Penalty Clauses: Seven Principles Stated By The U.K. Supreme Court

The recent judgment of the Supreme Court of the United Kingdom in Cavendish Square Holding BV v Talal El Makdessi is a must-read for anyone involved in contract law.

In this decision of some 132 pages and 316 paragraphs, the U.K. Supreme Court provides an exhaustive analysis of the history and policy behind one of the most contentious principles of contract law: the penalty doctrine. In doing so, the court lays to rest, at least for U.K. law, many of the contentious issues relating to the rule against penalties. This decision is bound to influence the views of Canadian courts as they wrestle with the same issues.

Under the traditional penalty doctrine of contract law, a clause in a contract which imposes a “penalty” for breach of the contract is unenforceable, while a clause which imposes a reasonable pre-estimation of damages – called “liquidated damages” – is enforceable. Because the penalty doctrine interferes with the freedom of contract –by striking down penalty clauses – it is a contentious one in modern contract law. Some commentators argue that the doctrine should be eliminated. Others argue that it should be extended to apply to all types of claims and clauses in contract law, not just those involving a breach of contract.

It was into that controversy that the U.K. Supreme Court dived in the Cavendish Square decision.

There are many elements of that decision which may be important for the development of Canadian law. However, the one that may be the most important is the conclusion of the U.K. Supreme Court that a contractual clause imposing agreed damages or repercussions on the wrongdoer is valid even if those damages are not a reasonable pre-estimate of damages, as long as they are justified by an interest of the innocent party in the performance of the contract, and are not extravagant or exorbitant.

The Background

The U.K. Supreme Court’s decision arose from two cases.

In Cavendish Square, one group of shareholders bought control of the company from the other group. The agreement between the two groups provided that if the seller breached the agreement by competing with the company whose shares were being sold, then two consequences occurred; under clause 5.1 the buyer did not have to pay the balance of the purchase price; and under clause 5.6, the buyer had the right to purchase the seller’s remaining shares at a much reduced price. In fact, the seller did breach the agreement by joining a competitor, and the buyer refused to pay the balance of the purchase price and exercised the right to buy the seller’s remaining shares at the lower price. The seller argued that those two rights amounted to unenforceable penalties because the impact of the exercise of those rights was totally disproportionate to any loss suffered by the buyer. The seller’s position was upheld in the Court of Appeal. The U.K. Supreme Court reversed that decision, holding that neither of the rights exercised by the buyer violated the penalty doctrine.

In the Parking Eye case, Parking Eye leased and operated a parking lot. Drivers could park their cars on the lot for up to two hours for free, but no longer. If they parked longer than two hours, then they had to pay £85. The idea behind this parking lot and charging system was to provide short term free parking for customers of the near-by shops, so customers could shop and park for short terms and get out of the lot and other customers could then come in. Mr. Beavis parked longer than two hours and when he was charged this amount, he argued that the charge was a penalty, saying that the charge was totally disproportionate to any loss suffered by Parking Eye due to his over-staying the two hours. His position was not accepted by the Court of Appeal or the U.K. Supreme Court.

Decision of the U.K. Supreme Court

Anyone interesting in the penalty doctrine should read this decision, so I am going to take this opportunity to set out what, in my view, are the principle issues decided by the Court:

  1. Enforcement of a remedial, or secondary, obligation

The U.K. Supreme court outlined three elements of the penalty doctrine. Under the first element, a contractual clause only falls within the rule against penalties if it imposes a secondary means of enforcing a primary contractual obligation.

The reason for this element of the rule is that the courts should not be allowing parties out of a bad deal, and the penalty doctrine does not permit them to do so. If a party enters into an “unfair” bargain, that is not a problem that the penalty doctrine can address. Lord Neuberger and Lord Sumption stated it this way:

