and preserving the doctrine of freedom to contract. This move is seen as the Courts assuming its proper role of enforcing contracts made by ‘meetings of minds’ and away from the ‘Judge made law’ whereby Courts would intervene and modify a contract which it thinks is unfair. It must be noted that the Court in this case took into consideration that the parties, who were well-advised by their respective legal counsels, made a voluntary choice and had clear understanding of the consequences.

The Federal Court in its judgment⁸ stated that LAD clauses in contracts promote business efficacy and minimise litigation between parties, and to place the burden on the innocent party to show that the amount is not excessive would undermine the purpose of having such a clause.

However, contrary to the Court’s observations, commercial realities could demonstrate this shift as potentially opening the floodgates of litigation, where innocent parties may forward LAD claims without having to prove any loss or damage suffered, which in turn may give rise to an increase in frivolous LAD claims. There are hopes that the Court will be steadfast and cognizant of all factors in determining such claims.

It cannot be denied that this decision has brought about a rather drastic change in the enforceability of LAD clauses, and moving forward, it is likely that the enforceability of the current common law position shall be the most frequently tested in adjudication claims brought under the Construction Industry Payment and Adjudication Act 2012.

¹Cubic Electronics Sdn Bhd v Mars Telecommunications Sdn Bhd [2018] MLJU 1935
²[1995] 1 MLJ 817 (FC)
³Supra
⁴Hadley v Baxendale [1854] EWHC J70
⁵Selva Kumar Murugiah v Thiagaraja Retnasamy [1995] 1 MLJ 817 (FC)
⁶Johor Coastal Development Sdn Bhd v Constrajaya Sdn Bhd [2009] 4 MLJ 445 (FC)
⁷Cubic Electronics Sdn Bhd v Mars Telecommunications Sdn Bhd [2018] MLJU 1935, at para [74]
⁸Supra, at para [73]