THE CENTER (76) LTD v. VICTORY SERVICED OFFICE (HK) LTD

HCA 1020/2020

[2020] HKCFI 2881

IN THE HIGH COURT OF THE

HONG KONG SPECIAL ADMINISTRATIVE REGION

COURT OF FIRST INSTANCE

ACTION NO 1020 OF 2020

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BETWEEN

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REASONS FOR DECISION

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Introduction

1.  This is the substantive hearing of:

(1) the Plaintiff’s summons dated 23 July 2020 for summary judgment or alternatively interim payment (“Summary Judgment Summons”);

(2) Plaintiff’s summons dated 7 October 2020 for an unless order in respect of the Defendant’s default in making periodical interim payment in accordance with the order of Master J Wong dated 21 September 2020 (“Unless Order Summons”); and

(3) the Defendant’s summons dated 16 October 2020 for extension of time to pay the balance of the interim payment of $1 million pursuant to the order of Master J Wong dated 21 September 2020 (“Extension of Time Summons”).

The background

2.  The Plaintiff is the landlord of prestigious office accommodation in the 76^th floor of The Center in Central (the “Premises”).  The Defendant is a company incorporated in Hong Kong operating under licence from Victory Offices Limited, a publicly listed company on the Australian Stock Exchange. 

3.  On 26 June 2019, the parties entered into a tenancy agreement in respect of the Premises (“Tenancy Agreement”).  A deposit equivalent to four months’ rent and air-conditioning charges was paid on 21 June 2019.  About a month prior, the parties executed a supplemental letter (“Supplemental Letter”) providing a rent free period of three months in respect of the Premises subject to certain conditions.  The Supplemental Letter was returned to the Plaintiff together with the Tenancy Agreement at the same time.  On 16 September 2019, the Defendant commenced its flexible workspace business at the Premises.

4.  Since February 2020, despite repeated demands, the Defendant has failed to fully settle the rent and other charges in respect of the Premises.  On 19 May 2020, the Plaintiff commenced distraint proceedings and obtained a Distress Warrant against the Defendant.  On 26 May 2020, bailiff attended the Premises in execution of the Distress Warrant and seized custody of goods and chattels from the Premises.  Security guards were stationed at the Premises.  On 4 June 2020, out of commercial consideration, the seized chattels were released following the Plaintiff’s withdrawal of the distraint proceedings. 

5.  On 19 June 2020, the Plaintiff commenced the present proceedings.  As at that date, the Defendant was liable to pay the Plaintiff a total sum of $20,480,473.60 being outstanding rent, air-conditioning and management charges, government rates, administrative charges and a sum of $7,889,389.20 equivalent to the rent during the three months’ rent free period under the Supplemental Letter. 

6.  At the call-over hearing of the Summary Judgment Summons on 21 September 2020, Master J Wong made an interim payment order (“Interim Payment Order”) against the Defendant as it has been continuously using and occupying the Premises without paying rent and other charges.  He ordered, inter alia, the Defendant to pay the Plaintiff by way of interim periodical payment(s), a periodical sum of $2,833,352.40; $2,629,796.40 being rent and/or mesne profits and $203,556 being the air-conditioning and management charges, commencing from 1 October 2020 and thereafter on the first day of each and every calendar month until determination of the Summary Judgment Summons or further order.

7.  Thus far, the Defendant only paid $1,833,352.40 in part compliance with the Interim Payment Order.  A sum of $1 million is still outstanding.  On 16 October 2020, the Defendant took out the Extension of Time Summons seeking extension of time of 28 days from the date of the order to be made to pay the outstanding balance of $1 million.  At the conclusion of the hearing, for expediency reasons, I granted the Defendant extension of time to pay the said balance until 1 November 2020 with costs to the Plaintiff in the agreed sum of $1,040.

8.  On 30 October 2020, I made the order stated in paragraph 52 of this decision.  Hereunder are the reasons. 

The applicable legal principles on the grant of summary judgment

9.  The legal principles applicable to the grant of summary judgment under Order 14 of the Rules of the High Court are well settled:  see Super Town Investments Limited v Ives Developments Limited and Ors[1] and Polykote Coating Manufacturing Co Ltd v Grace Rehabilitation Centre Ltd[2].  The following principles are relevant:

(1) summary judgment should only be given in clear and obvious cases in which there are no serious material factual disputes and if there is a legal issue, then no more than a crisp legal question as well decided summarily as otherwise;

(2) the plaintiff has to show that his case comes within Order 14 by affidavit verifying the facts on which the claim or the part of the claim to which the application relates is based and starting that in the deponent’s belief there is no defence to that claim or part of it or no defence except as to the amount of any damages claimed;

(3) once that hurdle is passed, the burden, as it were, is shifted to the defendant to satisfy the court why judgment should not be given against him; and

(4) the defendant may show cause against the plaintiff’s application by raising technical objections or on the merits, eg that he has a good defence to the claim, that a difficult point of law is involved, or a dispute as to the facts which ought to be tried, or a real dispute as to the amount due which requires taking of an account to determine, or any other circumstances showing reasonable grounds of a bona fide defence.

10.  Counsel have no dispute about these principles and that the Plaintiff’s case comes within Order 14.  The burden is therefore on the Defendant to satisfy this court why judgment should not be given against it.  The Defendant advanced the following defences and counterclaims:

(1) the Plaintiff is not entitled to retrospectively claim rent for the rent free period (“Rent Free Period Defence”);

(2) the Plaintiff is not entitled to forfeit deposit (“Forfeiture of Deposit Defence”);

(3) frustration (“Frustration Defence);

(4) counterclaim in relation to distraint proceedings (“Counter-claim for Wrongful Distraint”); and

(5) miscellaneous counterclaims (“Miscellaneous Counter-claims”).

