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    08:15 AM Kevin Ho Hin Tat (Practice Trainee, WongPartnership LLP) and Ernest Wong Changyan (Practice Trainee, David Lim & Partners LLP)

    Whither punishment and deterrence in contract law? Examining the rejection of punitive damages and its implications on the penalty rule

        

    Introduction

    Can a person be punished for breaching a contract? What is the role of punishment in contract law? These were difficult issues which the Singapore Court of Appeal (“the Court”) painted as going straight to the “heart of contract law” in PH Hydraulics & Engineering Pte Ltd v Airtrust (Hong Kong) Ltd and another appeal [2017] SGCA 26 (“Airtrust”) (at [1]). The Court held as a general rule that punitive damages cannot be awarded in a purely contractual context. This article will engage the decision and seeks also to contemplate its possible impact on the penalty rule.

    Brief Facts and decision

    The Appellant (PH Hydraulics) entered into a sale and purchase agreement with the Respondent (Airtrust (Hong Kong) Ltd) for the design and production of certain machinery for offshore use in the laying of cables. The Appellant was to design and supply the machinery, which would then be leased by the Respondent to an offshore Australian company. Eventually, there was a “catastrophic failure” as certain components of the machinery fell apart mid-way through the laying of cables and it broke up from its mounting. Investigations later surfaced problems with the machinery's design and manufacture.

    The Respondent commenced action against the Appellant for breach of contract, and argued for additional punitive damages to be awarded for the Appellant's alleged fraudulent conduct in its performance of the agreement. The trial judge found that the Appellant had, inter alia, provided “blatantly irresponsible designing, engineering and manufacturing” at [272], and misled the Respondent into believing that full certification had been obtained for the machinery. On this basis, the trial judge awarded punitive damages against the Appellant.

    On appeal, the Court was of the view that the acts of the Appellant were grossly negligent, not amounting to fraud (Airtrust at [60]). Importantly, on the issue of punitive damages, the Court established a general rule that punitive damages cannot be awarded in a purely contractual context, although caveating that a “particularly outrageous” type of breach might warrant the possibility of punitive damages in future (Airtrust at [136]).

    Arguments against an award of punitive damages in a purely contractual context

    The Court offered five reasons why punitive damages should not be awarded in a purely contractual context.

    1. First, the conceptual distinction between contract and tort means that they serve “different remedial purposes” (Airtrust at [69]). In the Court's view, contract law should play “minimal role” in “regulating the conduct” of voluntary parties because of the “key element of agreement” in contract, whereby parties had the chance to deliberate and bargain for the terms of contract (Airtrust at [71]). In contradistinction, there is greater latitude for the law to “impose an external standard” in tort, where damages may be awarded to “signify that such conduct should not be tolerated” (Airtrust at [74]).
    2. Second, since the Court felt that the concept of punishment and deterrence is “inapposite” in the law of contract, then there would not be a “remedial gap” which only an award of punitive damages could fill in the first place (Airtrust at [78]). Even if there was a gap, the Court pointed to other remedial options, such as account of profits, which were “compensatory in purpose”, even though they had incidental punitive or deterrent effects (Airtrust at [79]-[81]).
    3. Third, awarding punitive damages for an “outrageous breach” would be a vague exercise without any concrete criteria, which could engender commercial uncertainty and instability (Airtrust at [86]).
    4. Fourth, the Court turned to foreign jurisprudence for support, including the UK and Australia, where the position is that punitive damages are not awarded in a purely contractual context.
    5. Fifth, the Court offered two policy considerations for consideration. The first policy argument was that contracting parties might be incentivised to “simply tag on” a claim for punitive damages for breach of contract, adding to the “length, complexity and costs” of litigation (Airtrust at [104]). The second policy argument was that any “reprehensible conduct” to be addressed would be better left to regulation, as regulators are better equipped to “assess the wider social as well as economic impact” of sanctions instead of judicial intervention in the form of punitive damages (Airtrust at [106]).

    Arguments for an award of punitive damages in a purely contractual context

    The Court addressed and refuted three main counter-arguments. First, since punitive damages were available in tort as a matter of law, the argument was that such “morally outrageous behaviour” similarly warranted punishment in contract. However, since the Court had already addressed the contract-tort distinction, it did not find the argument from uniformity persuasive (Airtrust at [111]).

    Second, the Court addressed the strongest authority from the Supreme Court of Canada in Whiten v Pilot Insurance Company (2002) 209 DLR (4th) 257, which recognised for the first time punitive damages in a purely contractual context. The Court dismissed the authority with several reasons, including the fact that the case was not purely contractual as it involved tortious defamatory conduct, and that the Canadian court could have instead awarded other forms of compensatory damages or penalised the guilty party by way of indemnity costs (Airtrust at [117] – [118]).

