In the past, you have likely entered into a contract that contained a liquidated damages clause. These are prevalent in construction and general commercial agreements.
Liquidated damages and penalty clauses
Liquidated damages (or stipulated damages) clauses are estimates made at the time the contract is formed of the expected losses a party will suffer in the event of a breach of the contract. Traditionally, these clauses are enforced as long as they represent a genuine attempt to pre-estimate the loss. [1]
Where such a clause is deemed not to be a genuine pre-estimate but is rather a sum that is “extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved to have followed from the breach,” the clause will be considered an unenforceable “penalty clause.”[2] These are clauses which are essentially designed to deter a party from breaking a contract, irrespective of the anticipated loss.
What are the factors in determining whether such a clause is enforceable or not?
The most important factor in determining whether the contractual clause provides a genuine pre-estimate of damages is quantum.[3] The traditional test asks whether the sum seems to be extravagant and unconscionable, or is it a reasonable and appropriate effort to calculate the damages a party may suffer? This is a question of mixed fact and law, but the inability to precisely quantify the amount at the contract formation does not automatically lead to the conclusion that the clause is a penalty clause.
More recently, the courts have arguably begun to shift the inquiry towards unconscionability in relation to how the agreement was made. A determination of unconscionability (and therefore unenforceability) involves a two-part analysis — a finding of inequality of bargaining power and a finding that the terms of an agreement have a high degree of unfairness.[4] In this context, the court will generally look to whether a party has proven the following four elements:
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- a grossly unfair and improvident transaction;
- a lack of independent legal advice or other suitable advice;
- overwhelming imbalance in bargaining power caused by the victim’s ignorance of business, illiteracy, ignorance of the language of the bargain; and
- the other party’s knowingly taking advantage of this vulnerability.[5]
What if the damages were under-estimated?
In J.G. Collins Insurance Agencies Ltd. v Elsley, the Supreme Court considered how a gross underestimate of damages prescribed in a liquidated damages provision should be reviewed. If the actual loss turns out to exceed the clause, the normal rules of enforcement should apply to allow recovery of only the agreed sum.[6] Where there has been no oppression, the court should not strike down the clause as it interferes with the freedom to contract. In this decision the court reasoned that a party should not be able to utilize the intimidating force such a clause may have to induce performance only to be allowed to ignore it when it turns to be advantageous to do so.[7] Thus, an agreed sum payable on breach represented the maximum amount recoverable.[8]
However, in 1252662 Ontario Inc. v. Swisslog Logistics, Inc., the plaintiff sought a declaration that it was entitled to assert a claim for common law damages for a breach of contract by the defendant and argued that it was not restricted to claiming the pre-estimated damages for delay, based on the totality of the contract. Justice Conway adopted the general approach to interpretation of commercial agreements:
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- as a whole, in a manner that gives meaning to all of its terms and avoids an interpretation that would render one or more of its terms ineffective;
- by determining the intention of the parties in accordance with the language they have used in the written document and based upon the “cardinal presumption” that they have intended what they have said;
- with regard to objective evidence of the factual matrix underlying the negotiation of the contract, but without reference to the subjective intention of the parties; and (to the extent there is any ambiguity in the contract),
- in a fashion that accords with sound commercial principles and good business sense, and that avoid a commercial absurdity.[9]
Ultimately, on a plain reading of the entire contract, the plaintiff was entitled to assert its claim for damages, and was not restricted by the liquidated damages provision.[10] An important caveat is that the court did not ultimately decide whether the plaintiff was entitled to recover any damages or was able to prove them – only that it could assert those damages. The court pointed to a section in the agreement which stated that the plaintiff had “all rights and remedies provided by law and by this agreement”. Thus, if a liquidated claim is subservient to another clause entitled the claimant to a full range of damages, a liquidated damages clause might not limit a party’s entitlement to damages.
Conclusion
Parties should be careful when drafting a liquidated damages clause to, as much as possible, genuinely pre-estimate their losses considerations to ensure the clause is enforceable in the event of a breach of the contract. If a party claims a sum that is “extravagant” or “unconscionable”, the courts may choose not to enforce the clause by labeling it a “penalty clause.” Conversely, if a party under-estimates their damages, the courts may limit any recovery to the damages outlined in the contract, subject to other provisions in the agreement entitling the party to additional recovery. Proper prior planning helps mitigate risk and maximize recovery in the context of your specific business needs.
Should you have any questions or concerns, please feel free to reach out to a member of Miller Thomson’s Construction Litigation group.
[1] H.F. Clarke Ltd. v Thermidaire Corp., 1974 CarswellOnt 253F (SCC) at para 28
[2] Haas v Viscardi, 2018 ONSC 2883 at para 12, aff’d 2019 ONCA 133.
[3] Ibid, at para 15.
[4] Birch v. Union of Taxation Employees, Local 70030, 2008 ONCA 809 at para 45.
[5] Titus v William F. Cooke Enterprises Inc., 2007 ONCA 573 at para 38.
[6] J.G. Collins Insurance Agencies Ltd. v Elsley, 1978 CarswellOnt 1235 (SCC) at para 47.
[7] Ibid.
[8] Ibid, at para 48.
[9] 1252662 Ontario Inc. v. Swisslog Logistics, Inc., 2016 ONSC 90 at para 17.
[10] Ibid, at paras 20-21.