Rent Free Period Defence

11.  The Plaintiff’s claim for rent during the rent free period is based on the Defendant’s failure to observe and/or perform certain terms of the Tenancy Agreement and the following provision in the Supplemental Letter:

“And provided further that if the Tenant shall at any time fail to observe and/or perform any covenant, term or condition on its part to be observed and/or performed hereunder and under the Lease and the Tenant has not rectified such breach within fourteen (14) business days from the date of receipt of a written notice from the Landlord requiring rectification, the Tenant shall with retrospective effect cease to be entitled to the Rent Free Period … and, without prejudice to any other rights which the Landlord may have, the Tenant shall forthwith upon demand repay to the Landlord all the rents for the month(s) of the Rent Free Period …”

The failures alleged are the Defendant’s failure to meet its payment obligations, including the rent for the period from 28 January 2020 to 30 June 2020, air-conditioning and management charges for the period from 1 February 2020 to 30 June 2020; rates for the period from 1 April 2020 to 30 June 2020; and administrative charges.  These failures are not disputed.  By their solicitors’ letter of demand dated 4 June 2020, written notice requiring rectification of the failures was given to the Defendant.  Despite that the payments are still outstanding.  The Plaintiff’s case is that these failures triggered the operation of the above provision in the Supplemental Letter.  It argues that it is entitled to retrospectively claim an amount equivalent to the rent for the rent free period.  The thrust of the Defendant’s argument is that this claim which amounted to $7,889,389.20 is such a huge sum as to amount to an unenforceable penalty. 

12.  In Cavendish Holding BV v Makdessi[3], the principles on penalty clause as re-stated by the House of Lords are as follows.  First, whether a contractual provision is a penalty is a question of interpretation of the contract and the real question is whether it is penal or punitive in nature[4]. Second, a penalty clause exists where a secondary obligation is imposed upon a breach of a primary obligation owed by one party to the other[5]. It is to be distinguished from a conditional primary obligation, which depends on events that do not constitute breaches of contract.  Third, whether a clause imposes a secondary liability upon a breach of contract is a question of substance and not of form[6]. Fourth, a provision that in substance imposes a secondary liability for breach of a primary obligation is penal if it imposes on the party in default a detriment which is out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation[7] (or using traditional language, which ie exorbitant, extravagant or unconscionable[8]).  Fifth, the onus lies on the party alleging that a clause is a penalty clause.  Thus, the three essential elements of a penalty clause are:

(1) that it imposes a secondary obligation upon breach of a primary obligation;

(2) that the secondary liability imposes a detriment on the party in breach; and

(3) that the detriment is out of all proportion to the legitimate interest of the innocent party in the enforcement of the primary obligation.

13.  Ms Cheung, counsel for the Defendant, seeks to draw support from the case of Vivienne Westwood Ltd v Conduit Street Development Ltd[9] for her argument that the provision in the Supplemental Letter is a penalty clause.  In that case, the parties entered into a lease and a side letter which conferred on the lessee the benefit of a lower rent than that reserved by the lease for the first five and possibly ten years of the term.  The lower rent was conditional on various matters and terminable by the lessor in specified circumstances including breach by the lessee of any of the terms and conditions in the side letter or the lease.  The court held that the side letter was penal.  Ms Cheung submits that the present case is on all fours with Vivienne Westwood in that a secondary obligation to pay retrospective rent during the rent free period is imposed for breach of primary obligation under the Tenancy Agreement and Supplemental Letter which is out of all proportion to the Plaintiff’s legitimate interest in the Defendant’s performance of the primary obligation.  Accordingly, the provision in the Supplemental Letter is an unenforceable penalty clause.

14.  Despite the apparent similarities, Vivienne Westwood is distinguishable from the present case on the fact.  In Vivienne Westwood, the court held that what amounted to the primary obligation was a question of interpretation of the lease and side letter.  On the facts of that case, the court held that true bargain between the parties was that in return for having the tenant of the reputation of the lessee the lessor would accept a reduced level of rent.  The primary obligation was the claimant’s obligation to pay rent at the lower rate and the side letter created a secondary obligation to pay rent at the higher rate upon breach of the primary obligation.  The judge held:

“43. … The true bargain concluded by the lessor and the Claimant was that, in return for having a tenant of the reputation of the Claimant, the lessor would accept a reduced level of rent, below the market rent that it would otherwise have obtained … The obligations of the Claimant under the lease and the Side Letter together were to pay the lower amount of rent and otherwise comply with all the obligations of the Lease. The rental obligation was conditional, in the sense that the rent reverted to the full rent reserved by the lease if the Claimant assigned the lease or ceased itself to trade from the shop, but subject to those matters if the Claimant complied with its obligations the rent would remain payable at the lower rate specified in the Side Letter.

44. Given the terms of the Side Letter, there was no primary obligation on the Claimant to pay rent at the higher rate reserved by the lease …  The Side Letter obliged the lessor to accept the lower level of rent and therefore gave the Claimant the right to pay at that lower rate, so it cannot at the same time have been obliged to pay rent at the higher rate.  The primary obligation was therefore to pay rent at the lower rate.  That only changed if one of the conditions was no longer satisfied (e.g. if the shares in the Claimant changed hands) or in the event of a breach of contract by the Claimant.  …”

15.  To determine if a clause is penal, the starting point of investigation is what are the primary obligation and secondary obligation.  These are questions of facts to be determined by construing the Tenancy Agreement and the Supplemental Letter together against the factual background.  In the present case, Part I of the Second Schedule to the Tenancy Agreement provides in clear and unequivocal terms that the monthly rent throughout the term shall be $2,629,796.40.  The Supplemental Letter relating to rent free period reads:

“‘Rent Free Period’

Subject to the due performance of the terms and conditions of the Lease by the Tenant a rent free period of three (3) months shall be granted to the Tenant from the date on which the Landlord receives the Security Deposit from the Tenant on or before 15 July 2019 (the ‘Rent Free Period’) PROVIDED THAT (1) the Tenant shall have delivered to the Landlord the Bank Guarantee on or before 28 May 2019 as required under and in accordance with Clause 2 of Part III of the Third Schedule to the Lease; and (2) the Tenant shall pay the Air-conditioning and Management Charges, Government rent, rates and other outgoings in respect of the Premises during the Rent-free Period.