    Third, it may be argued that a duty of good faith (if any) could overcome the objection of the “undesirability of a court imposing on the parties its own normative standard of contractual performance” (Airtrust at [134]). However, the Court viewed this as simply a “neutral factor” which only negated the argument that contracting parties are free to perform the contract as they wish without external standards. It did not necessarily follow that punitive damages hence ought to be awarded (Airtrust at [134]).

    Exceptional exception rather than a complete rejection

    Although the Court largely rejected punitive damages for breach of contract, it nonetheless left open the possibility of doing so if a “truly exceptional” case were to arise (Airtrust at [136]). Is “never say never” truly a “sound judicial admonition” (Airtrust at [136])? It would seem that the overall difference between the position under contract and tort (where punitive damages is allowed) is merely one of degree, not of kind. If the principle is that there is no gap for punitive damages to fill, then logically, there should be no room for such an exception, even if the facts are “truly exceptional”.

    Furthermore, leaving room for such an exception might militate against the policy consideration to avoid frivolous litigation highlighted at [105], as parties might still be incentivised to argue that their case was “truly exceptional”, engendering the addition of “length, complexity and costs” to litigation (Airtrust at [104]). The threshold for parties to meet might be high, but the prospects of higher rewards are still there to lure parties into litigation.

    Hence, it is submitted that even if punitive damages were to be awarded in “truly exceptional” cases, the suggestion of the England and Wales Law Commission (albeit in the context of tortious punitive damages) to introduce “limiting devices” would be useful here (Aggravated, Exemplary and Restitutionary Damages (1997) (“Commission Report”) at [1.30]). In particular, punitive damages awarded should be “moderate” and the “minimum necessary to achieve the aims of punishment, deterrence and disapproval” (Commission Report at [1.30]). This would help to limit any incentive for plaintiffs to bring unfounded claims in future hoping to fall within the category of “truly exceptional” cases.

    Implications on the penalty rule

    The Court drew parallels between punitive damages and the penalty rule, stating in no uncertain terms that the latter exemplified the “strength of contract law’s commitment to the compensatory principle, and its aversion to concepts of punishment and deterrence” [emphasis added] (at [73]).

    The seminal inquiry for whether a liquidated damages clause is a penalty, based on the principles in Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd [1915] AC 79 (“Dunlop”) at 86-88 has been whether the clause is a “genuine pre-estimate” of loss or a deterrent (in terrorem). However, the UK Supreme Court in a watershed judgment ruled that the penalty rule should not depend on such “artificial categories”, and that the test instead is whether the detriment imposed by the clause is proportionate to the “legitimate interest” of the innocent party in enforcement (Cavendish Square Holding BV v Makdessi [2015] 3 WLR 1373 (“Cavendish”) at [32]).

    The position of Cavendish has not been settled in Singapore yet (insofar as it relates to the recognition of “legitimate interest”). The High Court had two opportunities recently to address Cavendish, but preferred to apply the Dunlop principles instead, as the Court of Appeal had not decided Cavendish's applicability in Singapore (iTronic Holdings Pte Ltd v Tan Swee Leon and another suit [2016] SGHC 77 (“iTronic Holdings”) and Allplus Holdings Pte Ltd v Phoon Wui Nyen [2016] SGHC 144 (“Allplus Holdings”)).

    Whither the concept of deterrence?

    In light of Airtrust, one possible objection to Cavendish in Singapore is its watering down of the concept of deterrence. In the UK Supreme Court's view, deterrence is not “inherently penal or against the policy of the law” and is merely “designed to influence the conduct of the party potentially affected” (Cavendish at [31]). Deterrence can be commercially justifiable and enforced in a clause, which “represents a significant weakening of the doctrine” of penalty (William Day, A Pyrrhic victory for the doctrine against penalties: Makdessi v Cavendish Square Holding BV, [2016] JBL 115-127 at p 125). This would appear at odds with Airtrust which perceives the penalty rule as an expression of the law's “distaste for deterrent damages in contract” (Airtrust at [73]).

    It is possible however, that a more nuanced approach could be taken, evident in the High Court of Australia's decision of Paciocco v Australia and New Zealand Banking Group Limited [2016] HCA 28 (“Paciocco”), which reaffirmed that a penalty clause will not be struck down simply because it is not a “genuine pre-estimate of losses”, and that a wider range of legitimate interests of the innocent party should be protected in enforcing the clause.