“This principle is worth restating at the outset of any analysis of the penalty rule, because it explains much about the way in which it has developed. There is a fundamental difference between a jurisdiction to review the fairness of a contractual obligation and a jurisdiction to regulate the remedy for its breach. Leaving aside challenges going to the reality of consent, such as those based on fraud, duress or undue influence, the courts do not review the fairness of men’s bargains either at law or in equity. The penalty rule regulates only the remedies available for breach of a party’s primary obligations, not the primary obligations themselves.” This [concept]…. provided the whole basis of the classic distinction made at law between a penalty and a genuine pre-estimate of loss, the former being essentially a way of punishing the contract-breaker rather than compensating the innocent party for his breach…It is not a proper function of the penalty rule to empower the courts to review the fairness of the parties’ primary obligations, such as the consideration promised for a given standard of performance. For example, the consideration due to one party may be variable according to one or more contingencies, including the contingency of his breach of the contract. There is no reason in principle why a contract should not provide for a party to earn his remuneration, or part of it, by performing his obligations. If as a result his remuneration is reduced upon his non-performance, there is no reason to regard that outcome as penal. Suppose that a contract of insurance provided that it should be cancelled ab initio if the insured failed to pay the premium within three months of inception. The effect would be to forfeit any claim upon a casualty occurring in the first three months but it would be difficult to regard the provision as penal on that account.” (emphasis added)

Lords Neuberger and Sumption held that Cavendish Square’s claims for the non-payment of the balance of the purchase price of the shares already bought was:

“in reality a price adjustment clause…... Clause 5.1 belongs with clauses 3 and 6, among the provisions which determine Cavendish’s primary obligations, ie those which fix the price, the manner in which the price is calculated and the conditions on which different parts of the price are payable. Its effect is that the Sellers earn the consideration for their shares not only by transferring them to Cavendish, but by observing the restrictive covenants.” (emphasis added)

  1. Not a legitimate interest of the innocent party    

Second, for the clause to contravene the penalty doctrine, the impact of the clause must be one which does not fall within the innocent party’s legitimate interest under the contract. In this respect, the court has narrowed the financial consequence of a contractual provision before it will offend the penalty doctrine. As long as the financial consequence has a legitimate relationship to the contract (and is not egregious), then it will not be a penalty.

The inquiry about the legitimacy interest of the innocent party is not confined to the actual damages arising from the breach, and the amount need not be justifiable as a reasonable pre-estimation of the likely damages that will be suffered by the innocent party. Rather, the overall consequences of the breach, and other similar breaches, may justify the imposition of the amount forfeited by the clause. As Lord Neuberger and Lord Sumption said:

“ The true test is whether the impugned provision is a secondary obligation which 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 innocent party can have no proper interest in simply punishing the defaulter. His interest is in performance or in some appropriate alternative to performance. In the case of a straightforward damages clause, that interest will rarely extend beyond compensation for the breach……. But compensation is not necessarily the only legitimate interest that the innocent party may have in the performance of the defaulter’s primary obligations.” (emphasis added)

Lord Hodge and Lord Mance agreed with this approach. In Lord Hodge’s view, this “broader approach escapes the straightjacket into which the law risked being placed by an over-rigorous emphasis on a dichotomy between a genuine pre-estimate of damages on the one hand and a penalty on the other.”

In the present cases, the court held that the amounts involved had a legitimate relationship to the contracts. Cavendish Square’s right not to pay the balance of the purchase price of the already purchased shares, and to pay a lower price for the to-be purchased shares, were direct consequences of the larger harm inflicted on the company, and thus the lesser value of the company to the shareholders, due to the seller’s breach of his fiduciary duty to the company. Lords Neuberger and Sumption said:

“Although clause 5.1 has no relationship, even approximate, with the measure of loss attributable to the breach, Cavendish had a legitimate interest in the observance of the restrictive covenants which extended beyond the recovery of that loss. It had an interest in measuring the price of the business to its value. The goodwill of this business was critical to its value to Cavendish, and the loyalty of Mr Makdessi and Mr Ghossoub was critical to the goodwill. The fact that some breaches of the restrictive covenants would cause very little in the way of recoverable loss to Cavendish is therefore beside the point. As Burton J graphically observed in para 43 of his judgment, once Cavendish could no longer trust the Sellers to observe the restrictive covenants, “the wolf was in the fold”. Loyalty is indivisible. Its absence in a business like this introduces a very significant business risk whose impact cannot be measured simply by reference to the known and provable consequences of particular breaches. It is clear that this business was worth considerably less to Cavendish if that risk existed than if it did not. How much less? There are no juridical standards by which to answer that question satisfactorily.”