And provided further that if the Tenant shall at any time fail to observe and/or perform any covenant, term or condition on its part to be observed and/or performed hereunder and under the Lease and the Tenant has not rectified such breach within fourteen (14) business days from the date of receipt of a written notice from the Landlord requiring rectification, the Tenant shall with retrospective effect cease to be entitled to the Rent Free Period or any part thereof including all parts of the Rent Free Period granted after the Tenant’s breach and also all parts of the Rent Free Period granted prior to the Tenant’s breach and without prejudice to any other rights which the Landlord may have, the Tenant shall forthwith upon demand repay to the Landlord all the rents for the month(s) of the Rent Free Period which have expired and been enjoyed by the Tenant.”

16.  Unlike in Vivienne Westwood, firstly, there is just one rent which applies throughout the entire term of the tenancy, including the initial three months’ period called “rent free period” during which no rent shall be charged or the rent shall be waived under the Supplemental Letter for as long as the Defendant performed the Tenancy Agreement and Supplemental Letter in accordance with their terms or failing that to rectify the breach within 14 days upon receipt of the Plaintiff’s written notice requiring rectification.  The Supplemental Letter does not stipulate a second level of rent.  It would be stretching the Tenancy Agreement and the Supplemental Letter beyond their four corners to argue that the Tenancy Agreement provides for a higher rent and the Supplemental Letter provides for a lower rent.  It is impossible to calculate what is the “lower rent” as it is absolutely uncertain when rent will be charged for the rent free period.  That depends on many variables, such as when the Defendant would fail to observe the terms of the Tenancy Agreement, whether and when the Plaintiff would issue the notice requiring rectification, and whether the Defendant would fail to rectify the breach.  There is only one rent.

17.  Secondly, a fundamental distinguishing feature is the absence of a secondary obligation in the present case.  In Vivienne Westwood, the court held that the true bargain concluded by the lessor and the lessee was that, in return for having a tenant of the reputation of the lessee, the lessor would accept a reduced level of rent, below the market rent.  Hence, the primary obligation was payment of rent at the lower level.  There was no primary obligation to pay rent at the higher level.  The obligation to pay rent at the higher level was a secondary obligation arising from breach of the primary obligation.

18.  By drawing analogy from Vivienne Westwood, Ms Cheung argues that the obligation to pay a sum equivalent to three months’ rent upon the Defendant’s breach of the Tenancy Agreement and failure to rectify the breach within fourteen business days of receipt of notice requiring rectification is a secondary obligation created as a result of breach of the primary obligation.  With respect, I disagree.  In Vivienne Westwood, the lower level of rent was a term to induce the lessee of reputation to take up the lease.  The rent free period in the present case was introduced as an inducement to the Defendant to perform the Tenancy Agreement in accordance with its terms.  The Defendant had the use and occupation of the Premises during the rent free period.  The obligation to pay back, whether with retrospective or prospective effect was just delayed or deferred performance of its primary obligation to pay rent, though it will be waived at the end of the term if the Defendant had fully observed the terms of the Tenancy Agreement and Supplemental Letter.  It cannot be described as a secondary obligation created upon breach of the primary obligation.  There is no secondary obligation under the Supplemental Letter.  The effect of the Supplemental Letter is to suspend the primary obligation under the Tenancy Agreement which would be activated by the Defendant’s breach and failure to rectify the breach within fourteen business days upon receipt of written notice demanding rectification.

19.  On the true construction of the Tenancy Agreement and the Supplementary Letter, it is clear that there is only one obligation to pay rent at the rate of $2,629,796.40 per month for each and every month throughout the entire term of the tenancy.  That is the primary obligation.  It is only that the right to receive rent is waived or suspended by the Plaintiff for as long as the Defendant performed its obligation under the Tenancy Agreement and the Supplemental Letter throughout the entire terms or, failing that, rectified the breaches within fourteen business days of receipt of notice to make rectification.  It is important to note that the Defendant had actually used and occupied the Premises for three months without paying rent.  The sum equivalent to three months’ rent repayable upon the Defendant’s breach etc is not exorbitant.  It is only back-payment of rent which the Defendant was obliged to pay under its primary obligation for its use and occupation of the Premises which it had enjoyed while the obligation to pay was suspended in accordance with the terms of the Supplemental Letter.  No secondary obligation is imposed for breach of the primary obligation.  There is no question of penalty clause. 

20.  The Defendant having failed to prove this threshold requirement, it would be futile and unrealistic to consider the detriment to the Defendant, the Plaintiff’s legitimate interest and proportionality.  But, even assuming that the provision in the Supplemental Letter was a penalty clause, the detriment to be suffered by the Defendant would be payment of three months’ rent; while the legitimate interest of the Plaintiff would be the Defendant’s observance of the terms of the Tenancy Agreement.  The breaches were substantial and may even be called “fundamental breaches”.  Though it may be argued that the penalty clause could be invoked for trivial breaches, the clause actually contains a built-in relief from the penalty.  The Defendant could rectify such trivial breaches within fourteen business days of receipt of the notice for rectification.  The penalty clause is not unreasonable.  The detriment to be suffered by the Defendant would not be out of proportion to the legitimate interest of the Plaintiff.  

21.  In my view, this question of whether the Supplemental Letter amounts to a penalty clause is no more than a crisp legal and factual issue of construction which may be decided summarily.  On the fact, there is no dispute that the Defendant has been in clear breach of the Tenancy Agreement.  It has been in arrears of rent for ten months.  The Plaintiff has given the Defendant written notice to rectify the breaches through its solicitors’ letter of demand dated 4 June 2020.  Not only were the breaches not rectified, the Defendant committed further breaches of non-payment of rent and air-conditioning charges.  There is no valid defence to the Plaintiff’s claim for rent during the rent free period.

