Contract law contains a fundamental rule: penalty clauses are prohibited and liquidated damage clauses are permitted. But in its recent decision in Ottawa Community Housing Corp. V. Foustanellas, the Ontario Court of Appeal held that there is another way to look at this rule. The clause is valid if, properly interpreted, the clause delays, but does not permanently affect, the exercise of the contractor’s rights. In this case, the clause is not a penalty or liquidated damages clause at all. Parties about to enter into a building contract should examine this decision to see if there are ways to draft the contract to avoid the penalty doctrine but achieve much of the desired result.

Background

Ottawa Community Housing Corp. (OCHC) entered into a contract with Argos Carpets, of which Foustanellas was the principal. OCHC later determined that Argos was overbilling OCHC. OCHC then notified Argos that it was withdrawing the remaining work under the contract and withholding payment of the past amount due under the contract. At trial, Arogos argued that the contractual provision in question amounted to a liquidated damages clause and limited, to the withheld payment, the amount which OCHC could recover against it.

Clause 1.6.1 of the contract entitled OCH, in certain circumstances, to “take the whole operation, or any part of the operation out of the hands of the Contractor.” The owner relied upon that clause to take the remaining work out of Argos’ hands.

Clause 1.6.3 stated that:

     “…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 yet 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 of the losses and damages incurred by the Owner for the non-completion of the work.”

Decision of the Ontario Court of Appeal

The Court of Appeal held that clause 1.6.1 entitled the Owner to terminate the contract on the happening of events which triggered that clause. If that occurred, the courts said, then the owner was entitled to invoke clause 1.6.3.

The Court of Appeal agreed with the trial judge that clause 1.6.3 was neither a penalty clause nor a liquidated damages clause as recognized in established contract case law. Rather, clause 1.6.3 had two effects:

“ First, it relieves the owner (OCHC) from any obligation to make payments to the contractor, including in respect of unpaid receivables, pending determination of the owner’s losses and damages arising from the contractor’s non-compliance with the carpet contract. Second, it establishes the contractor’s (Argos’) liability to the owner (OCHC) for an amount equal to the owner’s losses and damages occasioned by the contractor’s non-completion of the work provided for under the carpet contract.

Thus, properly interpreted, clause 1.6.3 functions as a “stop payment” provision. It is designed to halt the owner’s contractual obligation to make any payments to the contractor pending the determination of the owner’s losses and damages arising from the contractor’s breach of contract.”

The Court of Appeal found that several ingredients of the contract supported its interpretation of clause 1.6.3.

First, the clause did not state a specific amount which was recoverable by the owner, such as one would expect to find in a penalty or liquidated damages clause.

Second, the amount due to the contractor could vary widely from job to job, making the clause a sensible delay of the rights of the contractor on all jobs until the owner’s damages could be assessed.

Third, the fact that the clause gives the owner the right to set off its claims against the contractor’s entitlement to payment for work “does not convert clause 1.6.3 into a penalty or liquidated damages provision.”

Discussion

Clause 1.6.3 might have been held to be an unenforceable penalty clause if its effect was to forfeit the monies due to the contractor when the balance of the contract work was taken out of its hands. Or, if the amount of the forfeiture was a reasonable estimation of the owner’s damages – an apparently unlikely scenario – the clause might have been held to be effective as a liquidated damages clause which set the amount of the owner’s maximum entitlement as the amount owed to the contractor when the work was taken out of its hands, as the contractor argued. Instead of determining the dispute according to the traditional penalty/liquidated damages debate, the trial and appeal court took the debate to an entirely different debate – one about the proper interpretation of the contract.   And they found that all the clause did was defer the contractor’s right to enforce its claim to monies due until the owner’s claim for damages was determined.

This decision is a good example of the rule of contract interpretation known by its Latin name: ut res magis valeat quam pereat: or, that the thing shall have effect rather than perish. In other words, if there is an interpretation that saves the validity of the contractual provision, it should be preferred over one that would cause it to perish. In this case, interpreting the clause to delay the rights of the contractor gave force and effect to the clause which might otherwise have been an ineffective penalty clause.

A party negotiating a building contract should consider this decision when deciding what remedies it really wants in the event of a breach of the contract by the other party. If the party really wants a definitive fixing of the amount due by the wrongful party, then this decision will not help it. In that situation it will have to face up to the penalty/liquidated damages rule and all the perils that the rule involves. If the amount fixed is later considered by the court to be an unrealistic estimation of the damages flowing from the breach, then the clause may be struck down as a penalty clause.

But if the party really wants a means to forestall the other party from collecting monies due under the contract until its own damages are determined, then this decision offers a way to accomplish that result.

See Heintzman and Goldsmith on Canadian Building Contracts, 5th ed. Chapter 2, part 3(d), Chapter 4, part 3(h) and Chapter 9, part 6(j).

Ottawa Community Housing Corp. V. Foustanellas (2015), 125 O.R. (3d) 539

Building contracts – interpretation – penalty clauses – liquidated damages clauses

Thomas G. Heintzman O.C., Q.C., FCIArb                                                     October 14, 2015

www.heintzmanadr.com

www.constructionlawcanada.com