The British Columbia Court of Appeal (“BCCA”) has recently considered whether the doctrine of unconscionability can be invoked to set aside a contractual clause providing for the payment by one party to the other of a certain amount in circumstances in which a subdivision of land as contemplated by the contract did not occur. In Do1, the BCCA overturned the Supreme Court of British Columbia decision by confirming that the doctrine of unconscionability did not apply to the circumstances and the specific contractual provision in Do. This decision provides additional comfort to lenders who wish to include special terms in their commercial lending agreements but which terms may be considered harsh from the perspective of the borrower.
This case involved the sale of certain lands (the “Development Lands”) by Mr. and Mrs. Nichols (the “Nichols”) to Nam Nha Do (“Mr. Do”) pursuant to the terms of an agreement dated June 20, 2011 (the “June Agreement”). Pursuant to the June Agreement, the Nichols sold the Development Lands to Mr. Do for $1.7 million and granted a mortgage (the “Mortgage”) in the amount of $500,000 in respect of a separate residential property owned by the Nichols (the “Residential Property”). The Mortgage reproduced the specific term of the June Agreement which was in dispute at trial, being the obligation of the Nichols to pay $500,000 to Mr. Do if the Nichols were unable or unwilling to carry out the subdivision of the Development Lands before a specified date (the “Sub-Division Clause”).
The trial judge determined that while the Nichols were liable under the June Agreement to pay the $500,000 to Mr. Do, this obligation was both a penalty and unconscionable, and therefore unenforceable.
The trial judge concluded that the Sub-Division Clause was a penalty because:
- there was “no evidence that the parties had any reason to believe the value [of the Development Lands] would decrease in the absence of future subdivision and no evidence that the property today is worth any less than what the petitioner paid for it”2;
- the only loss to Mr. Do that could result from the Nichols’ failure to subdivide the Development Lands would be the loss of any increased value that was expected to result from the subdivision but no evidence was provided for the basis upon which the expected increased value was determined; and
- the consequences to the Nichols of the failure to obtain the subdivision, being the obligation to pay $500,000 to Mr. Do, exceeded the damages that Mr. Do could have expected to suffer due to such failure.3
The Sub-Division Clause in dispute was found by the trial judge to be unconscionable because at the time the Nichols entered into the June Agreement, they were on the verge of losing their property through an order absolute obtained by a prior mortgagee. The Nichols were, in his view, “in a position of weakness and distress amounting to an unusual inability to protect their own interests”4. Further, the trial judge found that the clause in dispute was substantially unfair given that the payment of the $500,000 was, in his view, in no way a reflection of the real damages that Mr. Do expected to suffer, or that Mr. Do actually suffered, because of the failure by the Nichols to subdivide the Development Lands.
Following these determinations, the trial judge granted relief to the Nichols under section 24 of the Law and Equity Act5 and held that the Sub-Division Clause was unenforceable.
Court of Appeal
Fortunately for Mr. Do, the BCCA disagreed with the trial judge’s finding that the clause in dispute was a penalty or that the clause was unconscionable. The BCCA referred to earlier case law confirming that the doctrine of penalty is not designed to grant relief from a commercially imprudent bargain. It emphasized the historical distinction drawn between payments of a sum in the event of no-performance of a contractual obligation (where the sum of money may amount to a penalty) and payment of a sum of money on the happening of an event (which is not a penalty).6 The BCCA held that the clause was not a penalty because the Nichols’ failure to subdivide did not constitute a breach of the June Agreement. Such failure simply gave rise to the application of the Sub-Division Clause of the June Agreement that was specifically contemplated to apply in the event that the Development Lands were not subdivided as contemplated.7
The BCCA then considered whether the clause in dispute in the June Agreement could be set aside on the grounds of unconscionability. A party wishing to set aside a contract for unconscionability, in their view, must meet a two-prong test, and specifically “must establish (a) inequality in the position of the parties arising from the ignorance, need or distress of the weaker, which left him in the power of the stronger; and (b) proof of substantial unfairness in the bargain”8. Presumably the BCCA was satisfied that the first part of the test was met as it concluded, without elaboration, that in the circumstances it only needed to consider the second part of the test, being whether the Sub-Division Clause was substantially unfair.9 The BCCA placed importance on the fact that the June Agreement clearly provided that if the subdivision of the Development Lands was not completed by the closing of the sale of the Development Lands, the Nichols would repay to Mr. Do the amount of $500,000 which amount was secured by way of the mortgage on the Residential Property. According to the BCCA, while Mr. Do agreed to pay $1.7 million for the Development Lands at closing, the value of the Development Lands in a pre-subdivision state was agreed by the parties to be $1.2 million, not $1.7 million.10 Without any evidence showing that the $1.2 million was not a fair price for the Development Lands in a pre-subdivision state, the BCCA determined that the June Agreement was not unfair, and accordingly was not unconscionable.11 The BCCA thus concluded that the mortgage was in default and all monies secured by such mortgage were due and owing.
The Do decision indicates that the courts will not be quick to conclude that rigorous terms or terms which are difficult to comply with in lending agreements are unconscionable. The test for unconscionability and unenforceability will likely continue to have a high threshold when two commercial parties are involved. The Do decision is a welcome support for lenders who wish to include special terms in commercial lending agreements in order to protect themselves against increased credit risk if certain anticipated events do not occur. Absent clear evidence of unfairness, it appears that special terms linked to the occurrence of events rather than to covenant breaches of a commercial borrower (and which may be considered harsh from the borrower’s perspective) are not unconscionable and could prove to be enforceable in many instances. While a party’s ability to successfully argue that a contractual term should be set aside on grounds of unconscionability depends on the facts, the BCCA’s decision in Do will likely have the effect of setting the bar higher for what constitutes unfairness. A term that is harsh to one party but which term was clearly contemplated by the parties at the time the agreement was entered into, will likely not satisfy the test for unconscionability regardless of the difficulties the term places on that party.