Forfeiture of Deposit Defence – construction of clause 9

22.  A security deposit equivalent to four months’ rent and air-conditioning charges in the sum of $11,859,368.88 was paid to the Plaintiff in accordance with the terms of the Tenancy Agreement and Supplemental Letter.  In paragraph 15 of the Statement of Claim, the Plaintiff claims forfeiture of deposit.  Ms Cheung argues that the Plaintiff is not entitled to forfeit and as the sum has already been paid to the Plaintiff, it should be wholly applied towards reduction of the liquidated sum claimed by the Plaintiff such that there is nothing left to be forfeited.  She further argues that the forfeiture provision in the Tenancy Agreement is an unenforceable penalty clause.  Ms Cheung’s argument is premised on her construction of clause 9.3 of the Tenancy Agreement as an automatic set-off clause.

23.  This defence is irrelevant.  The deposit is in the hands of the Plaintiff.  The Plaintiff is not seeking a judgment on this sum.  In claiming its forfeiture in the Statement of Claim, the Plaintiff is acting as if it were raising a defence to an anticipatory counterclaim for return of deposit.  The Defendant’s argument that the deposit should be or should have been applied towards setting off the outstanding rent in accordance with clause 9.3 of the Tenancy Agreement is inconsistent with its stance that the tenancy is alive and its refusal to vacate the Premises.  If the Defendant wishes to keep the tenancy alive, it is obliged to maintain the deposit.  It is not open to the Defendant to argue that the deposit should be or should have been applied towards setting off outstanding rent.  That would also be the situation, if summary judgment is refused.  On the other hand, if summary judgment is entered against the Defendant, the deposit should be raised by the Defendant as a counterclaim or as a set-off in reducing the amount of liquidated damages claimed by the Plaintiff.  That would be the proper occasion for raising the argument of penalty.  Hence, in my view, this defence is irrelevant.  I shall, however, consider the parties’ arguments for what they are worth.

24.  This defence raises the question of construction of clause 9 of the Tenancy Agreement.  That clause provides as follows:

“Deposit

9.1 The Tenant shall deposit with the Landlord the sum … to secure the due observance and performance by the Tenant of the covenants, terms and conditions herein contained and on the part of the Tenant to be observed and performed. The Deposit shall be used and enjoyed by the Landlord as its own money free of trust of any nature and free of any interest to the Tenant.

Increase of Deposit

9.2 … the Tenant shall, upon receiving written notice from the Landlord … pay to the Landlord in cash by way of an increase in the Deposit a sum proportional to the said increase in Rent or air-conditioning and management charges or Government rates …

Reduction of Deposit

9.3 … in the event of any breach or non-observance or non-performance by the Tenant of any of the covenants, terms or conditions contained herein, the amount of the Deposit paid by the Tenant shall be deemed to have been reduced by an amount required to remedy any such breach … the Tenant shall as a condition precedent to the continuation of the tenancy deposit with the Landlord the amount by which the Deposit is deemed to have been reduced and if the Tenant shall fail to do so the Landlord shall forthwith be entitled to re-enter on the Premises … and to determine this Lease in which event the Tenant’s right to payment of a sum equivalent to the Deposit so reduced hereinafter mentioned shall be forfeited and the Landlord shall be absolutely discharged from the Landlord’s obligation to make such payment.

Repayment of a sum equivalent to Deposit

9.4 Subject as aforesaid a sum equivalent to the Deposit (less any amount required to remedy any breach or non-observance or non-performance by the Tenant of any of the covenants terms or conditions contained herein) shall be paid to the Tenant by the Landlord without interest within forty-five (45) days after the expiration or sooner determination of this Lease and delivery of vacant possession to the Landlord  …   and after settlement of the last outstanding claim by the Landlord against the Tenant for any arrears of Rent, rates and other charges and for any breach non-observance or non-performance of any of the covenants, terms and conditions herein contained and on the part of the Tenant to be observed or performed whichever shall be the later.”

(Emphasis highlighted in bold and italic print)

25.  As stated in clause 9.1, the purpose of the deposit is to secure the due observance and performance of the Tenancy Agreement by the Defendant.  The clause must be construed with this purpose in mind.  For that purpose, the amount must be maintained during the currency of the tenancy. Hereunder is the meaning which a plain reading of the clause would convey to a reasonable reader with knowledge of the factual matrix, particularly, as a long term tenancy of luxurious office accommodation.

26.  The Plaintiff may increase the deposit in accordance with increases in the air-conditioning charges, management charges and government rates under clause 9.2.  

27.  Though clause 9.3 provides that the deposit is deemed to have been reduced by an amount required to remedy any breach committed by the Defendant, it is not a set-off clause as such.  Indeed, there is no set-off clause in the Tenancy Agreement.  This is because clause 1.1 provides that “Rent shall be payable … clear of all deductions in advance”.  This intention is reinforced by the second half of that clause which provides that it is a condition precedent to the continuation of the tenancy for the tenant to top up the deposit by the amount deemed to have been reduced and if the Defendant shall fail to do so the Plaintiff shall forthwith be entitled to re-enter the Premises and to determine the tenancy.  The clear intention is that the deposit may not be reduced for the purpose of setting off any amount required to remedy breach committed by the Defendant.  That the failure to top up is sanctioned by threat of forfeiture of the tenancy and deposit strongly evinces this intention. 

28.  Clause 9.3 does not deal with any issue of set-off, let alone an automatic set-off.  The reduction in deposit is carefully expressed to be a “deemed” reduction.  It is therefore a notional reduction and not an actual reduction.  If it were an actual or automatic reduction, it would defeat the expressed purpose of the deposit under clause 9.1 to “secure the due observance and performance by the [Plaintiff] of the covenants, terms and conditions” of the Tenancy Agreement.  The Defendant could render this clause nugatory simply by withholding payment of rent and air-conditioning charges for four months and thereby reduce the deposit to zero. That could not have been the intention of the parties at the time they entered into the Tenancy Agreement.

