31 August 2021 Open with your browser  

A milestone decision made by the Court of Appeal on the doctrine of penalties and law of employment

Written by: Mr. Mikey Li – Risk Consultant

Before the decision made by the Court of Appeal, the Hong Kong case of Law Ting Pong Secondary School v Chen Wai Wah suggested when an employment contract consists of several documents and an appointee signed every document, some terms may not form part of the employment contract. The Court of First Instance (CFI) also left uncertainty surrounding whether the clause of giving the notice to terminate the employment contract and the clause of payment in lieu of notice would be regarded as a penalty clause. The appellate decision of this case has made clear the law of contractual interpretation for employment agreements and answers the unresolved issue.

The Defendant, Chen Wai Wah, (‘Chen’) was a teacher who had entered into an employment contract (‘the Employment Contract’) with the Claimant, Law Ting Pong Secondary School (‘the School’). The Employment Contract consisted of 3 documents, namely (1) The Offer of Appointment as Teacher (“Offer of Appointment”); (2) Conditions of Services for Teachers in the School (”Conditions of Service”); and (3) Letter of Acceptance to be completed by the Teacher (“Letter of Acceptance”).

The Letter of Acceptance stated that once the Teacher accepted the Employment Contract, the conditions of the new contract would come into effect immediately. Under the Conditions of Service, it provided a termination mechanism. To terminate the Employment Contract, the Teacher was required to give three months’ notice in writing, make a payment in lieu of notice, or a combination of both to the School (the “Termination Provision). The Conditions of Service also stated that the employment period was from 1 September 2017 to 31 August 2018.

On 17 July 2017, Chen signed and returned the Conditions of Service and Letter of Acceptance to confirm his acceptance of the employment offer. On 22 August 2017, Chen informed the School that he would not report for duty on 1 September 2017 because he had decided to stay on with his current employer. The School then demanded Chen to make payment in lieu of notice pursuant to the employment contract. But he refused to pay the payment in lieu of notice and the School brought a claim against Chen in the Labour Tribunal.

Decision at Labour Tribunal
The Presiding Officer at the Labour Tribunal was of the view that the Employment Contract was constituted by reading together provisions of the Offer, the Conditions and the Letter of Acceptance. Upon the signing of the Letter of Acceptance and the Conditions of Service, the Employment Contract was legally binding. Thus, the Labour Tribunal ruled that Chen had breached the Employment Contract between the School and the Teacher and ordered Chen to pay 3 months’ payment in lieu of notice in the sum of HK$139,593 to the School. Furthermore, the Labour Tribunal found the Termination Provision was enforceable as it was a clause for providing for liquidated damages but not a penalty clause.

Appeal to CFI
Chen appealed to the CFI. The CFI allowed the appeal reasoning that the terms contained in the Letter of Acceptance did not form part of the Employment Contract, as they were not included in the Offer of Appointment or the Conditions of Service.

The Offer of Appointment referred to the conditions set out in the Conditions of Service. Yet, there was no provision in the Conditions of Service specifically referring to the Letter of Acceptance. To decide whether to accept or decline such an offer, a person would have to read the Offer of Appointment in conjunction with the Conditions of Service (not the Letter of Acceptance) to ascertain what terms would be agreed between the offeror and the offeree. Therefore, the CFI was of the view that the offer made by the School in relation to the Employment Contract was only subject to the terms of the Conditions of Service. In particular, the period of employment under the Employment Contract was expressly stated as: “From 1st September 2017 to 31st August 2018”.

The Court relied on the legal principle that an acceptance by the offeree must “mirror” the offer made by the offeror. As such, what Chen could accept was an offer with terms subject to the Conditions of Service only, as proposed by the School in the Offer of Appointment. The Court held that it would be inappropriate for the Labour Tribunal’s decision to hold that the terms contained in the Letter of Acceptance constituted part of the offer made by the School.

Appeal to Court of Appeal
The School subsequently brought an appeal to the Court of Appeal on the following 2 issues: (1) whether the CFI judge correctly applied the law of contractual interpretation on the Employment Contract; and (2) whether the Termination Provision is unenforceable as a penalty clause.

By citing the cases of Investors Compensation Scheme Ltd v West Bromwich Building Society [1998] and Jumbo King Ltd v Faithful Properties Ltd & Ors [1999], the judges at the Court of Appeal were of the view that the focus was when the two parties are signing the employment contract, whether the three documents reasonably conveyed the message to the other party.

The Court of Appeal considered that the CFI only focused on the words used in the Offer of Appointment, and had not considered the words in all documents in the context of the facts. As Chen was given the 3 documents together when the School’s offer was made and the documents stated how to accept the offer, the offer could only be accepted in such way. As a result, when Chen signed the documents in the specified way, the terms of all documents were accepted as a package. Hence, the Letter of Acceptance formed part of the Employment Contract.

For the second issue, the Court of Appeal cited and adopted the approach of the UK case of Cavendish Square Holdings v Makdessi [2016], and first considered whether Chen’s obligation to make payment in lieu was a primary obligation to pay or a secondary obligation arising from the breach of a primary obligation. The court then assessed whether the School has a legitimate interest in enforcing the performance of the Employment Contract and considered whether the clause is out of proportion to the legitimate interest by considering the circumstances in which the contract is made.

The Court of Appeal held that the termination provision gave the parties a right to terminate the employment contract by payment in lieu of notice. Payment in lieu of notice was a contractually agreed and lawful method to terminate the employment contract, and a claim for payment in lieu was not a claim for damages for breach of contract. Thus, the doctrine of penalties was not engaged. In addition, the Court of Appeal opined that even the Termination Provision was to be regarded as a liquidated damages clause, Chen also failed to demonstrate the Termination Provision constituted an unenforceable penalty clause. The School had a legitimate interest in enforcing the employment contract by requiring Chen to make the payment in lieu of notice for backing out of the contract.

Accordingly, the Court of Appeal allowed the appeal, and Chen was liable to make the payment in lieu of notice.

Key concerns
While the starting point of interpreting the contract is to look at the ordinary and natural meaning of the words of the contract, the parties should take into account the whole context when the contract is signed. In this case, Chen, the prospective employee, was given all three contractual documents at the same time. Thus, the onus is on the person signing the documents to assume their natural meaning on the whole.

The case also indicated that the termination by way of giving notice, payment in lieu of notice, or a combination of both in an employment contract is highly unlikely to be constituted as an unenforceable penalty clause, although it depends on how the provisions are drafted and agreed.

It is worth noting that the law of penalties has been moved from simply considering whether the clause representing a pre-genuine estimate of loss and/or has a deterrent effect, to a test of considering whether the innocent party has a legitimate interest to be protected by such clause and whether the clause is out of all proportion to the legitimate interest by considering the circumstances in which the contract was made.

Employers may consider to include a liquidated damages clause in the employment contract to mitigate the risk of an employee’s failure to show up for work on the commencement date. Yet, they have to consider their legitimate interest and whether the detriment placed on the contract-breaker will be out of proportion to such interest.

From an internal control perspective, employers should review the words used in the employment contracts carefully before issuing such documents to the prospective employees. The decision to include a liquidated damages clause in the employment contract means that there also needs to be evidence that the amount is proportional to the interests. Employers should retain an internal written record of their assessment. When employers offer employment contracts, they should expressly explain the terms in the employment contracts to employees, especially if the employment contracts include a liquidated damages clause. Employers should explain when the liquidated damages clause will be triggered and whether it is effective even employees have not yet commenced duty. Employers may consider retaining an internal record after their staff has performed the duties.

Law Ting Pong Secondary School v Chen Wai Wah [2021] HKCA 873

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