The court arrived at a similar conclusion with respect to clause 5.6. As Lords Neuberger and Sumption said:

“[Cavendish had] an interest in matching the price of the retained shares to the value that the Sellers were contributing to the business. There is a perfectly respectable commercial case for saying that Cavendish should not be required to pay the value of goodwill in circumstances where the Defaulting Shareholder’s efforts and connections are no longer available to the Company, and indeed are being deployed to the benefit of the Company’s competitors, and where goodwill going forward would be attributable to the efforts and connections of others. It seems likely that clause 5.6 was expected to influence the conduct of the Sellers after Cavendish’s acquisition of control in a way that would benefit the Company’s business and its proprietors during the period when they were yoked together. To that extent it may be described as a deterrent. But that is only objectionable if it is penal, ie if the object was to punish. But the price formula in clause 5.6 had a legitimate function which had nothing to do with punishment and everything to do with achieving Cavendish’s commercial objective in acquiring the business.” (emphasis added)

Parking Eye’s claim to £85, while apparently egregious in relation to what might be a very minor breach of the parking limit, was reasonably related to its interest in ensuring that parkers did not overstay the parking time limit, and funding Parking Eye’s operation of the parking lot for other patrons at no cost. The very fact that it was an amount that was in terrorem was part of its legitimacy in making the whole “free-parking for a short period” system operable. Lords Neuberger and Sumption explained the situation as follows:

“The reason is that although Parking Eye was not liable to suffer loss as a result of overstaying motorists, it had a legitimate interest in charging them which extended beyond the recovery of any loss. The scheme in operation here (and in many similar car parks) is that the landowner authorises Parking Eye to control access to the car park and to impose the agreed charges, with a view to managing the car park in the interests of the retail outlets, their customers and the public at large. That is an interest of the landowners because (i) they receive a fee from Parking Eye for the right to operate the scheme, and (ii) they lease sites on the retail park to various retailers, for whom the availability of customer parking was a valuable facility. It is an interest of Parking Eye, because it sells its services as the managers of such schemes and meets the costs of doing so from charges for breach of the terms (and if the scheme was run directly by the landowners, the analysis would be no different). As we have pointed out, deterrence is not penal if there is a legitimate interest in influencing the conduct of the contracting party which is not satisfied by the mere right to recover damages for breach of contract. Mr. Butcher QC, who appeared for the Consumers’ Association (interveners), submitted that because Parking Eye was the contracting party its interest was the only one which could count. For the reason which we have given, Parking Eye had a sufficient interest even if that submission be correct. But in our opinion it is not correct. The penal character of this scheme cannot depend on whether the landowner operates it himself or employs a contractor like Parking Eye to operate it. The motorist would not know or care what if any interest the operator has in the land, or what relationship it has with the landowner if it has no interest.….

  1. Extravagant or Exorbitant Impact of the clause

Third, in order to offend the penalty doctrine the clause must impose a consequence which is out of all proportion to the second element of the test, namely any interest that the innocent party can legitimately seek to protect. Lord Mance expressed how this third element works in relation to the second element:

“There may be interests beyond the compensatory which justify the imposition on a party in breach of an additional financial burden…… What is necessary in each case is to consider, first, whether any (and if so what) legitimate business interest is served and protected by the clause, and, second, whether, assuming such an interest to exist, the provision made for the interest is nevertheless in the circumstances extravagant, exorbitant or unconscionable……the focus should be not on any particular possible breach or its timing or consequences, but on the general interest being protected, and the question whether the protection which the parties agreed can be condemned as unconscionable or manifestly excessive.” (emphasis added)

Lord Hodge explained the same elements as follows:

“ I therefore conclude that the correct test for a penalty is whether the sum or remedy stipulated as a consequence of a breach of contract is exorbitant or unconscionable when regard is had to the innocent party’s interest in the performance of the contract. Where the test is to be applied to a clause fixing the level of damages to be paid on breach, an extravagant disproportion between the stipulated sum and the highest level of damages that could possibly arise from the breach would amount to a penalty and thus be unenforceable. In other circumstances the contractual provision that applies on breach is measured against the interest of the innocent party which is protected by the contract and the court asks whether the remedy is exorbitant or unconscionable.”

