Penalty Clauses and Liquidated Damages Clauses are included in contracts to specify the amount of damages the defaulting party is required to pay the innocent party when a contract is breached. They each serve different purposes and utilize different calculation methods, but both are meant to efficiently resolve disputes and avoid legal action. Like all contract clauses, penalty and liquidated damages clauses present challenges related to interpretation and enforceability.

According to the Supreme Court of Canada in Canadian General Electric Co. v. Canadian Rubber Co. [1915], 52 S.C.R. 349, a penalty clause stipulates a sum owed for breach of contract that bears no relation to the actual amount of damages sustained, whereas a liquidated damages clause is an actual estimate of damages. The purpose of a penalty clause is to deter breach and when that fails, to punish the breaching party. The purpose of a liquidated damages clause is to provide a reasonable estimate of damages, without the need to prove them in court.

Since Canadian courts tend to support the principle of freedom of contract, they will only interfere with unambiguously worded penalty and liquidated damages clauses that are unconscionable or oppressive (See HF Clarke v Thermidaire, {1976] 1 S.C.R. 319 (S.C.C.) and JG Collins Insurance Agency Ltd. v Elsley Estate, [1978] 2 S.C.R. 916 (S.C.C.)). To avoid costly legal battles and enforceability issues, most businesses use liquidated damages clauses rather than penalty clauses. However, a damages clause can be drafted in a way that reflects a reasonable estimation of damages and adds the deterrent effect of a commercially reasonable penalty. For example, in a subscription-based Business-to-Consumer (“B2C”) contract, a consumer may be asked to give three months notice of termination or pay the equivalent amount plus a 15% penalty. If three months and a 15% penalty is standard in the industry, a court may not interfere with the contract. It all depends on the facts and circumstances of the case.

While B2C contracts tend to be standard form contracts, which do not provide the opportunity for negotiation, Business-to-Business (“B2B”) contracts usually contain negotiated terms. Prior to drafting a new B2B contract, it is a good idea to create a confidential, even exclusive, non-binding term sheet to settle the most significant issues. At this stage, contentious items like damages and what triggers them can be agreed upon before creating the first draft of the contract. Term sheets are useful for internal business discussions, usually trigger the due diligence process and, if necessary, creation of a data room. At the same time, they allow the drafter to see the bigger picture of the contract and identify risk areas, which can be mitigated during negotiations. It is important to be flexible during this process. Just as a published paper is quite different from a first draft, the execution copy of a B2B contract will be quite different in language and substance than its first iteration.

In both B2C and B2B contracts, lawyers write and negotiate a network of clauses that reflect and protect their client’s interests. However, the ultimate audience of a contract is the person(s) who adjudicates disputes (i.e. judges or arbitrators). Practically speaking, that means that each clause is carefully crafted using precise language that has precedential value and has been judicially considered on both a stand-alone and within context basis. That is why you will often see the same clauses, with customizations, and terms like “fundamental breach”, “commercially reasonable efforts”, “material change”, “reasonable notice”, “including but not limited to”, “good faith”, etc. in business contracts.