Termination is the big hammer to take out when a contract starts to go irretrievably off the rails. However, termination may not be enough when your poorly-performing commercial partner is getting part payment and leaving you to either chase them to get money back or bear the loss yourself. If there has been misconduct or fraud by your commercial partner, then you have an even bigger mess on your hands, and figuring out your damages can be more challenging.

There are clauses that can be inserted up-front in a contract to try to ensure that you get some compensation if your business partner goes rogue. A recent Ontario court case, discussed below, looked at such clauses in the context of an Ontario government  housing agency having a massive carpet installation project go wrong. These clauses should be considered for all types of significant agreements, including those involving intellectual property (the author’s practice area), such as contract research agreements or technology commercialization agreements.

Typical clauses to provide some additional financial protection upon termination include a penalty clause or a liquidated damages clause. Both types of clauses specify a dollar amount agreed upon at the time the contract is signed.

A penalty clause requires the payment of a specific dollar amount after breach of the contract, irrespective of the actual damages. The amount specified in the liquidated damages clause is a pre-estimate based on estimated damage. (Canadian General Electric Co. v. Canadian Rubber Co., [1915] 52 S.C.R. 349; Elsley v. J.G. Collins Insurance Agencies Ltd., [1978] 2 S.C.R. 916 ). You can demand the specified amount of liquidated damages without regard to the actual monetary loss (provided that the liquidated damage amount is not actually a penalty – if it is a penalty, only a lesser amount of proven damages should be recoverable).

A recent Ontario Court of Appeal case looked at a lesser known and potentially useful additional approach to deal with poor performance, referred to as a ‘stop payment’ clause (Ottawa Community Housing Corporation v. Foustanellas (Argos Carpets), 2015 ONCA 276). This case involved a carpet company that overbilled the Ontario government for work done, and also installed lower quality carpet than specified in the agreement. The government was ultimately awarded over $1.5 million.

The contract stated a list of events which, if they occurred, would permit the government to terminate the contract. The list is broadly stated, so you can envision it being useful in other types of purchase and service contracts. To terminate, the government must give notice i) of the specified event, and ii) that the government was taking the remaining work out of the carpet company’s hands. The government stopped its contractual obligation to make payments, even payments already due, pending determination of the owner’s damages. The stop-payment clause is helpful to override a common type of contract clause that states that specific amounts (obligations) due at the time of contract termination will survive termination. (The relevant clauses of the carpet contract are reproduced at the end of this article.)

The stop-payment clause does not specify a monetary amount so it is not a penalty clause or liquidated damages clause. The idea is that the owner’s damages and losses require assessment, and the owner may cease payments to the contractor pending quantification of those damages. The amount of outstanding invoices owed to the contractor may eventually be set off against the quantified amount of the owner’s losses and damages.

The stop-payment clause is well-suited to a situation where the amount of damages may vary widely, so a penalty clause or liquidated damages clause is not as practical.   The clause should be clear that it does not limit the amount of recovery to the amount of stopped payments. The clause can also be written to reinforce the contractor's liability for an amount equal to the owner’s damages caused by poor performance.

This case shows that a stop-payment clause can be a useful tool when enforcing a contract. Consider that type of clause, a penalty clause, or a liquidated damages clause when you have the bargaining leverage to do so.

Carpet Contract Clauses:

An initial clause listed specific situations where work could be taken out of the hands of the Contractor.

1.6     TAKING WORK OUT OF THE HANDS OF THE CONTRACTOR

.1  If the Contractor:

.1  has delayed in commencing or is in default in the completion of the work or any portion of the work, within the contract commencement and completion dates;

.2  is in default of diligently executing the work or any portion of the work to the satisfaction of the Owner, and the Owner has given notice of the default to the Contractor, and the notice of default has required the Contractor to put an end to the default or delay, and the default or delay continues for past the time specified in [the] notice after the notice was communicated;

.3 fails to comply with any reasonable order he may receive from the Owner or shall persist in any course in violation of any of the provisions of this contract;

.4 has received from the Owner three written notices of default during the term of the contract;

.5 has made an assignment of the Contract without the required consent of the Owner;

.6  shall submit a bid that is subsequently found to contain false or misleading information;

.7 shall become bankrupt or insolvent, or compound with his creditors, or commit any act of insolvency;

.8  has substituted any material or equipment other than specified without the required consent of the Owner;

or for any other reason which the Owner deems proper, then in each and any such case, the Owner has the full right and power to take the whole operation, or any part of the operation out of the hands of the Contractor.

1.6.3 … where any or all of the work has been taken out of the hands of the Contractor, the Contractor will not be entitled to any further payment, including payments then due and payable but not paid. The obligation of the Owner to make payments will cease, and the Contractor will be liable upon demand to pay the Owner an amount equal to all the losses and damages incurred by the Owner for the non-completion of the work.