Lords Neuberger and Sumption explained why Parking Eye’s charge did not infringe this element of the rule:

“None of this means that Parking Eye could charge overstayers whatever it liked. It could not charge a sum which would be out of all proportion to its interest or that of the landowner for whom it is providing the service. But there is no reason to suppose that £85 is out of all proportion to its interests.….. While not necessarily conclusive, the fact that Parking Eye’s payment structure in its car parks (free for two hours and then a relatively substantial sum for overstaying) and the actual level of charge for overstaying (£85) are common in the UK provides support for the proposition that the charge in question is not a penalty.”

  1.  Other remedies or secondary obligations may fall within the rule against penalties

The members of the court who gave reasons stated that other clauses, aside from those requiring payment of damages as a result of a breach of contract, might be subject to the penalty doctrine. They appeared to agree that withholding payments on breach, or requiring the transfer of money or property on breach, also ran afoul of the doctrine. But the members of the court do not appear to have entirely agreed as to whether, or in what circumstances, the forfeiture of instalments or deposits could be classified as penalties. Those issues did no arise in the present appeals.

  1.  Penalty doctrine should not be abolished or limited

By one side of the debate, the U.K. Supreme Court was asked to abolish the penalty doctrine as an arcane piece of old contract law that interfered with freedom of contract and made no sense in today’s world, or to limit the doctrine to commercial contracts, procedural misconduct or payment of money. The court declined to do so, and gave lengthy reasons for its decision. It basically held that the penalty doctrine: continued to fulfill a public policy purpose in eliminating unconscionable financial remedies for breach of contract; was in line with contract law in other comparable jurisdictions; and should only be eliminated by legislators after a proper inquiry which courts are not able to undertake.

  1.  Penalty doctrine should not be extended beyond breach of contract

By the other side of the debate, the U.K. Supreme Court was asked to extend the penalty doctrine so that it applied to any term of a contract that imposed an egregious or unconscionable result, whether or not the claim arose from a breach of contract. In particular, the court was asked to follow the decision in Andrews v Australia and New Zealand Banking Group Ltd (2012) 247 CLR 205. In that decision, the Australian High Court held that the penalty doctrine applied to any clause in a contract, and not just a breach of contract, if the nature of the clause (in that case, the payment of a bank fee to process an NSF cheque) and the circumstances rendered the clause egregious or unconscionable. (See my article dated October 20, 2012 on the Andrew case)

The U.K. Supreme Court refused to follow the Andrews decision, and declined to extend the penalty doctrine beyond the field to which it has usually applied, namely as a consequence of a breach of contract. Lord Hodge said: “There is no freestanding equitable jurisdiction to render unenforceable as penalties stipulations operative as a result of events which do not entail a breach of contract. Such an innovation would, if desirable, require legislation.”

  1.  Relief from forfeiture may apply even if the penalty doctrine does not

The U.K. Supreme Court drew attention to the fact that relief from forfeiture may be available even if the clause is valid and does not infringe the penalty doctrine. Lord Mance and Lord Hodge were explicit in holding that relief from forfeiture could be granted in this situation. Lord Neuberger and Lord Sumption said that it was not necessary to decide that issue in the present appeals, but they could see the “force of the argument” to that effect.

The impact of the two rules occurs at different times. A clause is invalid under the penalty doctrine at the time the contract is written, and the actual circumstances in which it is imposed are irrelevant. Lord Neuberger and Lord Sumption stated this point as follows:

“The question whether a damages clause is a penalty falls to be decided as a matter of construction, therefore as at the time that it is agreed…. This is because it depends on the character of the provision, not on the circumstances in which it falls to be enforced. It is a species of agreement which the common law considers to be by its nature contrary to the policy of the law. One consequence of this is that relief from the effects of a penalty is….“mechanical in effect and involves no exercise of discretion at all.” Another is that the penalty clause is wholly unenforceable…”

But relief from forfeiture only occurs if, at the time a remedy is sought, the court decides that relief from forfeiture should be granted and the remedy declined. Accordingly, the penalty doctrine is “forward looking” and relief from forfeiture is “20-20 hindsight”. Again, Lord Neuberger and Lord Sumption stated the matter this way:

