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

Bizar Male

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, however, blew in
HF Clarke v Thermidaire, [1976] 1 SCR 319
(“Thermidaire“), where Laskin
CJ, for the majority, observed:

[T]he court will begin by construing the contract in which the
parties have objectively manifested their intentions, and will
consider the surrounding circumstances so far as they can
illuminate the contract and thus aid in its construction. It seems
to me, however, that if, in the face of the parties’ assertion
in their contract that they were fixing liquidated damages, the
court concludes that a penalty was provided, it would be
patently absurd to say that the
court was giving effect to the real intention of the parties when
the court’s conclusion was in disregard of that intention as
expressed by the parties.

The New Rule: Enforceable Unless Unconscionable or
Oppressive

The approach that is now favoured is to enforce an S-C Clause
unless the provision is “unconscionable” or
“oppressive”. As will be explained below, however,
vestiges of the venerable rule remain. While the framework of the
analysis differed from before (focused on unconscionability or
oppression and whether it is appropriate to grant relief, rather
than on the question of whether the clause constitutes a genuine
pre-estimate of damages at the time of contracting), much of the
former law on penalty clauses survives, as unconscionability or
oppression is often assessed by reference to what formerly would
have been considered to be a penalty clause.

Later in the Thermidaire decision cited above, Laskin
CJ dealt the first death-blow to the Penalty Rule:

The sum will be a penalty if it is extravagant
and unconscionable in amount in
comparison with the greatest loss that could conceivably be proved
to have followed the breach.9

In JG Collins Insurance Agencies Ltd v Elsley Estate,
[1978] 2 SCR 916
(“Elsley“), the SCC struck the
first nail into the Penalty Rule’s coffin. In that case, the
Court observed:

The power to strike down a penalty clause is a blatant
interference with freedom of contract and is designed for the sole
purpose of providing a relief against oppression for the party
having to pay the stipulated sum. It has no place where
there is no oppression
.10 

These observations were then picked up in subsequent
cases,11  and “judicial enthusiasm
for the refusal to enforce penalty clauses. waned in the face of a
rising recognition of the advantages of allowing parties to define
for themselves the consequences of the breach”.12

The Current State of the Law in Alberta

Three considerations appear to guide Alberta courts in
determining whether an S-C Clause is unconscionable or oppressive
and therefore an unenforceable penalty.

The quantum flowing from the S-C Clause in light of
the entire payment or entire damage award and industry
standards

In Precision Drilling Canada Limited Partnership v Yangarra
Resources Ltd
, 2015 ABQB 649
(“Yangarra“), the Alberta Court
of Queen’s Bench (“ABQB“) found that
the plaintiff’s 18% interest rate charged on unpaid invoices
did not constitute an unenforceable penalty. Although the 18%
interest rate was significantly higher than the plaintiff’s
cost of funds, it was an industry standard rate.13 The
Court commented:

While there is no doubt that an agreed upon interest rate of 18%
contains an element of ‘incentive’ in addition to an
element of compensation, I find nothing extravagant or
unconscionable about a goods or service provider charging 18%
interest if they are not paid on time for goods or services
provided. In my many years of experience, interest charges are
typically charged in such circumstances, and it is very common for
such interest charges to range from 1.5% to 2% per month.14

Conversely, the ABQB found that the 30% interest charge at issue
in Markdale Ltd v Ducharme, 1998 CanLII 29734 (ABQB)
(“Markdale“), was
unenforceable. In the absence of a justification for the elevated
interest rate, such as the interest rate paid by the plaintiff on
its financing, or the rate of return earned on its investments, the
30% rate was considered oppressive by the Court.15

The amount to which the innocent party would, on
breach of contract, be entitled

In National Bank of Canada v Merit Energy Ltd, 2001 ABQB 680
(“Merit“), the defendant
purchased a 50% interest in the plaintiff’s property pursuant
to a Petroleum, Natural Gas and Related Rights Conveyance Agreement
(the “Agreement“). The Agreement
required the defendant to pay $1,000,000, which was evidenced by a
promissory note (the “Promissory Note“).
Additionally, the Agreement required that the defendant pay Joint
Development Expenditures (“JDEs“). The
Agreement provided that, if the defendant failed to pay the amounts
owing under the Promissory Note, or failed to properly incur JDEs,
then the defendant would be required to pay an amount calculated
as: the balance owing under the Promissory Note, plus the
defendant’s JDEs, minus any amounts paid in respect of the
JDEs. Based on this calculation, the defendant owed nearly
$1,700,000. However, the amount owed under the Promissory Note at
the time of the trial was a mere $90,000. Consequently, the ABQB
held that a payment of $1,700,000 was “clearly
unreasonable” given the actual damages incurred by the
defendant.16

Similarly, the ABQB in Ashland Scurlock Permian Canada Ltd
et al v NESI Energy (Bankrupt)
, 1998 CanLII 29737
(“Ashland“) disallowed the
plaintiff’s claim comprised of $800,000 in unliquidated damages
and $1,300,000 pursuant to an S-C Clause. The Court stated that
“the amount of the multiple used in the formula [to calculate
the damages] creates an extravagant amount which cannot be regarded
as having any real relation to any loss” and therefore found
the S-C Clause to be unenforceable.17

