Penalty clauses in Canadian contract law.

Author:Veel, Paul-Erik
 
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I INTRODUCTION II THE EVOLUTION OF THE LAW OF STIPULATED DAMAGES CLAUSES IN CANADA Dunlop and the Traditional Doctrine Elsley and the Emergence of an Oppression-Based Doctrine III COMPARING DUNLOP AND ELSLEY: A NORMATIVE ANALYSIS OF COMPETING APPROACHES Stipulated Damages as a Mechanism for Increasing Contractual Certainty Stipulated Damages as a Mechanism for Avoiding Under-Compensation The Signaling Function of Supra-Compensatory Stipulated Damages Freedom of Contract and Bargaining Failures in Stipulated Damages Inefficient Behaviour and Supra-Compensatory Stipulated Damages IV A REFORMULATED TEST FOR THE ENFORCEABILITY OF STIPULATED DAMAGES CLAUSES V CONCLUSION Abstract

This article critically examines the current state of the law of penalty clauses in Canada. First, while many commentators regard the law of penalty clauses as being relatively settled, this article tracks the development of two competing lines of authority. This article contends that lower courts' decisions across Canada have been split between (1) the traditional standard regarding the non-enforceability of true penalty clauses, which stems from the House of Lords' decision in Dunlop Pneumatic Tyre Co. Ltd. v. New Garage and Motor Co. Ltd., and (2) a more recent oppression-based standard under which courts have been increasingly reluctant to strike down supra-compensatory penalty clauses, which has emerged from the Supreme Court of Canada's decision in J.G. Collins Insurance Agencies Ltd. v. Elsley Estate. Second, this article examines whether the recent authority in favour of greater enforceability of penalty clauses is a positive change in the law of penalty clauses. While many authors have argued in favour of greater enforceability of penalty clauses, this article argues that there are policy reasons in favour of the traditional position of stricter scrutiny of penalty clauses. Taking these policy considerations into account, this article proposes a reformulated test of the enforceability of such clauses based on Dunlop.

Resume

Cet article examine d'une maniere critique l'etat present de la loi sur les clauses de penalite au Canada. Premierement, bien que plusieurs commentateurs considerent la loi sur les clauses de penalite comme etant relativement etablie, cet article trace le developpement de deux types d'autorites qui sont en competition. Cet article suggere que les decisions des tribunaux inferieurs a travers le Canada sont divisees entre (1) le standard traditionnel de non validite des clauses de penalites veritables, qui derive de la decision de la Chambre des Lords dans l' arret Dunlop Pneumatic Tyre Co. Ltd. v. New Garage and Motor Co. Ltd., et (2) un plus recent standard d'oppression sous lequel les tribunaux ont ete de plus en plus reticents a invalider des clauses de penalites supra compensatoires, standard qui emergea de la decision de la Court Supreme du Canada dans l'arret J.G. Collins Insurance Agencies Ltd. v. Elsley Estate. Deuxiemement, cet article ce penche sur les autorites recentes en faveur d'une plus grande applicabilite des clauses de penalite et se demande si elles constituent un developpement positif a la loi sur les clauses de penalite. Bien que plusieurs auteurs se prononcent en faveur d'une plus grande applicabilite des clauses de penalite, cet article suggere qu'il existe des raisons politiques en faveur de la position traditionnelle d'examen plus minutieux des clauses de penalite. Prenant en compte ces considerations politiques, cet article propose un test reformule, base sur l'arret Dunlop, sur l' applicabilite de ces clauses.

I INTRODUCTION

Canadian contract law and the British contract law from which it developed have generally tended to support the ability of individuals to enter into contracts on their own terms. One notable exception to this general principle of freedom of contract has been the scrutiny with which courts have treated certain contractual arrangements specifying in advance the damages which will flow from a breach of contract. More specifically, courts have often been quite willing to strike down stipulated damages clauses which require the breaching party to a contract to pay a specified sum of money to the non-breaching party. In this respect, courts have traditionally made a distinction between liquidated damages clauses, which are enforceable, and penalty clauses, which are not enforceable. Judicial scrutiny in this area has struck many as anomalous, and it seems prima facie that the courts' willingness to strike down penalty clauses is an unreasonable and unprincipled interference with freedom of contract.