“What equity (and, where it applies, statute) typically considers to be contrary to the policy of the law is the enforcement of such rights in circumstances where their purpose, namely the performance of the obligations in the lease or the mortgage, can be achieved in other ways – normally by late substantive compliance and payment of appropriate compensation. The forfeiture or foreclosure/power of sale is therefore enforceable, equity intervening only to impose terms.” (emphasis added)

So a defendant may well wish to seek relief from forfeiture even if the claim against him or her arises under a valid clause which survives the rule against penalties.

Discussion

The Cavendish Square will undoubtedly fuel the debate in Canada as to whether the penalty doctrine should be abolished, extended or varied. Apart from that public policy debate, this decision is a “good news – bad news” story for those enforcing (usually owners) or defending against (usually contractors) clauses which impose consequences for breach of contract.

By stating the elements of the penalty doctrine in the way it did, the U.K. Supreme Court has greatly widened the basis upon which these clauses may be justified by the party seeking to enforce them. The traditional Canadian approach is simply to look at whether the agreed-upon damages or amounts referred to in the clause represent a reasonable pre-estimation of the damages that the innocent party would suffer from the breach of contract sued upon. According to this decision, there is a much broader basis upon which the clause may be upheld. If the clause can be justified as a reasonable basis to secure the total performance of the contract, and if the amounts or damages called for in the clause are not ridiculous in relation to that interest, then the clause is valid. In some circumstances, the innocent party may have an time demonstrating those facts than showing that the amounts or damages are a reasonable pre-estimation of damages.

On the other hand, a party defending itself against such a clause may rely on this decision to seek relief from forfeiture even though the clause is valid under the penalty doctrine. That possibility is not one that has been widely recognized in Canada.  

This decision is going into our toolbox to be used the next time we have to deal with penalty clauses.

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

Cavendish Square Holding BV v Talal El Makdessi [2015] UKSC 67

Construction contract – penalty clause – liquidated damages clause – relief from forfeiture

Thomas G. Heintzman O.C., Q.C., FCIArb                                    November 29, 2015

www.heintzmanadr.com

www.constructionlawcanada.com

Can Conduct Relating To A Mediation Lead To A Higher Costs Award?

In Ross v. Bacchus, the Ontario Court of Appeal recently set aside an order of the trial judge awarding a higher level of costs because of the defendant’s conduct at the mediation. This decision emphasizes that, absent proof of bad faith, courts will be reluctant, at least in Ontario, to impose costs awards relating to the conduct of parties during settlement discussions.

The decision also opens up interesting questions about how participation in mediation and settlement discussion may be proven and how a standing offer to settle affects the court’s decision about the reasonableness of a party’s conduct at mediation.

Background

In a personal injury case arising from a traffic accident, the jury awarded the plaintiff $248,000 and the judge ordered costs in favour of the plaintiff in the amount of $217,000. That costs award included $60,000 because the trial judge found that the defendant’s insurer had failed to attempt to settle the claim as expeditiously as possible, and had refused to participate in the mediation of the claim, as required by sections 258.5 and 258.6 of the Ontario Insurance Act. Those sections provide that a trial judge can take the insurer’s failure to perform those obligations into consideration when awarding costs.

The action was started in September 2010. The defendant’s insurer offered to settle for $40,000 in August 2011 and withdrew the offer in March 2012. About three weeks before the trial in November 2013, the plaintiff offered to settle for $94,065 plus prejudgment interest and costs and, for the first time, offered to participate in mediation. The defendant then offered to settle for $30,000 plus interest and costs and to participate in a half-day mediation, but counsel for the defendant stated that the insurers were “not interested” in settling the case. The plaintiff responded with an offer to settle for $79,065 plus prejudgment interest and costs.

A half-day mediation occurred four days before trial. After the six day trial and the jury’s award of $248,000, the trial judge ordered costs in favour of the plaintiff on a partial indemnity basis up to the plaintiff’s pre-trial offer and substantial indemnity costs after that offer. The trial judge awarded an additional $60,000 in costs in favour of the plaintiff by reason of the failure of the defendant’s insurer to comply with sections 258.5(5) and 258.6(2) of the Ontario Insurance Act.

