Federal Court Rules on Forfeiture of Deposits and Liquidated Damages Clauses

Malaysia’s apex court, the Federal Court, has decided on significant points of law relating to the right to forfeit deposits and the application of liquidated damages clauses. This is seen in the grounds of judgment of Cubic Electronics Sdn Bhd (in liquidation) v Mars Telecommunications Sdn Bhd.

These issues relate to the interpretation of section 75 of the Contracts Act 1950, whether there is a need to prove actual loss, and whether there has been an alignment of Malaysia law with the UK Supreme Court position in Cavendish.

This Federal Court decision significantly clarifies the previous position under Selva Kumar.

Brief Facts

Cubic was a wound up company and with liquidators appointed. The liquidators put up Cubic’s land and machineries for sale by way of an open tender exercise. An Information Memorandum was issued. Mars made an offer to purchase the properties for RM90 million.

Mars paid the sum of RM1 million as earnest deposit (the first earnest deposit). The liquidators accepted this offer and did not proceed with the tender exercise.

Under the terms of the Information Memorandum, the sale and purchase agreement was to be executed within 30 days, failing which, the earnest deposit of RM1 million would be forfeited as agreed liquidated damages and not by way of penalty. This was also made clear in Cubic’s letter of acceptance of Mars’ offer.

Mars could not meet the deadline and asked for three further extensions of time.  Further sums of money was agreed to be deposited with Cubic in exchange for the three further extensions of time. In total, Mars had paid the total sum of RM3,040,000 as shown below:

  1. RM1 million (the first earnest deposit).
  2. RM500,000 (the second earnest deposit).
  3. RM500,000 (the third earnest deposit).
  4. RM1 million (the fourth earnest deposit).
  5. RM40,000 interest.

The liquidators of Cubic agreed to the further extensions of time and the acceptance of further deposits. But the liquidators also made it clear to Mars that any further failure to execute the sale and purchase would result in the forfeiture of all the sums paid to Cubic up to that date.

Eventually, as the extensions of time were not met, the liquidators of Cubic terminated the intended sale of properties to Mars. Cubic wrote to Mars to inform it that the RM3,040,000.00 would be forfeited.

The properties were subsequently sold to a third party by way of an open tender.

Mars filed a civil action against Cubic to seek for, among others, a declaration that the termination of the sale was wrongful and invalid. Mars sought for the return of its deposit money. In turn, Cubic counterclaimed for outstanding rentals and utility charges.

At the High Court, the liquidators of Cubic succeeded in the counterclaim. The liquidators also succeeded in its defence that there was a valid termination of the proposed sale. The liquidators of Cubic had also validly forfeited all the deposits and where there was no need to prove loss or damage.

At the Court of Appeal, Mars succeeded in the finding that Cubic could only validly forfeit the first RM1 million deposit, and the remaining RM2,040,000 deposits had to be refunded to Mars. The Court of Appeal applied the cases of Selva Kumar and Johor Coastal and held that there was no evidence of loss and damage.

Leave to appeal to the Federal Court was allowed.

Legal Principles: Forfeiture of Deposit and Liquidated Damages Clause

His Lordship Richard Malanjum CJSS (as he then was) wrote the grounds of judgment of the Federal Court. The Federal Court examined closely the history of section 75 of the Contracts Act 1950, the appellate authorities in Malaysia, the appellate authorities from India as well as the UK Supreme Court decision in Cavendish.

I next distill what appears to be the applicable principles in two scenarios. The first scenario is where there is a forfeiture of a deposit paid. The second scenario is where the innocent party relies on a liquidated damages clause without putting forward any proof of loss or damages.

Scenario 1: Innocent Party Forfeits a Deposit

  • If there is a breach of contract, money paid in advance as a form of part-payment of the contract price is generally refundable to the payer. But a deposit paid which is not merely part payment, but also a guarantee of performance, is generally not recoverable i.e. it will be forfeited by the innocent party (see [74(i)] of the Grounds of Judgment).
  • Whether the payment is part-payment or a deposit is a question of contractual interpretation. If the payment possesses the dual characteristics of earnest money and part payment, it is a deposit (see [74(ii)] of the Grounds of Judgment).
  • A deposit, which is about to be forfeited, is subject to a reasonable compensation test under section 75 of the Contracts Act. The innocent party will be subject to the tests of “legitimate interest” and “proportionality” following the principles in Cavendish (see [74(iv)] of the Grounds of Judgment).
  • Once the innocent party satisfies the tests of legitimate interest and proportionality, the onus then shifts on the defaulting party to show that the forfeiture of the deposit was excessive (see [88] of the Grounds of Judgment).

Scenario 2: Innocent Party Relies on Liquidated Damages Clause

  • Section 75 of the Contracts Act allows reasonable compensation irrespective of whether actual loss or damage is proven. Thus, proof of actual loss is not mandatory. Nonetheless, evidence of such loss is a useful starting point (see [74(vi)] of the Grounds of Judgment).
  • The first stage is that the innocent party seeking to enforce the liquidated damages clause must first show a breach of contract. Next, the innocent party points to the contract that contains a clause specifying a sum to be paid upon breach. Once this first stage is met, the innocent party can receive a sum not exceeding the amount stipulated in the contract (see [74(vii)] of the Grounds of Judgment).
  • The second stage then shifts the burden on the defaulting party. The defaulting party must now show that the liquidated damages clause, including the sum stated in the clause, is unreasonable (see [74(vii)] and [74(viii)]).
  • A sum payable on breach of contract will be held to be unreasonable compensation if it is extravagant and unconscionable in amount in comparison with the highest conceivable loss which could possibly flow from the breach (see [74(v)] of the Grounds of Judgment).

