December 1, 2020
Liquidated damages, deposits and forfeiture clauses
BY ROBERT KENNALEY
Historically at common law in Canada, a liquidated damages clause will be treated as a penalty, and not enforced for public policy reasons, unless the amount is a “genuine pre-estimate” of damages that will actually be suffered. For a time, however, it appeared that Ontario’s highest Court might abandon the “genuine pre-estimate” test in favour of the equitable approach historically taken to forfeiture clauses, such as those relating to deposits. As the Ontario Court of Appeal confirmed in describing such clauses in Redstone Enterprises Ltd. v. Simple Technology Inc., 2017 ONCA 282 (citing BC Court of Appeal decision):
“The deposit constitutes an exception to the usual rule that a sum subject to forfeiture on the breach of a contract is an unlawful penalty unless it represents a genuine pre-estimate of damages. However, where the deposit is of such an amount that the seller’s retention of it would be penal or unconscionable, the court may relieve against forfeiture.”
The suggestion that the law prohibiting penalty clauses should change was made by Sharpe J.A. in his 2005 reasons for decision in 869163 Ontario Ltd. v. Torrey Springs II Associates Ltd. Partnership (2005), 76 O.R. (3d) 362) (otherwise known as “Peachtree II”). In that case, His Honour expressed the view that courts should avoid classifying contractual clauses as either forfeitures or penalties and, rather, evaluate both under the principles of unconscionability. This, he opined, would be consistent with freedom of contract and allowing parties to define for themselves the consequences of a breach or non-performance of an agreement. His Honour nonetheless confirmed the question would have to be left to “another day.”
Sounding the “death knell” on the law of liquidated damages would, of course, have significant consequences for contractors and subcontractors. It would allow owners, contractors (and anyone one up in the construction ladder) to apply liquidated damages as a penalty, the only exception being that the clause might be struck as unconscionable in certain circumstances. It would, subject to unconscionability for example, allow an owner to apply liquidated damages of $100,000 per day of delay, even if a day of delay was worth only a few thousand dollars. Perhaps thankfully for contractors and subcontractors (and less so for Owners), the Ontario Court of Appeal (in Haas v. Viscardi 2019 ONCA 133) recently upheld a lower Court’s determination that the common law of penalty clauses remains in force in Ontario. In addition, on Oct. 2, the Supreme Court of Canada, in Chandos Construction Ltd. v. Deloitte, 2020 SCC 25, upheld an Alberta Court of Appeal decision which applied the traditional law of penalties to a liquidated damages clause. It accordingly appears that, for the time being at least, a liquidated damages clause will continue to be struck as a penalty if it was not a genuine pre-estimate of actual losses.
Deposits, on the other hand, will continue to be treated differently. As the Ontario Court of Appeal recently explained in Aylward v. Rebuild Response Group Inc., 2020 ONCA 62, 2020 (citing a prior decision):
“A true deposit is an ancient invention of the law designed to motivate contracting parties to carry through with their bargains. Consistent with its purpose, a deposit is generally forfeited by a buyer who repudiates the contract, and thus is not dependent [as is a liquidated damages clause] on proof of damages by the other party.”
A clause requiring the forfeiture of a deposit can therefore be enforced, subject to unconscionability, even if the party that gets to keep it suffers no damages. It is for this reason, for example, that purchasers under Agreements of Purchase and Sale will generally forfeit their deposits even if the vendor later sells the home for substantially more money, suffering no loss whatsoever. Again, the ability to retain the deposit will be subject to unconscionability.
As the Supreme Court of Canada confirmed in Uber Technologies Inc. v. Heller, 2020 SCC 16, establishing the two required elements of unconscionability (inequality of bargaining power and an “improvident bargain”) can be difficult to do. In that regard, see our prior article on the Uber decision. As regards the first test of unconscionability, one of the factors the Court will take into consideration in determining if there is an inequality of bargaining power is “necessity”. This occurs, as per the Supreme Court in Uber, “where the weaker party is so dependent on the stronger that serious consequences would flow from not agreeing to a contract”. The Supreme Court went on to state that:
“This imbalance can impair the weaker party’s ability to contract freely and autonomously. When the weaker party would accept almost any terms, because the consequences of failing to agree are so dire, equity intervenes to prevent a contracting party from gaining too great an advantage from the weaker party’s unfortunate situation.”
As regards a tender process (and although there are no cases directly on point), it appears the mere fact that a bidder has no real opportunity to negotiate the terms of a tendered contract will not, in and of itself, establish the ‘inequality of bargaining power’ required to meet the test.
Not all penalty or forfeiture clauses involve liquidated damages or deposits. In the land development and custom home building industries, clauses which require a purchaser of land to sell the land back to the vendor if certain conditions relating to the development or construction are not met, for example, have become increasingly popular.
In sum, while liquidated damages clauses will continue to be struck unless they reflect a genuine pre-estimate of actual damages, forfeiture clauses (including those relating to deposits) will be enforced even if the forfeiture bears no resemblance to actual damages, unless enforcement would be considered unconscionable (based on inequality of bargaining power coupled with an improvident bargain). Given the Court’s preference to enforce contracts, however, unconscionability will be difficult to establish and will only occur in the rarest of circumstances. Parties accordingly need to carefully review and understand forfeiture clauses. As regards liquidated damages, parties who wish to rely on such clauses will need to establish that the damages specified do, in fact, represent a genuine pre-estimate of damages. They should also beware that the law of liquidated damages may eventually give way to the law of forfeiture, opening the door for liquidated penalties for a failure to perform under a contract.
Rob Kennaley is with Kennaley Construction Law, a construction law firm with offices in Simcoe, Toronto and Barrie, Ont. For more information please visit kennaley.ca. This material is for information purposes and is not intended to provide legal advice in relation to any particular fact situation.