Four points emerge from the Court of Appeal’s decision over-turning the judgment of the trial judge:

  1. The statement by the defendant’s counsel before the mediation that the defendant’s insurer was “not interested in settlement” was not a sufficient basis to conclude that the insurer would not make a bona fide effort to settle at the mediation. Effectively, the Court of Appeal said that posturing of that sort is part of the litigation and settlement process:

“An insurer’s statement on the eve of trial that it is not prepared to settle a claim cannot be equated with an insurer’s failure to “attempt to settle the claim as expeditiously as possible.” Nor can an insurer who actually participates in a mediation be declared to have failed to participate simply because the insurer indicated prior to the mediation that it was not prepared to settle the claim. A clear statement of the insurer’s position going into the mediation, even a strong statement, does not preclude meaningful participation in a mediation….. The trial judge assumed that because the insurer’s counsel advised that his client was “not interested” in settling the case, the insurer’s subsequent participation in the mediation was “a sham.” The assumption was unwarranted. A firm position strongly put going into mediation does not preclude meaningful participation in the mediation.”

  1. The plaintiff did not tender any evidence that the defendant had not participated meaningfully in the mediation. In writing for the court, Justice Doherty ducked the question as to whether evidence about the conduct of the mediation would have been admissible. He said that this question “raises an interesting legal issue. I need not get into that issue.” Rather, the court held that the plaintiff’s position failed because there was no evidence on the issue:

“If the respondent wanted costs for the insurer’s failure to participate in the mediation, it was incumbent on the respondent to lead evidence establishing the failure to participate in the mediation. Had the respondent attempted to do so, the question of the impact of the settlement privilege on the admissibility of evidence relevant to the insurer’s participation in the mediation may have come front and centre. On this record, the trial judge’s finding that the insurer did not participate in the mediation fails, not because the settlement privilege cloaks the mediation in confidentiality, but because the factual finding of the trial judge has no support in the evidence.”

  1. The fact that the defendant’s insurer had made offers to settle which was of considerable importance to the Court of Appeal. It referred to this fact several times in its judgment:

“There is no evidence that the appellant’s insurer failed to attempt to settle this claim as expeditiously as possible. The appellant made an “all-in” offer to settle for $40,000 in August 2011, less than one year after the action was commenced……. In any event, the insurer had made a settlement offer which was not revoked before trial…..

  1. The Court of Appeal held that the trial judge’s finding about the insurer’s motivation in rejecting the plaintiff’s offer and proceeding to trial were unsupported and irrelevant:

“…the trial judge was also influenced by what he saw as the insurer’s attempt to intimidate the respondent by refusing to make a counteroffer after the respondent’s last offer. The trial judge described the insurer as risking a trial for the sake of $50,000, the difference between the two offers…..Insurers, like any other defendant, are entitled to take cases to trial. When an insurer rejects a plaintiff’s offer and proceeds to trial, the insurer risks both a higher damage award at trial and the imposition of substantial indemnity costs after the date of the rejected offer. Both risks came to pass in this case. The insurer paid a significant financial penalty for its decision to proceed to trial. The costs provisions in ss. 258.5 and 258.6 do not address those risks, but instead address the failure to meet the specific obligations identified in those provisions. The trial judge’s assumptions about the insurer’s motivation for rejecting the respondent’s offer and proceeding to trial had no relevance to the determination of whether augmented costs should be awarded under the Insurance Act provisions.”

Discussion

A number of lessons can be learned from this decision.

The first lesson is that a standing offer to settle can be powerful evidence of a bona fide intention to settle. So parties to litigation are well advised to make the best offer they can, if for no other reason than to avoid an order of costs based upon an unreasonable refusal to discuss settlement.

The second lesson is that it requires evidence to establish that a party has failed or refused to participate in mediation. This lesson may ultimately require a court to decide whether the conduct of a party at the mediation is admissible in evidence. It seems unlikely that such evidence will be admissible. Section 9 of the Ontario Commercial Mediation Act, 2010 states that mediations are confidential, unless the parties otherwise agree. The recent decision of the Supreme Court of Canada in Bombardier v Union Carbide emphasized the confidential nature of mediation, although it did find that, if a settlement is alleged to have been made during mediation, that fact can normally be proven.