29.  Clause 9.4 provides for return of deposit or such amount less any amount required to remedy any breach or non-observance or non-performance by the Defendant of any of the covenants.  On the face, this sub-clause runs contrary to clause 9.3 which gives the Plaintiff the right to forfeit deposit or the amount so reduced.  Since this sub-clause is expressed to be “subject as aforesaid”, it only applies to circumstances other than forfeiture for failure to top up the deposit under clause 9.3.  By its own terms, it does not apply to termination of tenancy upon expiry of its term or on early consensual determination, despite some breaches not remedied by the Defendant.  Understandably, the amount required to remedy those breaches would not exceed the amount of the deposit, otherwise, the Plaintiff would demand toping up or re-entry and forfeiture under clause 9.3.

30.  Against the above scheme, Ms Cheung submits that clause 9.3 is an automatic set-off clause.  She quotes the case of New Castle Investments Limited v WFC Holding Limited and others[10] to support her argument.  In fact, New Castle is an authority against her.  What Ms Cheung did was to quote that case and then sought to distinguish it from the present case.  She is desperately short of authorities in support.  New Castle was a case of tenancy dispute involving a similar deposit clause and a general forfeiture clause.  The tenants were in arrears of rent and the landlord obtained, inter alia, default judgment for the arrears of rent.  Long after the entry of the default judgment, the tenants applied to set it aside.  The master set aside the default judgment on condition that the tenants paid half of the judgment sum.  The tenants appealed to a judge in chambers.  The judge set aside the default judgment unconditionally on the ground that the tenants had a good defence based on the application of the deposit towards the reduction of rent under clause 5.03 of the tenancy agreement.  In essence, the tenants relied on the same argument as now advanced by Ms Cheung that clause 5.03 is an automatic set-off clause.  On the landlord’s appeal, the Court of Appeal held that clause 5.03 was not a set-off clause[11].  New Castle is therefore an authority against the Defendant. 

31.  However, Ms Cheung argues that clause 5.03 in New Castle is distinguishable from clause 9.3 in the present case.  Clause 5.03 provides:

“5.03 … in the event of the amount of any Rent or other charges payable hereunder being in arrear … or any loss or damage … as the result of any non-observance or non-performance by the Tenant of any agreements stipulations or conditions contained in this Agreement, the amount of the Deposit paid to the Landlord by the Tenant shall be deemed to have been reduced by the amount of Rent or other charges in arrear or the loss or damage suffered by the Landlord and the Tenant shall on demand by the Landlord forthwith further deposit the amount by which the Deposit is deemed to have been reduced and failure by the Tenant so to do shall entitle the Landlord forthwith to re-enter the Premises and to determine this Agreement as herein provided.”

(Emphasis highlighted in bold and italic print)

Ms Cheung submits that the distinction lies in the absence of a similar provision as clause 1.1 of the Tenancy Agreement which provides that the rent should be paid “clear of all deductions”.  She quotes Woodfall’s Law of Landlord and Tenant[12] in which the learned authors stated that such a clause is not sufficient to exclude the right to set-off.  She therefore submits that it is open to the Defendant to set-off the deposit held by the Plaintiff against rent payable by the Defendant.

32.  Whether clause 1.1 has that effect depends on the true construction of that clause.  It is a trite principle of construction that a document must be construed as a whole against the factual matrix.  The proposition stated in Woodfall was based on the English Court of Appeal decision in Connaught Restaurants v Indoor Leisure[13].  The lease in that case provided that the tenant shall pay rent “without any deduction” as in clause 1.1 of the Tenancy Agreement in the present case.  The leased premises were flooded and suffered severe damage as a result of the landlord’s breach of covenant for quiet enjoyment. The tenant withheld payment of rent.  The judge held that the tenant’s right of set-off had been excluded by the covenant for the payment of rent ‘without any deduction’.  On appeal, the Court of Appeal held:

“… clear words were needed to exclude a tenant’s remedy of an equitable right of set-off. The word ‘deduction’ however could not be accurately described as a clear word. It was a useful and flexible word, which could be employed either in the strict sense to describe the process of subtraction with which it was grammatically associated, or in a broader sense to describe the result where one claim was set off against another and a balance struck, but it was heavily dependent on its context and if the context afforded no guidance, it necessarily suffered from ambiguity. It followed that the simple expression ‘without any deduction’ was insufficient by itself, in the absence of any context suggesting the contrary, to operate by implication as an exclusion of the tenant’s equitable right of set-off. On the facts, the provision in the lease that rent should be paid ‘without any deduction’ was insufficiently clear to exclude the tenant’s equitable right to set off a claim for damages for the landlord’s breach of covenant against the rent due. The tenant’s appeal would accordingly be allowed.”

(Emphasis highlighted in bold and italic print)

33.  The factual context in Connaught Restaurants is very different from the present case.  As the Court of Appeal noted, the conclusion was reached because “the context offered no guidance” and there was “absence of any context suggesting the contrary”.  As analysed above, clause 9.3 amply suggests the contrary, particularly, the need to top up the deposit after the deemed reduction to remedy the Defendant’s breach and the consequence of forfeiture for failure to do so.  An automatic set-off does not sit comfortably with these provisions.  Ms Cheung argues that the reference to “the deposit so reduced” and forfeiture of “the deposit less the amount required to remedy any breach” indicates set-off.  I respectfully disagree.  Her argument totally ignored that the reduction was a “deemed reduction”.  It is just notional for the purpose of calculating the amount to top up.  The mechanism is to ensure maintenance of an amount equivalent to four months’ rent to secure the due observance and performance of the covenants, terms and conditions under the Tenancy Agreement by the Defendant.  If an automatic set-off were allowed, the entire clause would be rendered nugatory by the Defendant’s unilaterally withholding payment of rent.  In my view, in the context of the Tenancy Agreement, the word “deduction” in clause 1.1 is unambiguous. Ms Cheung’s reliance on the proposition stated in Woodfall is misconceived.