Application to the Facts

Step 1: Payment of Additional RM2 million was a Deposit

First, the Federal Court held that the bargain between Cubic and Mars could be discerned from the written exchanges between the parties. This was when Mars was requesting for more time to execute the sale and purchase agreement. The communications between the parties showed that Mars paid the additional sums totalling RM2.04 million to Cubic in return for Cubic extending time. The RM2 million would also constitute part payment of the earnest deposit which included a guarantee of performance in executing the sale and purchase agreement.

Secondly, when parties were negotiating for the extension of time, they characterised the impugned payments as earnest deposits.

Thirdly, when Mars wrote to Cubic to ask for the second, third and final extension, it had done so on the understanding that the payments of additional earnest deposit would go towards reducing the outstanding earnest deposit amount.

Fourthly, the parties were well aware that should there be default in executing the sale and purchase agreement, Mars’ earnest deposit payments would be forfeited as “agreed liquidated damages.” On every occasion where Cubic granted an extension of time, Cubic had repeatedly warned Mars that failure to execute the sale and purchase agreement would result in the forfeiture of the amounts paid as “agreed liquidated damages and not by way of penalty.”

Fifthly, both parties had the benefit of legal representation and Mars made no objection to the imposition of all the above conditions.

Hence, the Federal Court found that the additional payments bore the characteristics of a deposit.

Step 2: Deposit to be Examined under Reasonableness Test under Section 75

Liquidators of Cubic had legitimate interests to safeguard: First, when the three extensions of time were granted, the primary obligation on Mars’ part was to ensure that the sale and purchase agreement was completed by the new deadline. The failure by Mars to perform this primary obligation then resulted Mars having to fulfill its secondary obligation to forfeit the agreed sums.

Secondly, where a company has gone into liquidation, the liquidator has a duty to realise the assets of the insolvent company at the best possible price to maximise the assets available to the creditors of the company. Hence, not unreasonable for the liquidators to require some form of guarantee from potential bidders to show that they mean business.

Thirdly, there was financial impact on Cubic. Depreciation in value of Cubic’s moveable assets, and the monetary expenditure in the form of liquidators’ fees.

Fourthly, Cubic, as the innocent party, had experienced a loss of opportunity to enter negotiations with a third party.

Additional RM2 million was not disproportionate: This additional RM2 million was not too large a figure when compared against the total purchase price of the properites of RM90 million. The additional RM2 million represented 3.33% of the total purchase price.

Step 3: Onus on Mars to Now Show that the Forfeiture of the RM2 million was Excessive

The onus now shifted to Mars to show that the forfeiture of the additional RM2 million was excessive. Mars had not adduced any proof showing that the forfeited payments were exorbitant or unreasonable.

The final point was the RM40,000 interest. The parties had agreed and intended for the RM40,000 interest to be non-refundable. Since the RM40,000 was not refundable regardless of whether the sale went through, it was payable regardless of any breach and thus fell outside the scope of section 75 of the Contracts Act.

In conclusion, the Federal Court answered the following two leave questions as follows:

Question 1: Where, in a sale and purchase of property, where terms and conditions of the sale and purchase agreement have been agreed and a date is fixed for the execution of the agreement, whether any additional deposit paid for the extension of time for completion is equally subject to forfeiture

Answer: Yes. Any additional deposit paid for the extension of time for completion is subject to forfeiture if it is consistent with the section 75 of the Contracts Act, that is, if it is a reasonable amount.

Question 2: Whether a purchaser who has agreed and willingly paid an interest in consideration of an extension of time be entitled to claim a refund of the same in the event he defaults in executing the sale and purchase agreement and paying the balance deposit on the due date:

Answer: No, the purchaser is not entitled to claim a refund. 

Commentary

This case was focused on questions of law and facts on forfeiture of deposits. But the Federal Court nonetheless took the opportunity to also clarify the law both for the forfeiture of deposits and liquidated damages clauses seen under the lens of section 75 of the Contracts Act.

From a contractual point of view, this is more favourable to upholding the wording of contracts and agreements via exchange of letters and communications. Where parties agree to the terms of the forfeiture of deposits due to non-performance, the courts will more readily uphold that agreement. Similarly, where the terms of a contract provide for liquidated damages clauses, there is no longer a strict requirement to prove all of the loss suffered by the innocent party. In fact, the burden will largely rest on the defaulting party to now show the unreasonableness of the prescribed liquidated damages. The innocent party can largely rely on the contractual liquidated damages clause.

From the aspect of forfeiture of deposits, the facts of this case may have made it easier to rule that there was proportionality to forfeit what amounted to 3.33% of the overall purchase price. But what is less clear will be the cases where the forfeited amounts may be more than the usual 10% or even 12% of the overall purchase price. In the earlier Federal Court case of Johor Coastal, the innocent party had attempted to forfeit 50% of the deposited amounts. Would 50% then still satisfy the tests of proportionality, and what would the defaulting party have to prove in terms of the forfeiture being excessive?

While the Federal Court referred to the UK Supreme Court decision in Cavendish, I read the Malaysian position as not clearly adopting wholesale the Cavendish test of primary obligations and secondary obligations. The Federal Court has now set out the elements and tests when reading a liquidated damages clause and when deciding on a forfeiture of deposit scenario.

 

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