J. Penalties and Liquidated Damages

Author:John D. McCamus
Profession:Professor of Law. Osgoode Hall Law School, York University

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The parties to an agreement may wish to stipulate the remedy or remedies available in the event of breach for a variety of reasons. They may wish to avoid the uncertainties and expense of litigation by clear agreement with respect to the consequences of breach. Alternatively, one of the parties may wish to stipulate for a severe penalty in the event of the other party’s breach in order to increase the pressure on the other party to perform. Such provisions are often said to be intended to have an in terrorem effect. We here consider the enforceability of contractual terms aligned to either one of these purposes. In the further alternative, however, a party might wish to stipulate a remedy that minimizes or, indeed, eliminates that party’s exposure to liability in the event of breach. Clauses of this type, normally referred to as exclusion clauses or limitation of liability clauses, are considered elsewhere in this volume.299We will consider here, however, the effect of clauses that, though inserted by the innocent party for an in terrorem purpose, accidentally underestimate the amount of loss that actually occurs and ask whether, in such circumstances, the clause should constitute a cap on the quantum of relief available to the innocent party. Parties may also attempt to control the consequences of breach by stipulating that moneys or other values already transferred by the party in breach will be forfeited upon breach. The enforceability of these arrangements would normally be tested in the context of an attempt by the party in breach to seek restitution of the value being forfeited. This issue is considered elsewhere in a more general treatment of the restitutionary remedies of parties in the context of a breach of contract.300Where the parties to an agreement engage in the exercise of attempting to predict the financial consequences of breach and stipulate for the payment of an equivalent sum in the event of breach in order to avoid the risks of litigation, their purpose is considered benign and such arrangements are generally held to be enforceable. An enforceable term of this kind is characterized as a "liquidated damages" clause. On the other hand, a term that is designed to operate in terrorem by stipulating payment of an amount that exceeds the likely damages caused by breach is characterized as a "penalty" and held to be unenforceable. The rule striking down penalty clauses represents an extension of a traditional equitable doctrine relating to penal bonds to apply to contractual provisions in a more general way. Penal bonds were typically sealed instruments

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providing that a certain sum of money would be paid unless the promisor performed a particular contractual undertaking. Upon breach of that undertaking, then, the promise to pay the penalty became enforceable at common law. As early as the late-seventeenth century, however, courts of equity intervened and prevented collection of the penal sum leaving the victim of the breach to pursue a claim for damages for breach at common law.301Similarly, under contemporary practice, if a penalty clause is struck down, the innocent party is entitled to pursue a claim for damages for breach of contract in the normal fashion.

In order to determine the effect of a particular stipulated remedies provision, then, it is necessary to consider whether the clause is correctly characterized as either a liquidated damages clause or a penalty clause. The basic test for distinguishing between the two was described in the following terms by Fitzpatrick C.J.C. in a decision of the Supreme Court of Canada: "A penalty is the payment of a stipulated sum on breach of the contract, irrespective of the damage sustained. The essence of liquidated damages is a genuine covenanted pre-estimate of damage."302

The underlying rationale of the rule striking down penalty clauses was described by Laskin C.J.C. in H.F. Clarke Ltd. v. Thermidaire Corp.303as follows: "The primary concern in breach of contract cases ... is compensation, and judicial interference with the enforcement of what the Courts regard as penalty clauses is simply a manifestation of a concern for fairness and reasonableness rising above contractual stipulation, whenever the parties seek to remove from the Courts their ordinary authority to determine not only whether there has been a breach but what damages may be recovered as a result thereof."304The question in each case, then, is whether the stipulated sum is "considered to be a bona fide pre-estimate of the damage."305The rule thus effects a substantial limitation on the ability of the parties to fix damages in advance. Indeed, in another decision of the Supreme Court,306Dickson J. observed that "the power to strike down a penalty clause is a blatant inference with freedom of contract."307

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Application of the test is easiest in a stark case where the "sum stipulated for is extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved to have followed from the breach."308Where the in terrorem nature of the clause is less evident, however, application of the test may prove to be a subtle matter. The fact that the parties may describe the stipulated sum as "liquidated damages" or, as is often stipulated, "as liquidated damages and not as a penalty" is not dispositive.309Conversely, although a prudent drafter would not describe such a term explicitly as a penalty, the use of that term would not preclude a court from determining that the stipulation is a liquidated damages clause.310In each case, the court must look behind the language of the provision and attempt a proper classification of the term.

A number of guidelines have emerged in the jurisprudence applying the distinction.311Thus, a stipulation requiring payment of a larger sum for breach of a covenant to pay a lesser sum is penal in nature. Where the consequences of the breach may vary in severity, the fact that the stipulated sum also varies in a manner proportionate to the severity of loss points in the direction of liquidated damages.312On the other hand, where the provision stipulates for the payment of a single sum with respect to the occurrence of any one of a number of possible breaches, some of which may be important but others of which may be trivial, the stipulation is more likely to be characterized as penal. Thus, in Shatilla v.Feinstein,313a stipulation in a contract for the sale of a wholesale dry goods business provided that the sum of ten thousand dollars would be payable for each and every breach of a non-competition covenant given by the vendor. The non-competition clause was drafted very broadly and, as Martin J.A. pointed out, the provision could be breached in a serious way by, for example, opening up a competing business or, on

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the other hand, in a trivial fashion by, for example, taking employment as a...

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