Forfeiture of Deposit Defence – whether clause 9.3 is a penalty clause

34.  Next, Ms Cheung argues that the deposit is not forfeitable as an unenforceable penalty.  The essence of her argument on the law is that the applicable test for determining whether a clause is a penalty clause is that as laid down by the House of Lords in Cavendish v Makdessi and that the authorities relied on by the Plaintiff do not sit well with the current state of the law represented by Cavendish v Makdessi. The thrust of her argument on the fact is that the amount of deposit is excessive.

35.  At common law, there is no bar to a landlord forfeiting deposit if there was a stipulation as to the deposit and the forfeiture of it in the tenancy agreement: see Wong Kam-kong v Intercontinent Mercantile Co[14] and Orient Bright International Ltd v Hiang Kie Hong Kong Ltd[15].  Though these cases pre-dated Cavendish v Makdessi, there is nothing to suggest that the above principle has been altered by Cavendish v Makdessi as the House of Lords expressly recognized that the court had no power at common law to regulate the parties’ primary obligations.  Most importantly, whether these forfeiture provisions are penalty depends on their construction.  That depends on the facts of each individual case. 

36.  Applying the principle in Cavendish v Makdessi, the primary obligation of the Defendant is to pay rent and the secondary obligation is to suffer forfeiture of the deposit for breach of the primary obligation.  The legitimate interest of the Plaintiff is in the performance by the Defendant of its obligation and covenant under the Tenancy Agreement.  It has no proper interest in simply punishing the Defendant for default.  Prima facie, the forfeiture provision is a penalty clause.  The issue is whether the detriment suffered by the Defendant is out of all proportion to the Plaintiff’s legitimate interest in enforcing the primary obligation.  

37.  The detriment to be suffered by the Defendant is forfeiture of the deposit, which is equivalent to four months’ rent.  Whether such forfeiture is excessive or is out of all proportion to the Plaintiff’s legitimate interest depends on the circumstances of the case.  To my knowledge, the commercial practice is to impose one month’s rent as deposit for each year’s tenancy.  For longer tenancies, the deposit may be slightly reduced.  Thus, one month’s rent is appropriate and reasonable for a short tenancy of one year and four month’s rent is appropriate and reasonable for a four-year tenancy.  The deposit is to secure the due observance and performance by the tenant of the covenants, terms and conditions of the tenancy agreement.  It is a reasonable pre-estimate of the damages likely to be suffered by the landlord for the tenant’s breach of the tenancy agreement.  That includes an element for damages where the tenant does not complete the term, which is the most significant loss to the landlord.  For short tenancies, the landlord could expect to find a new tenant within a short duration.  For longer tenancies, the landlord may run the risk of having to leave the premises vacant for a longer duration.  Hence, the one month rent per year rule is not an unreasonable pre-estimate of damages.  In the present case, the lease is for five years.  A deposit of four months’ rent is, prima facie, not excessive.  The Premises consist of an entire floor of luxurious office accommodation in Central.  The Plaintiff may not be able to find a ready tenant within short duration to take over such a prestigious and large accommodation.  The Premises may have to be left vacant for a significant duration before the Plaintiff could find another tenant willing to pay the original rent under the Tenancy Agreement or other alternatives to mitigate its loss caused by the Defendant.  Having regard to the factual circumstances, I do not consider the detriment suffered by the Defendant out of all proportion to the Plaintiff’s legitimate interest.

Frustration Defence

38.  The Defendant argues that the Tenancy Agreement has been frustrated by reason of the then ongoing social disruption and COVID-19 pandemic since, at the latest, February 2020.  Both parties accept that the doctrine of frustration could be applied to determine a lease.  Both counsel quoted the House of Lords decision of National Carriers Ltd v Panalpina (Northern) Ltd[16]. The following dicta of Lord Simon of Glaisdale are pertinent:

“Frustration of a contract takes place when there supervenes an event (without default of either party and for which the contract makes no sufficient provision) which so significantly changes the nature (not merely the expense or onerousness) of the outstanding contractual rights and/or obligations from what the parties could reasonably have contemplated at the time of its execution that it would be unjust to hold them to the literal sense of its stipulations in the new circumstances; in such case the law declares both parties to be discharged from further performance.”[17]

(Emphasis highlighted in bold and italic print)

Lord Simon continued:

“[The tenants] were undoubtedly put to considerable expense and inconvenience. But that is not enough. Whenever the performance of a contract is interrupted by supervening event, the initial judgment is quantitative – what relation does the likely period of interruption bear to the outstanding period for performance? But this must ultimately be translated into qualitative terms: in the light of the quantitative computation and of all other relative factors (from which I would not entirely exclude executed performance) would outstanding performance in accordance with the literal terms of the contract differ so significantly from what the parties reasonably contemplated with those literal terms?” [18]

His Lordship also said that the doctrine was developed by the law as an expedient escape from injustice where such would result from enforcement of a contract in its literal terms after a significant change in circumstances[19]. The doctrine is modern and flexible and not subject to being constricted by an arbitrary formula[20]. Lord Wilberforce also said that like all judicially evolved doctrines it is and ought to be flexible and capable of new application[21].

39.  Ms Cheung argues that COVID-19 pandemic and the social disruption have significantly changed the nature of the rights and obligations of the parties under the Tenancy Agreement in a way that could not have been reasonably contemplated at the time of its entry.  They affected access to the Premises and caused the demand for flexible workspace to sharply decline.  While COVID-19 pandemic and the social disruption may be unforeseen at the time of execution of the Tenancy Agreement, none of these has fundamentally or radically changed the nature of the parties’ obligations thereunder or otherwise rendered it physically or commercially impossible to fulfil the Tenancy Agreement.  The Defendant leased the Premises for the purpose of providing flexible workspace to rent to its customers. Its obligation is to pay rent and observe the covenants, terms and conditions of the Tenancy Agreement.  There has been no change in the nature of the Defendant’s obligation, though the social disruption and COVID-19 pandemic must have rendered its business operation more onerous and not profitable.  The doctrine of frustration is not to be lightly invoked to relieve contracting parties of the normal consequences of imprudent commercial bargain or commercial risk.  The test of frustration is objective.  In National Carriers Ltd v Panalpina, the closure of the only access street to a warehouse for a year or a little longer in the remaining term of four years was held to be not enough to invoke the doctrine of frustration. The Defendant has not adduced any evidence to show how long the disruptive events and/or COVID-19 pandemic were expected to last during the unexpired term of the tenancy or at least for a long period of that unexpired term.  Furthermore, the Defendant’s conduct in holding onto the Premises instead of surrendering them is inconsistent with its claim of frustration.  Its refusal to deliver up possession of the Premises is evidence of its lack of good faith in this defence.  It is in fact trying to hold onto the Premises and generate income without paying rent to the prejudice of the Plaintiff.  There is no substance in this defence.

