Liquidated Damages: From the Malaysian “Penalty Rule” to Chinese Judicial Adjustment

In cross-border contracts, the Liquidated Damages (LD) clause manages risks of delay or non-performance. Both Malaysia and China allow parties to pre-estimate damages, but judicial intervention differs. Malaysian courts focus on ensuring the clause is not a penalty, while Chinese courts, under Article 585, may adjust the amount to match actual losses.

The Malaysian Approach: The Shift to Legitimate Interest

For decades, Malaysian law applied a strict reasonable compensation test under Section 75 of the Contracts Act 1950. The Federal Court’s decision in Cubic Electronics Sdn Bhd v Mars Telecommunications Sdn Bhd [2019] significantly changed this approach.

The court held that once a breach occurs in a contract with an LD clause, the agreed sum is prima facie payable. The defaulting party must now prove the sum is unreasonable or a penalty. The focus has shifted from a genuine pre-estimate to whether the sum is proportionate to the innocent party’s legitimate interest. Malaysian courts generally uphold the clause unless the amount is clearly excessive compared to the highest possible loss.

The Chinese Civil Code: The “Adjust and Balance” Power

The 2020 Chinese Civil Code takes a more interventionist approach through Article 585. While parties may agree on a fixed sum for breach, courts have clear authority to adjust this amount based on the actual loss at the time of breach.

Article 585 treats the LD clause as a provisional estimate. If the agreed amount is less than the actual loss, the court may increase it. If it is significantly higher, the court may reduce it at the defaulting party’s request.

The “30% Rule” and Judicial Practice in China

While the Civil Code sets the general principle, Chinese judicial interpretations specify that if agreed liquidated damages exceed actual loss by more than 30 per cent, courts will generally consider them excessive and reduce the amount.

This creates a significant divergence for Malaysian practitioners. A clause valid under the Cubic Electronics test in Malaysia may still be reduced by a Chinese court if actual loss is lower than the estimate. The Chinese system prioritises compensation over deterrence.

Strategic Implications: The Evidentiary Burden

The key difference is in the evidence required. In Malaysia, the innocent party does not need to prove actual loss to claim the LD amount, only that the sum is not extravagant.

In China, the focus is on the time of breach. To challenge or defend an LD clause, parties must provide detailed evidence of actual financial loss, such as lost profits, additional operational costs, and mitigation efforts. Malaysian lawyers handling Chinese-governed contracts cannot rely on prima facie enforceability and must ensure clients keep thorough records of actual losses to support claims in court.

Conclusion: From Certainty to Compensation

In Malaysia, an LD clause serves as a fixed insurance policy against delay. In China, it is a flexible estimate subject to judicial review. Success in cross-border litigation requires recognising that Chinese courts balance economic interests. Drafting a reasonable clause is only the first step; practitioners must also ensure thorough documentation of actual losses, as strong records are essential in a jurisdiction where damages are adjusted to reflect the breach.

The article was first published on LinkedIn.