Can a deposit paid under a contract be forfeited without having to prove the damage suffered?
The recent Federal Court decision in Cubic Electronics Sdn. Bhd (in liquidation) v Mars Telecommunications Sdn. Bhd. (Appeal No. 02(f)-64-09/2016(W), 21 November 2018) sheds some light on this query, especially given the earlier Malaysian case law about liquidated damages.
The Law on Deposits and Liquidated Damages
Generally, if there is a breach of contract, any money paid as part-payment of the contract price is recoverable by the defaulting party.
However, a deposit paid which is not merely part payment but also as a guarantee of performance is generally not recoverable and can be forfeited by the innocent party in the event of a breach.
Whether a payment is part-payment of the price or a deposit is a question of interpretation that turns on the facts of a case.
Section 75 of the Contracts Act 1950 (“Act”), the main legislative framework in Malaysia that governs and regulates contracts, provides:
“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.”
Section 75 requires proof of damages/reasonable compensation before an innocent party in a contract that has been breached can recover the sum fixed in a clause, unless his case falls under the limited situation where it is difficult to assess actual damage or loss (Selva Kumar Murugiah v Thiagarajah Retnasamy, approved in Johor Coastal Development Sdn Bhd v Constrajaya Sdn Bhd).
The “sum” envisioned in section 75 had been interpreted by earlier courts to be limited to damages and not deposits. Thus, once a payment is found to be a deposit it is forfeitable without the need to resort to section 75.
The Federal Court’s Decision in Cubic Electronics
The Federal Court in Cubic Electronics Sdn. Bhd (in liquidation) v Mars Telecommunications Sdn. Bhd. held that a deposit is also subject to section 75.
This means that in order to have the right to forfeit, the initial onus lies on the innocent party to adduce evidence that:
- There was a breach of contract; and
- The contract contains a clause specifying a sum to be paid upon breach.
Once these two elements have been established, the innocent party is entitled to receive a sum not exceeding the amount stipulated in the contract irrespective of whether actual damage or loss is proven unless the defaulting party is able to prove the unreasonableness of the sum stated therein.
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.
An innocent party is therefore allowed to forfeit the deposit sum (without having to prove the loss he has suffered) if:
- He is able to prove breach of contract;
- He is able to prove that the contract contains a forfeiture clause;
- The defaulting party fails to prove the unreasonableness of the sum forfeited.
The Federal Court’s decision can be summarised as follows:
- If there is a breach of contract, any money paid in advance of performance and as part-payment of the contract price is generally recoverable by the payer. But a deposit paid which is not merely part payment but also as a guarantee of performance is generally not recoverable.
- Whether a payment is part-payment of the price or a deposit is a question of interpretation that turns on the facts of a case, and the usual principles of interpretation apply. Once it has been ascertained that a payment possesses the dual characteristics of earnest money and part payment, it is a deposit.
- A deposit is subject to section 75 of the Act. Section 75 does not require proof of loss in all cases. However, the amount/deposit to be forfeited must be reasonable;
- 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. In the absence of proper justification, there should not be a significant difference between the level of damages spelt out in the contract and the level of loss or damage which is likely to be suffered by the innocent party.
- Section 75 of the Act allows reasonable compensation to be awarded by the court irrespective of whether actual loss or damage is proven. Thus, proof of actual loss is not the sole conclusive determinant of reasonable compensation although evidence of that may be a useful starting point.
- An innocent party can enforce a damages clause under Section 75 of the Act by proving (1) there was a breach of contract and (2) the contract contains a clause specifying a sum to be paid upon breach. Once these two elements have been established, the innocent party is entitled to receive a sum not exceeding the amount stipulated in the contract irrespective of whether actual damage or loss is proven subject always to the defaulting party proving the unreasonableness of the damages clause including the sum stated therein, if any.
- If there is a dispute as to what constitutes reasonable compensation, the burden of proof falls on the defaulting party to show that the damages clause including the sum stated therein is unreasonable.
This article was written by Donovan Cheah (Partner) and Adryenne Lim (Legal Executive). Donovan has been named as a recommended lawyer for labour and employment by the Legal 500 Asia Pacific 2017, 2018 and 2019, and he has also been recognised by Chambers Asia Pacific and Asialaw Profiles for his employment law and industrial relations work.
Donovan & Ho is a law firm in Malaysia. Our practice areas include employment law, dispute resolution, tax advisory and corporate advisory. Have a question? Please contact us.