40.  In the alternative, the Defendant argues that its liability to pay rent is suspended by events constituting “Acts of God” under clause 7.1 of the Tenancy Agreement.  That clause provides:

“If the Premises or any part thereof shall at any time during the Term be destroyed or damaged or become unfit for occupation or inaccessible not due to any default of the Tenant but owing to fire, earthquake, subsidence of the ground or Acts of God … or if any time during the Term the Premises or the Building shall be condemned as a dangerous structure or a demolition order or closure order shall become operative in respect of the Premises or the Building then the Rent, Air-conditioning and Management Charges and Government Rates hereby reserved or a fair proportion thereof according to the nature and extent of the damage sustained or order made shall after the expiration of the then current tenancy month be suspended until the Premises shall again be rendered fit for occupation or accessible or the order removed …”

(Emphasis highlighted in bold and italic print)

The Defendant contends that its liability to pay rent has been suspended under clause 7.1 by reason of the ongoing social disruption, being an Act of God, which had caused the Premises to become inaccessible. 

41.  Payment of rent would be suspended under clause 7.1, if the Premises shall be destroyed or damaged or become unfit for occupation or inaccessible for one of the reasons stated in that clause including Acts of God.  There is no evidence that the Premises have been destroyed, damaged or become unfit for occupation or inaccessible other than a general assertion of social disruption, poor economy and the COVID-19 pandemic.  The frustrating events stipulated in clause 7.1 are all natural hazards outside human control, such as earthquake or tsunami for which no person can be held responsible.  The Defendant has not given any particulars in its affirmation as to how the alleged disruptive events have rendered the Premises destroyed or damaged or become unfit for occupation or inaccessible.  Ms Cheung has not adduced any authority to support the proposition that social disruption amounted to an act of God.  In fact, the Premises are still being used by the Defendant for the purpose for which they were rented.  There is no substance in this defence.

Counterclaim for wrongful Distraint 

42.  The Defendant contends it has a counterclaim of at least $4.5 million against the Plaintiff arising out of the distraint proceedings which can be set-off against the Plaintiff’s claim as a matter of equitable set-off.  The Defendant further complains that the distraint proceedings caused serious disruptions to the Defendant’s business; and as a result, a customer who accounted for $1.5 million of the Defendant’s rental revenue per month decided not to renew its contract with the Defendant.  On this basis, the Defendant argued that the Plaintiff’s liquidated claim should be at least reduced by $4.5 million. 

43.  The major thrust of the Defendant’s argument is that at the time of the distraint proceedings were commenced back in May 2020, the amount of rent owing to the Plaintiff was less than the deposit.  The amount owing should first be deducted from the deposit pursuant to clause 9.3 before the Plaintiff was entitled to commence distraint proceedings.  For reasons as explained above[22], this argument is based on the Defendant’s erroneous construction of clause 9.3.  There is no automatic set-off under clause 9.3.  The Defendant is not entitled to set-off rent payable against deposit held by the Plaintiff to secure the Defendant’s observance and performance of its covenant, terms and conditions under the Tenancy Agreement.  It is therefore not open to the Defendant to argue that as the amount of outstanding rent was less than the amount of deposit, the Plaintiff was not entitled to commence distraint proceedings. This counterclaim is doomed to fail.

44.  Furthermore, the Defendant raised no substantive defence to the Plaintiff’s claim for outstanding rent and charges or otherwise challenged the legitimacy of the distraint proceedings.  In fact, it admitted that it owed at least $7,194,760 rent to the Plaintiff but insisted that it had the financial means to pay.  The distraint proceedings were hence legitimately commenced by the Plaintiff in the usual exercise of its right as landlord to recover the rent and charges in arrears as at 14 May 2020 as provided for under clause 8.7 of the Tenancy Agreement and Part III of the Landlord and Tenant Consolidation Ordinance.  Commencement of the proceedings by the Plaintiff does not constitute any breach of the Tenancy Agreement. 

45.  Even assuming that it constituted a breach of the Tenancy Agreement, the amount of the Plaintiff’s claim, which is indisputable, far exceeds the Defendant’s counterclaim.  If the Plaintiff is entitled to summary judgment, the Defendant would, at best, be entitled to a stay of execution of the Plaintiff’s monetary judgment.  The distraint proceedings cannot constitute a complete defence.  

Miscellaneous Counter-claims 

46.  The Defendant also raises other counterclaims arising from excessive noise from the under-floor air-conditioning units in the Premises; the closures of the male toilets by reason of blockage; the suspension of the executive lift for four consecutive days; and suspension of fresh and flushing water supply for one day.  These are minor complaints.  Even if they are proven, the Defendant is only entitled to damages.  This counterclaim does not constitute a complete defence.  

Conclusion

47.  On the true construction of the Tenancy Agreement and the Supplemental Letter, the provisions requiring the Defendant to pay retrospective rent for the rent free period and forfeiture of deposit upon breach of its obligations under the Tenancy Agreement and/or Supplemental Letter are not penalty clauses.  The Defendant is obliged to pay retrospective rent for its use and occupation of the Premises during the three months’ rent free period because of its failure to meet the requirement for the concession, ie its failure to pay rent.  On the true construction of the Tenancy Agreement, clause 9.3 does not contain an automatic set-off provision which would entitle the Defendant to set-off its rent payable to the Defendant against the deposit it had paid to and held by the Plaintiff.  The Plaintiff is entitled to keep the deposit as its own money without setting it off against rent due from the Defendant during the currency of the tenancy and to forfeit the deposit upon termination of the tenancy for the Defendant’s breach of the Tenancy Agreement.  These are crisp legal or factual issues which may be determined summarily.

