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Breach of Contract – Forfeiture of Deposits/Payment of Agreed Sums

With so much uncertainty in these times and the upheaval caused to commerce, it may be timely to consider a legal issue which would now arise in many transactions. If there is a breach of contract and the contract provides for a certain sum to be paid/forfeited in the event of a breach, can the non-defaulting party be permitted to forfeit/claim such sum?

The Federal Court decision of Cubic Electronics Sdn Bhd (In Liquidation) v. Mars Telecommunications Sdn Bhd [2019] 6 MLJ 15 considered the above question recently. The Federal Court, in holding that a deposit paid for a contract can be forfeited by the non-defaulting party due to a breach of contract, had examined section 75 of the Contracts Act, 1950. The Court had set out the principles as to when a certain sum, stated to be payable upon a contractual default, may be paid/forfeited.

Historically, under earlier common law, where a stipulated sum was provided in a contract to be payable if there was a breach of the contract, a distinction was made as to whether that sum was stipulated as a penalty or as liquidated damages. The non-defaulting party could claim a sum viewed as liquidated damages but not if it is a penalty. The Malaysian Courts have long decided that section 75 of the Contracts Act, 1950 did away with such distinction.

Section 75 provides:-

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.”

Thus section 75 allows the innocent party to claim reasonable compensation not exceeding what has been stipulated in the contract, if there was a breach of contract.

Prior to this Federal Court decision, the legal position arising from the interpretation of section 75 had been this:  If there was a challenge to the reasonableness of the sum stated in the contract to be paid/forfeited upon a breach of contract, the non-defaulting party had to prove that such sum to be paid/forfeited was “reasonable compensation”.   Cubic Electronics changed that position.

The Decision in Cubic Electronics

In Cubic Electronics, the Vendor company (Appellant), owner of a piece of land with plant and machinery thereon (“the Property“), had by its liquidators conducted a tender sale of the Property. The Respondent offered to buy the Property for RM90 million which the liquidators accepted together with an earnest deposit of RM1 million paid by the Respondent. The acceptance of the offer was premised on the condition that the sale and purchase agreement (“SPA”) was to be executed within 30 days, failing which the RM1 million earnest deposit would be forfeited “as agreed liquidated damages and not by way of penalty”. The earnest deposit would be taken into account as part-payment of the deposit payable under the SPA.

Subsequently, the liquidators granted three extensions of time for the Respondent to execute the SPA against further earnest deposit payments from the Respondent which totalled a further RM2 million (“the Additional Earnest Deposit“). The Respondent further paid the Vendor interest of RM40,000  in respect of the unpaid balance deposit payable had the SPA been signed on time. The Respondent however, failed to execute the SPA on the final extended deadline. The Vendor’s liquidators terminated the agreement to sell and forfeited the earnest deposit sums which together with the interest paid amounted to a total of RM3,040,000.

The Respondent sued the Vendor for, inter alia, the return of the Additional Earnest Deposit and the late payment interest, amounting to RM2,040,000.  The High Court dismissed the Respondent’s claim. The Court of Appeal allowed the Respondent’s appeal. In referring to section 75 of the Contracts Act, the Court of Appeal had placed the onus of proving that the RM2,040,000  was reasonable compensation on the Vendor and held that there was no evidence to show that such amount represented the damage suffered by the Vendor as a result of the Respondent’s breach.

The Federal Court, however,  allowed the Vendor’s appeal and held that the Additional Earnest Deposit of RM2 million could be forfeited by the Vendor. The Federal Court also allowed the Vendor to retain the interest of RM40,000 as the same was agreed to be not refundable irrespective of whether the SPA was executed. In delivering its decision, the Federal Court examined section 75 of the Contracts Act, 1950 and set out, amongst others, the following principles:-

(a)      Section 75 curtails the freedom to contract as it is a check against potential abuse by a party at the other party’s expense.

(b)      However, the court would be slow to refuse to give effect to a damages clause in the contract if there had been negotiations between parties who have been properly advised.

(c)      If there was a breach of contract, a deposit paid is generally not recoverable as it is a guarantee of performance of the contract.

(d)      A deposit or any sum payable for breach of contract, however, is still subject to section 75, and has to be “reasonable compensation”. It would be an unreasonable compensation if it is “extravagant and unconscionable in amount” when compared to the actual loss or damage suffered by the innocent party from the breach of contract.

(e)      Section 75 allows reasonable compensation to be awarded by the court irrespective of whether actual loss or damage is proven.

(f)      The initial onus lies on the party seeking to enforce a damages clause to adduce evidence that: (i) there was a breach of contract, and (ii) the contract contains a clause specifying a sum to be paid upon such breach.  Upon establishing these two elements, the innocent party is entitled to receive a sum up to such amount stipulated, irrespective of whether actual damage or loss is proven.

(g)      If there is a dispute as to what constitutes reasonable compensation, the defaulting party has the burden to prove that the damages clause and the sum stated to be payable is unreasonable.

This landmark decision has clarified the nature of clauses which provide for payment of certain sums in the event of a breach of contract. It has shifted the burden of proof such that it is now for the defaulting party to prove that such sum is unreasonable, rather than for the innocent party to prove otherwise.

Underlying this, of course, in this unique period of Covid-19, is whether there can be defences raised against a claim for breach of a particular contract.

This article is intended for general information of the clients of our Firm. It should not be regarded as legal professional advice. If you need advice based on specific facts, please feel free to contact us.

 

Yoong Sin Min

Partner

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Samuel Tan Lih Yau

Partner

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Carmen Cheo Kar Meng

Associate

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