    Although the majority (Nettle J dissenting) provided various reasoning, what is significant is that the court did not abandon, but instead anchored the concept of deterrence in its analysis. In particular, Gageler J's test is worth considering, which can be interpreted as consisting of 2 limbs:

    1. Whether the clause has a purpose other than to punish (Paciocco at [159]).
    2. In turn, the “relevant indicator of punishment lies in the negative incentive to perform being so far out of proportion with the positive interest in performance that the negative incentive amounts to deterrence by threat of punishment” (Paciocco at [164]).

    Rather than Cavendish which views deterrence as simply a neutral concept that “does not add anything” to the analysis (Cavendish at [31]), the second limb of Gageler J's test takes a calibrated approach in determining the extent of “negative incentive” that can be tolerated before it amounts to “deterrence by punishment” that is prohibited by the penalty rule. This is practical as it accepts that there will invariably exist a certain degree of “negative incentive” in contract performance - even the “prospect” of paying court-assessed compensatory damages in a normal breach could be considered so (Paciocco at [164]). However, this does not necessarily cross the boundary from legitimate incentivisation for performance into prohibited deterrent behaviour.

    If our courts were to follow suit in recognising the “legitimate interest” of parties in enforcement of such clauses, then the Australian position would be a preferable one, as it not only accepts that a broader, more flexible view of the interests of contracting parties should be taken but also stays conceptually true to the principle that deterrence is prohibited as part of the penalty rule.

    Is the penalty rule concerned with substantive or procedural justice?

    The court in Cavendish regarded the penalty rule as rooted in the protection of parties of unequal bargaining power, noting somewhat paradoxically that although the rule is “substantive, not procedural”, the circumstances in which the contract is made are relevant as well (Cavendish at [35]). Hence, properly advised parties of similar bargaining power would lead to a “strong initial presumption” that parties are aware of their legitimate interest in the clause, which should therefore be enforced (Cavendish at [35]).

    The position seems to be unsettled in Singapore. In iTronic Holdings, George Wei J cited with approval at [177] Cavendish's “strong initial presumption” that operated between properly advised parties without further elaboration. In contrast, Foo Tuat Yien JC in Allplus Holdings treated the presumption with circumspect and leaned towards the substantive aspect of the rule i.e. whether the clause was intended to punish, emphasizing that a penalty clause will be “contrary to public policy and unenforceable, no matter how freely or willingly entered into at the time of contracting” (Allplus Holdings at [37]). It is submitted that Allplus Holdings squares with and is more consistent with the Court's strong aversion in Airtrust to the concepts of punishment and deterrence in contract law. It is hard to see why parties being of equal bargaining power might affect the court's analysis of whether a clause is intended to punish or not, given that if the clause is void as a penalty clause, the fact that “the parties were legally advised” or on equal bargaining strength would not “logically change that” (Allplus Holdings at [37]).

    This approach is supported by the Australian position in Paciocco, where the issue of equality of bargaining power weighed little in the court's mind, which was more concerned with the substantive aspect of the penalty rule. Keane J noted acutely that the “unfair or unreasonable use of superior bargaining power” should be left to the purview of other relevant laws, and the penalty rule would interfere with parties' freedom to contract only if the clause is “distinctly punitive” (Paciocco at [221]).

    Overall, it seems that the Australian position coheres better than Cavendish with the penalty doctrine as envisaged by the Court in Airtrust. Ultimately though, the reception of Cavendish (or Paciocco) in Singapore would have to be supported by “principle and policy”, also depending on the “impact of Cavendish on English law and practice” (Goh Yihan and Yip Man, English Reformulation of the Penalty Rule - Relevance in Singapore? (2017) 29 SAcLJ 257 at para 40).

    What lies ahead?

    It has been said that a theme that runs through contract law is that the “reasonable expectations of honest men must be protected” (First Energy (UK) Ltd v Hungarian International Bank Ltd [1993] 2 Lloyd's Rep. 194 at 196). The question then, in light of the recent developments, is to what extent should these “reasonable expectations” be reasonably protected? As far as punitive damages are concerned, the Court has all but closed the possibility of punishment for breach of contract. We have argued that the Singapore courts should award only moderate damages even if “truly exceptional” cases were to arise in future to avoid encouraging frivolous litigation. It remains to be seen how the Court will treat Cavendish, although the sentiments expressed in Airtrust could be telling.

    * This blog entry may be cited as Kevin Ho Hin Tat and Ernest Wong Changyan, “Whither punishment and deterrence in contract law? Examining the rejection of punitive damages and its implications on the penalty rule” (8 May 2017) (http://www.singaporelawblog.sg/blog/article/185)

    ** A PDF version of this entry may be downloaded here

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