48.  On the fact, there is no dispute that as at 30 September 2020, the total amount of rent, air-conditioning charges, management charges and rate owing by the Defendant to the Plaintiff was $21,308,317.60.  There is no defence to this amount of claim.  The Defendant is in clear breach of the Tenancy Agreement.  The Plaintiff is entitled to summary judgment for possession of the Premises; the outstanding rent, air-conditioning charges, management charges and rates; and for liquidated damages for breach of the Tenancy Agreement to be assessed.  When assessing liquidated damages, the Plaintiff is required to give credit to the deposit forfeited. 

49.  The Defendant has refused to deliver up possession of the Premises.  As at the date of hearing of these summonses, it is still using and occupying the Premises.  It also failed to pay in full the rent/mesne profit pursuant to the Order of Master J Wong for its occupation of the Premises for the month of October 2020.  By its Extension of Time Summons dated 16 October 2020, it sought extension of time to pay the balance of $1 million within 28 days of the order to be made.  It offered no evidence as to the source of funds and the time when such funds would become available.  There is no indication of ability to pay.  Its request for extension of time for 28 days from the date of the order to be made carried with it no sense of a commitment to pay.  The Defendant is clearly impecunious.  For expediency reasons, I granted it extension of time to pay until 1 November 2020.

50.  The Defendant raised three defences, ie the Rent Free Period Defence, Forfeiture of Deposit Defence, and Frustration Defence.  On my analysis of the applicable legal principles and facts, these defences are unmeritorious and moonshine.  It also raised two counterclaims for wrongful distraint and for miscellaneous breaches of the Tenancy Agreement by the Plaintiff.  For reasons as discussed above, the counter-claim for wrongful distraint is unmeritorious. The counterclaim for the Plaintiff’s breaches is trivial and for insignificant amount.  In any event the amount of the counterclaims, even if proven, is only about one-quarter to one-third of the outstanding rent and other charges due to the Plaintiff, not to mention the liquidated damages to be assessed.  Usually, in such circumstances, summary judgment with a stay of execution pending the counterclaim would be appropriate.

51.  In the present case, the lease was a long lease of five years.  The Defendant intended a long term commitment.  However, it was struck with the social disruption and then the COVID-19 pandemic soon after commencement of the tenancy.  Summary judgment would definitely put an end to the Defendant’s business.  If the Defendant could somehow fund its business or reach some new arrangement mutually acceptable to the parties to keep the tenancy alive, I would be prepared to give it one last chance.  On the other hand, the Defendant is obviously impecunious.  The Defendant has been in arrears of rent for ten months.  The arrears have exhausted the deposit.  Any delay to judgment and repossession of the Premises would be prejudicial to the Plaintiff.  On balance, I consider interim payment of all outstanding sums within 21 days with interim payment on account of the Defendant’s liabilities in respect of its continued use and occupation of the Premises during the pendency of this action appropriate.  Otherwise, summary judgment would be the least prejudicial option to the parties.

52.  The total amount outstanding is $21,308,317.60, which includes three months’ rent for the rent free period.  I am unable to reduce the amount by the amount of deposit held by the Plaintiff because if the Tenancy Agreement is to be kept alive the deposit should continue to be held by the Plaintiff to secure the performance of the Tenancy Agreement by the Defendant.  For the above reasons, I made the following order on 30 October 2020 in respect of the Summary Judgment Summons:

(1) The Defendant shall pay the Plaintiff a sum of $21,308,317.60 by way of interim payment within 21 days from 30 October 2020;

(2) The Defendant shall pay the Plaintiff a sum of $2,833,352.40 per month ($2,629,796.40 being rent and/or mesne profits and $203,556.00 being air-conditioning and management charges) by way of interim payment on account of the Defendant's liabilities in respect of its continued use and occupation of the Premises during the pendency of this action, commencing from 1 November 2020 and thereafter on the first day of each and every calendar month until further order;

(3) There be liberty to apply for further interim payment;

(4) In the event of default on the part of the Defendant in payment of the sum ordered to be paid under sub-paragraph (1), final judgment be entered against the Defendant forthwith for:

(i) vacant possession of the Premises;

(ii) payment of the sum under sub-paragraph (1) or such part of it which remains unpaid;

(iii) payment of government rate and rent from 1 October 2020 until date of delivery of vacant possession of the Premises;

(iii) interest on the sums payable under sub-paragraph (4)(ii) and (iii) at the contractual interest rate from the respective due dates until the 21st day after 30 October 2020 and thereafter at judgment rate;

(iv) damages to be assessed; and

(v) liberty to apply.

(5) There be stay of execution of the order in sub-paragraph (4)(ii) and (iii) for 14 days pending the filing by the Defendant of its counterclaim, with liberty to apply; and 

(6) The Defendant shall pay the Plaintiff’s costs of and occasioned by the Summary Judgment Summons on indemnity basis.

53.  Having made the above orders under the Summary Judgment Summons, it is not necessary to determine the Unless Order Summons.  I make no order on that summons. 

54.  At the hearing on 20 October 2020, I granted the Defendant extension of time until 1 November to pay the balance required to be paid under the Interim Payment Order made by Master J Wong with costs to the Plaintiff in the agreed sum of $1,040.  For avoidance of doubt, that Interim Payment Order ceased to have effect after 31 October 2020.

55.  Despite the order made under the Summary Judgment Summons, I think it would be to the mutual benefit of the parties to reach some mutually acceptable arrangements to keep the tenancy alive.  I trust, if the Defendant could come up with a substantial interim payment, the parties could come to some such arrangement.  That is a matter to be left to the parties.