Despite a rather substantial volume of case law relating to the enforceability of such clauses in Canadian courts in recent years, substantial legal commentary on this area of contract law has been limited. Texts on Canadian contract law have devoted only a few pages to examining select historically important cases and briefly articulating a few policy arguments in favour of upholding penalty clauses, and no academic articles have appeared on the topic of penalty clauses in Canadian law in the last three decades. A few brief comments on the topic have appeared in more specialized reviews, but these have tended to focus on some very specific aspect of penalty clauses or on their application in a particular industry. (1) Perhaps this is because of a general perception that, as claimed by Hunt J.A. of the Alberta Court of Appeal, the principles governing this area of law are "long standing and relatively free of controversy". (2) This article will demonstrate the incorrectness of this view and will seek to contribute to the scholarly debate on a topic which has been undeservedly lacking in attention, at least from a strictly legal perspective.

Following this introduction, part two of this article will review in some detail the Canadian case law on penalty clauses, primarily focusing on the developments which have occurred since the Supreme Court's decision in J.G. Collins Insurance Agencies Ltd. v. Elsley Estate in 1978. (3) This article will argue that rather than being settled, the law on the enforceability of such clauses is actually in a state of flux, as two distinct yet muddled strands of case law have emerged. Moreover, this article will posit that the trend in the Canadian law on penalty clauses has been a gradual movement away from the traditional position articulated in Dunlop Pneumatic Tyre Co. Ltd. v. New Garage and Motor Co. Ltd. and will conclude that courts are increasingly reluctant to strike down stipulated damages clauses, even if they could be characterized as penalty clauses according to the traditional test. (4)

Following the arguments relating to the development of the law presented in part two, part three of this article will critically assess the policy arguments related to the enforceability of stipulated damages clauses. While there has been significant academic commentary, particularly from the law and economics movement, on the policy considerations related to the enforceability of stipulated damages clauses, such analysis has often been undertaken in the abstract without application to the more pertinent issue of deciding between competing legal principles governing the enforceability of such clauses. This section will fill this lacuna by situating the policy discussion in the context of the two competing principles discussed in the previous section, and it will argue that many of the policy considerations underlying the enforceability of stipulated damages clauses suggest that the traditional Dunlop approach is superior to the Elsley approach.

The fourth part of this article will synthesize the conclusions of the discussion in the previous section with the aim of articulating the appropriate legal framework that courts should be employing in their analysis of the enforceability of stipulated damages clauses. This part will posit that courts should apply a test of enforceability similar to the test articulated in Dunlop under which courts refuse to enforce supra-compensatory penalty clauses. Rather than providing wholesale support for the framework outlined in Dunlop, however, this article will propose a modified framework which remains based on the Dunlop approach but also incorporates some of the policy considerations outlined in the third part. Specifically, this section will argue that stipulated damages clauses should generally be enforced where it would be difficult to determine exactly what truly compensatory damages would be, that is, where damages cannot be easily quantified at the time of breach or there is evidence that the non-breaching party has a particularly high subjective valuation of performance of the contract. A fifth part will then serve as a brief conclusion.

A few points of clarification must be made from the outset about the scope of this article. This article deals with stipulated damages clauses which require a party to pay a certain amount of money upon a breach of contract. More specifically, this article is primarily concerned with the enforceability of supra-compensatory stipulated damages clauses, commonly referred to as penalty clauses; such clauses are frequently litigated and ate the most contentious in academic work on the topic. By contrast, this article does not deal with forfeitures and deposits, which are clauses requiring a party to forfeit any claim to certain money already paid upon a breach of contract. Historically, and arguably irrationally, Anglo-Canadian law has made a distinction between penalty clauses and forfeitures; even more problematic is the fact that in many instances courts have used the term "penalty" to describe both. This article, however, will only deal with penalty clauses, as the law on this point is already sufficiently muddled without introducing the further complication of forfeitures.

II THE EVOLUTION OF THE LAW OF STIPULATED DAMAGES CLAUSES IN CANADA

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