Liquidated Damages (LD) clauses are often included in construction contracts as a means of motivating timely project completion. Through an LD clause, the owner and the contractor are able to pre-agree on the compensation payable to the owner if the contractor fails to complete the work within the stated contract time.

LDs replace the need for an owner to prove what damages it actually suffers when a project is delayed. Once the owner establishes that a delay has occurred which is not otherwise excused by the contract, the amount of compensation payable is determined by simply applying the LD formula.

LD clauses are effective in part because they outline clear consequences for a delay. Knowing in advance how much a delay will cost can be a strong incentive for a contractor to meet its completion deadlines. However, courts have established boundaries which must be satisfied in order for an LD clause to be valid. If these legal requirements are not met, a court can declare an LD clause to be unenforceable and strike the clause from the contract.

Canadian law on the enforceability of LD clauses stems from the U.K. House of Lords’ decision in Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co Ltd. This case set out factors to consider when determining whether a given clause: (1) represents a valid and enforceable agreement as to LDs; or (2) imposes an unenforceable penalty on a contract party. Since Dunlop, Canadian courts have upheld LD clauses when the compensation payable represented a genuine pre-estimate of damages resulting from a contract breach, but have declared such clauses as imposing unenforceable penalties where the sum payable was extravagant and unconscionable in light of the non-breaching party’s actual losses.

The U.K. Supreme Court’s recent decision in Cavendish Square Holding BV v Talal El Makdessi and ParkingEye Ltd v Beavis[2015] UKSC 67, changed the law on LDs and penalty clauses in a manner favourable to those seeking to enforce these clauses. The key takeaways from this decision are as follows:

  • In reviewing an LD clause’s validity, the focus is no longer on whether the sum payable represents a genuine pre-estimate of the loss
  • The true test is whether the LD clause “imposes a detriment on the contract-breaker out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation”
  • The first step is to determine whether a “legitimate business interest is served and protected by the clause”. If so, the second step is to determine “whether the provision made for that interest is extravagant, exorbitant or unconscionable” in light of the innocent party’s interest in contract performance
  • Courts must give due regard to parties’ freedom of contract, particularly where the parties are commercially sophisticated and deal with each other on an equal basis and with the benefit of expert advice

Overall, the Cavendish decision provides an added degree of flexibility for parties looking to incorporate LD remedies in their contracts. Although the decision is not directly binding on Canadian courts, Cavendishmodified the law on LDs from Dunlop (which has been long been a leading authority in Canada). We can therefore reasonably expect that Canadian courts will soon start applying Cavendish in Canadian cases concerning LD clauses, both in the construction context and otherwise. As a result, Cavendish may become a welcome development for Canadian project owners looking to incorporate LD remedies in their building contracts.