Private parties entering into a contract may be unaware of the likelihood of a penalty provision being enforced by a court upon one party breaching the contract. Broadly, a penalty is a sum above the actual damage amount incurred by a party required to be paid when a breach occurs. The common law penalty rule considered by the courts was whether the stipulated penalty under a contract was a genuine estimate of the damages suffered by the innocent party upon breach. If a penalty provision estimated damages above those actually incurred, it would not be enforceable. Whereas traditionally courts followed the common law penalty rule and nullified any penalty provision that yielded a damage estimate over the damages actually incurred, over the past half century there has been an increasing trend towards enforcing penalty clauses under the equitable doctrine of forfeiture.
A forfeiture has been defined as “the loss of a right, property, or money (often held as security), or part payment, by reason of some specific conduct.” The shift towards enforcing penalty clauses began in the Supreme Court of Canada’s decision in Elsley v JG Collins Ins. Agencies wherein the Court wrote:
It is now evident that the power to strike down a penalty clause is a blatant interference with freedom of contract and is designed for the sole purpose of providing relief against oppression for the party having to pay the stipulated sum. It has no place where there is no oppression.
Elsley favoured reliance on equitable principles of oppression or unconscionability as opposed to the common law rule that considered whether the penalty was a valid pre-estimate of damages.
Recent decisions from the Ontario Court of Appeal have affirmed the Elsley analysis. In 869163 Ontario Ltd. v. Torrey Springs II Associates Limited Partnership, the Court followed the groundwork laid in Elsley and held that the equitable doctrine of relief from forfeiture upholds penalty clauses where their enforcement is not unconscionable. In Kechnie v Sun Life Assurance Company of Canada, the Court followed its own line of cases that prioritize equitable principles centred on an unconscionability analysis. Kechnie also recognized parties’ rights to freely enter into contracts and independently define the consequences of a breach.
Recognizing that Courts will analyze a penalty clause through the lens of unconscionability, lawyers and their clients should be attuned to what makes a penalty provision unconscionable. The Court of Appeal’s April 2017 decision in Redstone Enterprises Ltd. v. Simple Technology Inc. listed the following non-exclusive indicia of unconscionability: i) inequality of bargaining power, a substantially unfair bargain, the relative sophistication of the parties, the existence of bona fide negotiations, the nature of the relationship between the parties, the gravity of the breach, and the conduct of the parties.
Sophisticated parties with relatively equal bargaining power entering into a contract ought to know that a contract’s provisions as stated therein will likely stand in front of a court in case of a breach. This is even more likely when parties have had the ability to negotiate the penalty provision in dispute. Courts are hesitant to interfere with privately negotiated contracts between sophisticated parties. However, if there is inequality of bargaining power or, otherwise, a contract of adhesion in question, courts may be apt to strike down a contract’s provision by concluding that it is unconscionable. Nonetheless, when advising clients, lawyers should take the approach that a contract’s provision will stand as is. Therefore, diligence should be taken when drafting and negotiating the terms of a contract to ensure that in case of a breach a party’s liability to pay damages is minimized.