Last week, the U.K. Supreme Court (UKSC) changed the law on liquidated damages clauses (LDCs), giving parties greater freedom to decide on damages for contractual breaches. The case may cause Canadian courts to revise the law in a similar manner and provide parties with greater flexibility for predetermining damages in commercial contracts — a change which many parties would welcome.

CANADIAN POSITION ON LDCs

LDCs allow parties to agree upon damages for contractual breaches and save time and expense on litigating these claims in the future.

The Canadian law on LDCs is shaped by a 101-year-old case from the United Kingdom, Dunlop Pneumatic Tyre Company Limited v. New Garage and Motor Company Limited (Dunlop). In Dunlop, the House of Lords distinguished between LDCs, which courts will not interfere with, and penalty clauses, which courts will not enforce.

The Supreme Court of Canada followed Dunlop in H.F. Clarke Limited v. Thermidaire Corp. Ltd. and stated that “a sum will be held to be a penalty if extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved to have followed” from a breach. The result is that Canadian courts will not enforce an LDC where the damages stipulated by the provision are determined not to be a genuine pre-estimate of loss.

The lone Canadian outlier is in New Brunswick, where section 5(1) of the province’s Law Reform Act states: “A party to a contract may enforce a penalty clause or a liquidated damages clause to the extent that it is reasonable in all of the circumstances that the clause should be enforced.” In McKeen v. The Mortgage Makers Inc. and Libby, the New Brunswick Court of Appeal held that this provision reverses the Canadian common law position and allows a plaintiff at trial to establish the reasonableness of an LDC.

CHANGES TO THE U.K. LAW

The UKSC has changed the law on LDCs to focus on the interests of the parties and the scale of damages stipulated by an LDC relative to those interests. The test in the United Kingdom is now whether an LDC “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 result of the decision is that parties can now, subject to the parameters of the new test, agree to damages for contractual breaches that are greater than the losses they may actually incur and know that the provision will likely be enforced. The new law in the United Kingdom gives parties greater flexibility to use LDCs as a means to encourage compliance with contractual terms based on legitimate commercial interests.

For example, in one appeal (the UKSC decided two appeals together), the respondent managed a parking facility and charged customers £85 for parking longer than the free period of two hours. The appellant argued that this fine was not a genuine pre-estimate of loss and constituted a penalty, as neither the respondent company nor the owner of the parking facility suffered a financial loss for customers overstaying the free period.

Using the revised approach to LDCs, the UKSC held that both the landowner and the respondent company had a legitimate interest in charging overstaying motorists, and that the amount charged was not extravagant or unconscionable taking into account the notice given to motorists and practice around the United Kingdom.

IMPACT ON THE LAW IN CANADA

The changes to the law on LDCs in the United Kingdom may influence Canadian courts to reform the common law in a similar manner for commercial contracts. To date, Canadian courts have cited Dunlop as the leading authority on LDCs and penalty clauses. As Dunlop is no longer the leading case on LDCs in the United Kingdom, there is now a possibility for courts to revise the law in Canada accordingly.