Supreme Court May Consider Enforceability of Liquidated Damages

October 04, 2019

Written By Brian Reid and Gita Keshava

On July 11, 2019, the Supreme Court of Canada (the SCC) granted leave to appeal from the Alberta Court of Appeal's decision in Capital Steel Inc v Chandos Construction Ltd, 2019 ABCA 32 [Chandos]. In a previous blog post, we considered the Alberta Court of Appeal's decision with respect to the enforceability of contract liquidated damages (LDs) upon the insolvency of one of the contracting parties. In this blog, we address the potential implications of Chandos with respect to the common law principle that an LDs clause may be unenforceable if it is found to be a penalty and not a genuine pre-estimate of damages. 

General Law on Liquidated Damages Clauses 

LDs are commonly used in construction and other contracts to pre-determine damages for specific breaches of contract. For example, a general contractor may be required to pay LDs for each day beyond the required completion date taken to complete the work. In theory, by setting LDs in the contract, the innocent party can avoid the complexities and significant costs of having to prove actual damages before a court or arbitrator. However, in reality, even if two sophisticated parties have agreed to LDs in their contract, a court or arbitrator may find the clause to be a penalty, rather than a genuine pre-estimate of damages, and elect not to enforce it.

In 1914, the U.K. House of Lords in Dunlop Pneumatic Tyre Co. v New Garage and Motor Co., [1914] UKHL 861 [Dunlop] created a test to determine whether LDs are a penalty. Canadian courts adopted Dunlop in the 1915 decision Canadian General Electric Co. v Canadian Rubber Co., 52 SCR 349 at 352 [General Electric]. In General Electric, Chief Justice Fitzpatrick explained the difference between a penalty and an enforceable LDs clause as: "…[a] penalty is the payment of a stipulated sum on breach of the contract, irrespective of the damage sustained," while "…[t]he essence of liquidated damages is a genuine covenanted pre-estimate of damage" (at 351). However, since General Electric, Canadian courts have struggled to apply the Dunlop test consistently, resulting in uncertainty in the business community.

More recently, the British courts reinvented the test for LDs in Cavendish Square Holding BV v Talal El Makdessi, [2015] UKSC 67 [Cavendish]. The U.K. Supreme Court reasoned that the prior law of penalties resulted in unsatisfactory distinctions. Rather, the Court held that the test should be whether an LDs clause protects any legitimate business interest, and whether the provision is extravagant, exorbitant, or unconscionable in the context. However, Canadian courts have not yet adopted Cavendish and uncertainty over LDs clauses remains. This uncertainty is apparent in Chandos: the majority elected not to assess the impugned provision as an LDs clause while the dissent emphasized the need for a more clear and modern test.

Capital Steel Inc v Chandos Construction Ltd, 2019 ABCA 32

Chandos Construction Ltd (Chandos), a general contractor, hired a subcontractor, Capital Steel Inc. (Capital Steel), for work on a condominium development project. The subcontract between Chandos and Capital Steel included an LDs insolvency clause, wherein Capital Steel agreed to forfeit 10 percent of the total contract price (approximately $140,000) if it became insolvent. 

In 2016, Capital Steel became insolvent and assigned itself into bankruptcy, at which time it was owed approximately $150,000 by Chandos. Chandos attempted to rely on the LDs insolvency clause to offset the amount they owed to Capital Steel with the $140,000 that Capital Steel owed them upon insolvency. However, offsetting the balance owed to Capital Steel would decrease the assets available to Capital Steel's creditors.  

At trial, Justice Nielsen found that the LDs clause was a genuine pre-estimate of damages, not a penalty, because it represented a bona fide commercial transaction, the predominant purpose of which was not to deprive Capital Steel of its property. Further, the sum was not "extravagant and unconscionable." Therefore, Justice Nielsen concluded that the clause was enforceable. On appeal, two questions were raised: 

1. Did the clause violate the common law anti-deprivation rule?
2. Did the clause impose a penalty or was it a valid liquidated damages clause?

The majority of the Court of Appeal found that the clause was unenforceable because it violated the anti-deprivation rule, which we addressed in our prior blog post. As a result, the majority did not comment on LDs. However, in dissent, Justice Wakeling came to a different conclusion regarding the applicability of the anti-deprivation rule and considered common law principles regarding LDs.

Justice Wakeling rejected the notion that a consequence for breach of contract needs to be reasonable in the circumstances or correlated with the damages flowing from the breach. Stressing the importance of freedom of contract between parties, Justice Wakeling stated that the true measure is a standard of oppression. He concluded that an LDs clause should only be considered oppressive if it is so "…grossly one-sided that its enforcement would bring the administration of justice into disrepute." Therefore, absent extraordinary circumstances, a clause imposing a consequence for breach of contract in the commercial context should be enforced. On this issue, Justice Wakeling concluded that the LDs insolvency clause was enforceable against Capital Steel's creditors as it was neither a penalty nor unconscionable, but rather served a justifiable business purpose.  

Leave to Appeal to the SCC Granted

On July 11, 2019, the SCC granted Chandos leave to appeal the Court of Appeal's decision, which will provide an opportunity for the SCC to consider and clarify the law in Canada regarding the enforceability of LDs clauses. 

If you have any questions about the impact of this decision, please contact a member of our Construction team.

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