CMC Group Plc & Ors v Zhang

A contractual provision is a penalty where, construed at the time of contracting, its predominant function is to deter breach rather than compensate for loss. A substantial lump sum payable for any breach, including breaches capable of causing only trivial loss, strongly indicates a penalty, especially where additional damages may also be claimed. The penalty doctrine applies to compromise agreements. A provision cannot be recharacterised as repayment for failure of consideration where, on its true construction, payment is linked to breach. A default judgment leaving damages for assessment does not determine whether a stipulated sum is recoverable.

CMC Group brought proceedings against Michael Zhang to enforce a written settlement offering US$40,000 in full and final settlement, subject to confidentiality and non-harassment obligations. The agreement provided for a further payment of US$40,000 if Zhang breached its terms. After Zhang failed to acknowledge service, default judgment was entered, leaving the amount and costs for determination by the court. On assessment, Master Eyre awarded CMC US$40,000 and £1,000 in damages. The appeal concerned whether the US$40,000 provision was an unenforceable penalty and whether that issue remained open after the default judgment.

The Court of Appeal unanimously granted permission to appeal and allowed the appeal insofar as the judgment included US$40,000. The provision was a penalty and could not be recovered by CMC.

1. Default judgment and new point. Sir Charles Mantell held that the order requiring Zhang to pay an amount and costs which the court would decide did not determine quantification. The penalty issue therefore remained open at the assessment hearing. The court was also prepared to hear the point although it had first been raised on appeal, because it was a substantial point of law and Zhang had been a litigant in person who had been ill-equipped to raise it earlier. Mummery LJ agreed.

2. Applicable test. The classification of a clause as a penalty or liquidated damages is a matter of construction, assessed by reference to the terms and circumstances existing when the contract was made. The predominant contractual function is relevant: deterrence indicates a penalty, while compensation indicates a genuine pre-estimate of loss. The court applied the principles in Dunlop Pneumatic Tyre Co Limited v New Garage and Motor Co Limited [1915] AC 79 and Lordsvale Finance plc v Bank of Zambia [1996] QB 752.

3. Construction of the compromise. Dyson LJ rejected the argument that the US$40,000 was merely repayable because a condition of payment had failed or because there had been a total failure of consideration. On the true construction of the agreement, the sum was compensation payable upon breach. The distinction identified in Jervis v Harris [1996] Ch 195, concerning sums payable upon events other than breach, did not assist CMC. Mummery LJ agreed.

4. Application. US$40,000 was payable for any breach, including a trivial derogatory communication, without tailoring the sum to the circumstances or loss. The agreement also allowed claims for legal costs and loss of business. The lump sum was therefore deterrent, extravagant or unconscionable in the relevant circumstances, and fell within the presumption applicable where one sum covers breaches causing serious or trifling loss. The presumption was not rebutted.

1. Court of Appeal (Civil Division) — [2006] EWCA Civ 408. Permission to appeal was granted and the appeal was allowed in relation to the judgment for US$40,000.

2. High Court, Queen’s Bench Division (Master Eyre) — Default judgment was entered on 5 November 2004, with the amount and costs left for determination. On 5 April 2005, Master Eyre awarded CMC US$40,000 and £1,000 in damages.

3. Earlier appellate applications — Waller LJ directed that the matter continue as an application with the appeal to follow. Dobbs J refused permission to appeal against the striking out of Zhang’s separate claim.