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Enforceability of a compensation clause in Hong Kong: is it a penalty?

21 July 2022

A recent case in the Hong Kong Court of First Instance has seen the court apply the Court of Appeal’s penalty clause test to a compensation clause in an employment contract.

In the 2020 case of Law Ting Pong Secondary School v. Chen Wai, the Court of Appeal (Hong Kong) considered the question of how to interpret a penalty clause in the employment context. We wrote about this in detail here. The principles established in this case have now been applied in the case of Ng Yan Kit Alfred and Another v Ever Honest Industries Limited and Another to the interpretation of a compensation clause.

Facts of the case

Mr. Ng was an employee of a company affiliated with Ever Honest Industries Ltd. His employment contract contained a clause, which stated:-

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.” 

Based on the evidence, the purpose of this clause (the Subject Clause) was to recognise the Claimant’s contributions and to offer the Claimant stable employment for at least 3 years.

The Claimant was dismissed during his first year of employment and he brought a claim at the Labour Tribunal (the LT) for a sum equivalent to 2 years’ compensation. His case was dismissed by the Presiding Officer at the LT on the basis that the Subject Clause was an unenforceable penalty clause. The Claimant then appealed to the Court of First Instance.

The relevant law

The question for the Court of First Instance was whether the Subject Clause was a penalty clause. If so, it would be unenforceable.

The approach taken by the Court of Appeal in the Law Ting Pong case is regarded as the modern judicial approach to the penalty rule question in Hong Kong.

This approach involves a two-step analysis:

i. Is the relevant clause a primary obligation, or is it a secondary obligation arising from a breach of a primary obligation of performance?

On these facts, this means that the Court would have to consider whether the Subject Clause is a contractually agreed method of lawfully terminating of the contract (a primary obligation), or whether the sum stipulated is a damages clause for breach of contract (a secondary obligation arising from a breach).

ii. If the relevant clause is a secondary obligation, what is the legitimate interest of the innocent party that is being protected by the clause? And is the clause proportionate to that interest?

This question 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 to the relevant terms. If there is no legitimate interest at all that is being protected by the clause, or if the clause is out of proportion to such legitimate interest, the clause would be considered a penalty clause and therefore unenforceable.

The Court of First Instance’s decision

The key points decided by the CFI were:

  • In determining that the Subject Clause was an unenforceable penalty, the Presiding Officer failed to apply the correct test in considering the nature of the Subject Clause. The Presiding Officer had not considered the true nature of the claim for 2 years’ compensation, in particular why the parties had agreed to include the restraint of trade provision near the end of the Subject Clause.
  • The case was remitted back to the LT for proper analysis. The LT was specifically directed to reconsider the nature of the Subject Clause in light of the Law Ting Pong case:
  • If the LT concludes that the payment of the 2 years’ compensation is a primary obligation, the LT should allow the Claimant’s claim; but
  • If the LT concludes that the payment is secondary (arising from a breach), it should then consider and determine whether the Subject Clause would be caught by the penalty rule (i.e. does the clause protect any legitimate interest of the innocent party – here the Claimant - and is it proportionate to that legitimate interest?). If this analysis establishes that the 2 years’ compensation is not a penalty, the Claimant should succeed in his claim; if it is a penalty, his claim should be dismissed.

Implications for employers

If employers would like to incentivise employees to be retained for a period of time, they could offer a guaranteed bonus or other incentives upon completion of an agreed duration. An employer and an employee may also consider entering into a fixed-term employment contract. The fixed-term employment contract should ideally contain a provision on early termination to provide flexibility to the employer. Any contractual provisions that provide for compensation or payments in the event of early termination or any clauses that grant contractual bonuses or awards that are subject to clawbacks should be carefully drafted to mitigate the risk of legal disputes.

How We Can Help You

We would be pleased to review your employment contracts and provide tailored drafting for bespoke circumstances to mitigate the risk of legal disputes.

Ng Yan Kit Alfred and Another v Ever Honest Industries Limited and Another [2022] HKCFI 1834 – judgment available here.

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