Old Wine Into New Bottles: A Brief History And Current State Of The Law On Penalty Clauses

• Published date: 22 February 2021
• Subject Matter: Corporate/Commercial Law, Real Estate and Construction, Contracts and Commercial Law, Construction & Planning
• Law Firm: McCarthy Tétrault LLP
• Author: Canadian Appeals Monitor, Mark Risebrough and Brittany Morrow

Introduction

Parties to a contract may, at the time of contracting, turn their minds to the appropriate remedy in the event of breach, and specify that remedy in their contract through a stipulated-consequence-on-breach clause ("S-C Clause").

Historically, where the S-C Clause provided for a specific quantum of damages upon the occurrence of a breach, courts were reluctant to enforce the parties' intentions. Pursuant to an old and "venerable common law rule", such a term would not be enforced unless it represented a "genuine pre-estimate of liquidated damages". As a consequence, in spite of the promisor's express agreement to the contrary, the disappointed promisee has had to prove the damages caused by the promisor's breach of contract, just as the promisee would have to do in the absence of an S-C Clause. These and related propositions are known as the common law "Penalty Rule".

The Penalty Rule was changed, however, as a result of two decisions of the Supreme Court of Canada ("SCC") in the 1970s,¹ and a series of decisions by four provincial appellate courts in the 1990s.² The revised approach has been to enforce S-C Clauses unless the effect of doing so would be "unconscionable" or "oppressive".

In recent years, however, the old and the new have been conflated, in that unconscionability or oppression has often been assessed by determining whether the sum yielded by the enforcement of an S-C Clause is penal or a genuine pre-estimate of liquidated damages.

As a result, commercial parties are uncertain of whether their own S-C Clauses will be enforced by the courts, and there is a need for a more clear and modern test, as recently recognized in Capital Steel v Chandos Constructions Ltd, 2019 ABCA 32 ("Chandos"), per Wakeling JA (in dissent).

An Overlooked and Under-Considered Threshold to the Penalty Rule

There is a threshold issue to each analysis of whether an S-C Clause amounts to a penalty. A contractual term cannot be classified as a penalty unless it requires a payment to be made for breach of contract by one of the parties.³ Thus, a term requiring payment upon a stipulated event cannot be held to be a penalty,⁴ even though the event may constitute a breach of contract by another party under a different contract.⁵

The "Venerable Common Law Rule"

"There is a venerable common law rule to the effect that the courts will not require a party to pay a genuine or true penalty on grounds of public policy."⁶ The venerable rule distinguished between an unenforceable penalty clause and an enforceable liquidated damages clause. The distinction was whether the clause represented a genuine pre-estimate, made at the time of contracting, of the damages to be suffered in the event of breach. In Canadian General Electric Co v Canadian Rubber Co of Montreal, [1915] 52 SCR 349 ("General Electric"), the SCC wrote:

A penalty is the payment of a stipulated sum on breach of the contract, irrespective of the damage sustained. The essence of liquidated damage is a genuine covenanted pre-estimate of damage.⁷

The unenforceability of penalties was based on notions of fairness and reasonableness, a concern that the penalty would act "in terrorem of the offending party" and coerce that party to perform for fear of being exposed to damages in excess of what was reasonable to compensate the innocent party for its loss of bargain.⁸ The winds of change...