Liquidated Damages Law – A Change on the Way?

Authors: Josh Morrison, Andrew Konopelny and Ethan Reis, Summer Student-at-Law

The Supreme Court of Canada will hear an appeal from a recent Alberta judgment that may result in a change to the law of liquidated damages in Canada.

Parties to a commercial contract may try to predict the financial consequences of a breach of contract and agree on a set formula of compensation to be paid to the innocent party. These are called “liquidated damages” clauses.

Canadian courts have expressed a willingness to enforce these arrangements if they represent a good faith attempt to pre-estimate losses. These clauses can be commercially beneficial. They allow parties to avoid the uncertainties of litigation, while motivating the timely fulfilment of obligations.

However, if the compensation to be paid is disproportionate to a party’s actual losses, the courts will deem such clauses unenforceable per the longstanding “penalty rule.” The penalty rule provides that a liquidated damages clause is unenforceable if it is not a genuine pre-estimate of damages.

Prior to Capital Steel Inc v Chandos Construction Ltd  (Capital Steel), Canadian courts regularly drew from older English authorities that held that liquidated damages were enforceable so long as they were a genuine pre-estimate of damages and were neither unconscionable nor extravagant in comparison to actual losses suffered.

More recently, the U.K. Supreme Court reversed course and held that enforceability depended on compensation being proportionate to a legitimate interest of the innocent party. It was contemplated that this decision would soon take hold in Canada.

In Capital Steel, the Alberta Court of Appeal assessed the enforceability of a “stipulated-consequence-on-breach” clause in an agreement between contractor and subcontractor.

In the event that the subcontractor entered insolvency, the provision stipulated that 10% of the total agreement price would be forfeited to the contractor. The majority of the Alberta Court of Appeal decided the case based on the common law anti-deprivation rule which precludes parties from circumventing bankruptcy laws. On this ground, the provision was unenforceable.

The dissenting opinion, however, held that the stipulated remedies clause was enforceable as a valid liquidated damages clause and, importantly, that the traditional penalty rule was unhelpful and should be abandoned in Canadian law. Instead, a pre-agreed remedies clause should be unenforceable only in extraordinary circumstances, particularly if the clause is oppressive in nature. Oppressive was described as being “so manifestly grossly one-sided that its enforcement would bring the administration of justice into disrepute.”

The dissent emphasized freedom of contract as a fundamental principle and reasoned that commercial actors have the necessary resources to access legal counsel should they require clarification of their contractual obligations. The dissent further reasoned that commercial actors ought to be bound by the terms negotiated for and a court’s assessment of enforceability after-the-fact may lead to a result that departs significantly from the parties’ intentions.

Liquidated damages clauses are common in many commercial agreements, including construction contracts, meaning any change in this area of law will impact how these clauses are drafted and enforced.

On July 11, 2019, the Supreme Court of Canada granted leave to appeal from the Alberta Court of Appeal judgment. Should the Canada’s highest court weigh in on the liquidated damages issue, the decision may result in a significant change in Canadian contract law.

Given the potential of a change in the law regarding the enforceability of liquidated damages clauses, parties should carefully consider and seek legal advice on the use of these clauses in their contracts – and the enforceability of those clauses in their current contracts.

Note: This article is of a general nature only and is not exhaustive of all possible legal rights or remedies. In addition, laws may change over time and should be interpreted only in the context of particular circumstances such that these materials are not intended to be relied upon or taken as legal advice or opinion. Readers should consult a legal professional for specific advice in any particular situation.