The justification or commercial reasonableness of
the S-C Clause

The Alberta Court of Appeal was given the opportunity to weigh
in on S-C Clauses in Capital Steel Inc v Chandos Construction
Ltd
, 2019 ABCA 32
(“Chandos“). While the majority
decided the issue of the enforceability of the S-C Clause according
to the anti-deprivation rule in bankruptcy, Wakeling JA, in
dissent, also considered whether it constituted an impermissible
penalty. In holding that the S-C Clause was not oppressive,
Wakeling JA offered the following reasons: (i) it flowed from a
commercial contract; (ii) there was no indication that the
defendant had insufficient resources to retain legal counsel prior
to signing the contract; (iii) it reflected the fact that the
plaintiff would incur administrative costs associated with finding
a replacement sub-contractor; (iv) it documented the parties’
agreement that there was a correlation between the defendant’s
performance and its remuneration; (v) and it made commercial
sense.18

The ABQB also employed commercial reasonableness in evaluating
the enforceability of the impugned S-C Clause in Bodkin Leasing
Corp v Mighty Moose Holdings Ltd
, 2014 ABQB 280 (“Mighty
Moose
“). Under the S-C Clause, the plaintiff was
entitled to the full amount of all future payments under the lease,
without discounting them back to present value. Most leases,
however, contain a discount calculation that reflects the present
value of future payments.19 Consequently, the S-C Clause
permitted the plaintiff to earn
“interest-upon-interest.”20 The Court found the
S-C Clause to be arbitrary in that liability on default would be
much higher if default occurred during the first few months of the
lease despite the fact that the administrative cost of seizing and
selling the vehicle would not change depending on the time of
default.21 Ultimately, the ABQB held that,
absent a present value clause, the S-C Clause was “arbitrary,
unconscionable, and unenforceable as a penalty.”22

There remains a need for judicial clarity regarding the test to
be applied in determining the enforceability of S-C Clauses.
However, the foregoing cases illustrate that Alberta courts will be
guided by factors such as the amount payable under the S-C Clause
in comparison to the entire damage award or industry standards,
proportionality between compensation under the S-C Clause and the
amount to which the innocent party would be entitled on breach of
contract, and the basis for, and commercial reasonableness of, the
S-C Clause.  

Footnotes

1. HF
Clarke v Thermidaire Corp
, [1976] 1 SCR 319
(“Thermidaire“); JG Collins
Insurance Agencies Ltd v Elsley Estate
, [1978] 2 SCR 916
(“Elsley“).

2.
Fern Investments Ltd v Golden Nugget Restaurant (1987)
Ltd
, 1994 ABCA 153 (“Golden
Nugget
“); Prudential Insurance Co of America
v Cedar Hills Properties Ltd
, 1994 CanLII 1960 (BCCA)
(“Prudential“);
Peachtree  II Associates – Dallas LP v 857486 Ontario
Ltd
, 2005 CanLII 23216 (ONCA), leave to appeal to
the SCC refused (“Peachtree“);
Birch et al v Union of Taxation Employees, Local 70030, 2008 ONCA 809, leave to appeal to the SCC
refused.

3.
Jones v Gerosa, 2016 ABQB 207 at para 118
(“Jones“), citing: Gunning
v Thorne Riddell
, 1990 CarswellBC 1541 (BCCA) at para 22
(“Gunning“); BLT Holdings
Ltd v Excelsior Life Insurance Co
, 1986 CarswellAlta 172
(ABCA) at para 13
(“Excelsior“). See also:
Polaroid Canada Inc v Continent-Wide Enterprises Ltd, 2000
CarswellOnt 2039 (ONCA) at para 9; Macleod v Viacom
Entertainment Canada Inc
, 2003 CarswellOnt 305 (ONSC) at para
6 (“Macleod“); Bidell
Equipment LP v Caliber Midstream GP LLC
, 2020 ABCA 478 at para 26.

4.
Doman Forest Products Ltd v GMAC Commercial Credit Corp
Canada
, 2007 BCCA 88 at paras 119-125
(“Doman“), citing:
Gunning at para 26; Excelsior. Doman was
cited with approval in Jones at paras 213-214 and
Bidell Equipment LP v Caliber Midstream GP LLC, 2019 ABQB 296 at paras 135-136
(Bidell“).

5.
Pattison v Mudry, 1999 CarswellOnt 46 (ONCJ) at para 53,
cited with approval in Macleod at para 11.

6. Geoff
R. Hall, Canadian Contractual Interpretation Law 2nd ed
(Toronto: Carswell, 2012) at 303.

7.
General Electric at 351 (emphasis added).

8.
Prudential at para 16.

9.
Thermidaire at 338.

10.
Elsley at 937.

11.
Calgary v Northern Construction Company Division of
Morrison-Knudsen Company, Inc et al
, 1985 ABCA 285 at para 29; Golden
Nugget
at para 17.

12.
Peachtree at para 34.

13.
Yangarra at para 25.

14.
Yangarra at para 24.

15.
Markdale at para 66-68.

16.
Merit at para 37.

17.
Ashland at para 21.

18.
Chandos at paras 308-313.

19.
Mighty Moose  at para 10.

20.
Mighty Moose  at para 12.

21.
Mighty Moose  at para 25.

22.
Mighty Moose  at para 29.

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