Liquidated Damages Clause

"Liquidated" means fixed or ascertained. A liquidated damages clause replaces the usual process of proving loss after a breach with an amount the parties agreed on when they signed. Common examples in Ontario business contracts include:

• a daily or weekly charge for late delivery or late completion;
• an early termination fee when a customer or franchisee ends a fixed-term contract before it expires;
• a set payment for breach of an exclusivity or non-solicitation promise; and
• a break fee payable if a party walks away from a transaction for a stated reason.

The appeal is certainty. Each side knows its exposure in advance, and the innocent party can collect without hiring experts to prove lost profits that may be genuinely hard to measure. If the clause is enforceable, the agreed sum is payable without proof of actual loss.

A liquidated damages clause is different from a limitation of liability clause. A cap sets the most a party can recover after it proves its loss; a liquidated damages clause sets what it recovers regardless of the proven loss. It is also different from a deposit, which is money paid up front and governed by the law of forfeiture, as our guide to deposits and break fees in a letter of intent explains.

The traditional test comes from the House of Lords decision in Dunlop Pneumatic Tyre Co. v. New Garage and Motor Co. (1915), and the Supreme Court of Canada has adopted a virtually identical formulation. A sum is enforceable as liquidated damages if it is a genuine pre-estimate of the loss the innocent party is likely to suffer. It is an unenforceable penalty if its purpose is to frighten the other party into performing; the classic description, quoted by the Court of Appeal for Ontario, is a payment "stipulated as in terrorem of the offending party."

Under this rule the clause is judged as of the day the contract is made, not the day of the breach. The label the parties choose does not decide the question. Warning signs that a court may treat a clause as a penalty include:

• an amount that is extravagant and unconscionable compared with the greatest loss that could conceivably follow from the breach;
• a single lump sum payable for any breach, whether trivial or serious; and
• a sum that bears no visible relationship to the commercial interest it protects.

If a clause is struck down as a penalty, the contract survives. The innocent party simply falls back on proving its actual damages in the ordinary way.

Canadian courts have grown wary of the strict penalty rule. In Elsley v. J.G. Collins Insurance Agencies Ltd., [1978] 2 S.C.R. 916, the Supreme Court of Canada described the power to strike down a penalty clause as a blatant interference with freedom of contract, justified only to relieve oppression.

In Peachtree II Associates - Dallas, L.P. v. 857486 Ontario Ltd. (2005), Sharpe J.A., writing for the Court of Appeal for Ontario, endorsed the English Court of Appeal's description of the penalty rule as inflexible compared with the equitable rules of relief against forfeiture. He reasoned that courts should, if at all possible, avoid classifying clauses as penalties and should, whenever possible, favour an analysis based on equitable principles and unconscionability, which looks at the circumstances at the time of the breach rather than only at signing. The clause in that case, which deemed the investors' promissory notes paid if the company holding them defaulted, was treated as a forfeiture and enforced.

The statutory basis for relief is section 98 of the Courts of Justice Act, which provides that a court may grant relief against penalties and forfeitures, on such terms as to compensation or otherwise as are considered just.

The practical result is that a proportionate clause negotiated between commercial parties is usually enforced. The penalty rule has not been formally abolished, though, so a sum that is wildly out of line with any realistic loss, or imposed on a much weaker party, remains at risk.

Supply agreements. Per-day credits for late delivery and payments for shortfalls against minimum purchase commitments are common in a supply agreement. They work best when tied to the customer's documented costs of a delay, such as idle labour, expedited freight and lost production.

Franchise agreements. Many franchisors include a fee payable if the franchisee closes early, often calculated from royalties over a fixed number of months. Because the Arthur Wishart Act imposes a statutory duty of fair dealing on both parties to a franchise agreement, a franchisor should be able to show how the formula relates to its real loss and should apply it consistently.

Business sale agreements. Break fees and reverse break fees in letters of intent and purchase agreements are judged on the same principles, as are fixed payments for breaching a seller's non-competition covenant.

Service agreements. Service level credits in managed services and SaaS contracts work much like liquidated damages. The key drafting question is whether the credits are the customer's sole remedy for poor performance or only a floor, with a right to terminate for a material breach if service failures persist.

1. Record how the amount was calculated, in a recital or schedule, so the estimate can be shown later.
2. Scale the payment to the breach, for example per day of delay or per unit short, rather than one sum for every breach.
3. Tie it to specific breaches where loss is hard to prove, not to the whole contract.
4. Say whether the amount is the exclusive remedy for that breach, and whether it counts toward any overall liability cap.
5. Set a ceiling on total liquidated damages, such as a percentage of the contract price.
6. Avoid language that suggests the purpose is to punish or deter.

The clause should also be reviewed against the rest of the contract, since indemnities and termination rights can overlap with it. Lamba Law's business agreements and contracts practice drafts and reviews these clauses for GTA businesses.

Ines Carvalho runs an appliance assembly plant in Oakville. Her company signs a two-year supply agreement with Northgate Plastics Ltd., a Brampton moulder owned by Arjun Mehta, for injection-moulded housings. Ines's operations team estimates that each day without housings costs about $9,000 in idle labour, overtime and missed shipments, and the estimate is attached to the contract as a schedule.

The contract provides for liquidated damages of $7,500 per business day of late delivery, capped at $75,000 in any contract year, as the plant's sole monetary remedy for delay. In the first year, a tooling failure delays one order by six business days, and Ines's company claims $45,000.

Arjun's position is that the clause is a penalty. Northgate's own lawyer reviews the file and advises that the daily rate sits below a documented estimate of loss, scales with the length of the delay and is capped, and that both sides were commercial parties with their own counsel. A court would be unlikely to find the clause either a penalty or unconscionable. Northgate accepts a $45,000 credit against its next invoices. A flat $250,000 payable for any late delivery, however short, would have been far more exposed to the challenge Arjun raised.