The Bombardier v. Union Carbide case opens up the question of whether evidence of a total failure to mediate would be admissible. Say, the defendant attends the mediation with its insurer, and the insurer announces to the mediator: “We’re here but we decline to make or respond to any offer by the plaintiff or to engage in settlement discussions.” Would those facts be admission in evidence? There seems to be a powerful argument that they would be, and that the settlement privilege should not apply to a refusal to participate in settlement discussions. The mere fact that this conduct occurred in the mediation room rather than before the parties came to that room does not logically seem to make that conduct part of the mediation and preclude it from being proven. Rather, it would appear to be conduct which “preclude[s] meaningful participation in a mediation” as referred to by the Court of Appeal.

However, it seems unlikely that evidence about the conduct of a mediation itself, if a real mediation does commence, will be admissible in evidence. Accordingly, if a party does actually participate in mediation, it will be difficult to prove that it failed to do so in a bona fide manner, especially if it has made an offer to settle which was open until trial.

While this decision arose in the context of sections 285.5 and 285.6 of the Ontario Insurance Act, these issues could arise in any litigation or arbitration in which a party’s failure to make reasonable efforts to settle is an issue and, as a result, a higher amount of costs is sought by the other party.

See Heintzman and Goldsmith on Canadian Building Contracts (5th ed.), chapter 11, part 13(d).

Ross v. Bacchus, 2015 ONCA 347

Alternate Dispute Resolution – mediation – offer to settle – costs- insurance

Thomas G. Heintzman O.C., Q.C., FCIArb                                                   November 8, 2015

www.heintzmanadr.com

www.constructionlawcanada.com

Are “Services” Lienable If They Relate To Something That Is Not An “Improvement”?

Whether something put on land is an “improvement” for the purposes of construction and builders’ liens can be a difficult question of fact and law. Usually the dispute revolves around the degree of attachment of the “thing” to the land and the permanence of the attachment.

Then, add to that dispute the fact that “services” are provided to design the thing, bring it to the land or place it on or attach it to the land. Are the services lienable?

In Grey Owl Engineering Ltd. v. Propak Systems Ltd., the Saskatchewan Court of Appeal appears to have recently held that the services may be lienable even if the “thing” is not an improvement, as long as the services are in relation to a larger project that falls within the lien statute. I say “appears” because the court also seems to have held that the matter was not finally decided. So, while this decision is very important so far as it goes, it may not be the last word on this issue.

In making its decision, the Saskatchewan Court of Appeal over-turned the trial judge’s decision to the contrary: Propak Systems Ltd. v. Grey Owl Engineering Ltd. 2015 CarswellSask 91, 2015 SKQB 43. That lower court decision was reviewed by me in my article of April 28, 2015.

Background

A lessee of land contracted with Propak for engineering, procurement, and fabrication services for an oil extraction system to be provided by Propak for use on the leased land. Propak entered into a subcontract with Advanced Metal for the construction of three storage tanks to be used on the land as part of the extraction facility. In turn, Advanced Metal entered into a sub-subcontract with Grey Owl to provide engineering design services relating to those storage tanks.

The storage tanks were each to be 24 to 38 feet tall and weigh between 34,000 and 43,500 pounds. Each tank was to sit on an engineered gravel pad. Piles would run through the gravel pad and extend about 20 feet into the ground. An anchor chair was to be welded to the base of the tank and then bolted to the piles. The three tanks would then be connected to the entire oil extraction facility through steel and fiberglass piping that would be bolted to the tanks.

Grey Owl materially completed its design services, but Advanced Metal abandoned the project before any of the tanks were built and failed to pay Grey Owl for any of its engineering services. Grey Owl then registered a lien against the leased land pursuant to the Saskatchewan Builders’ Lien Act (the Act).

Propak applied to the Court of Queen’s Bench to vacate Grey Owl’s lien. Propak paid into court the full amount claimed plus an extra 25% as security for costs, and an order was granted vacating the lien.

Propak then applied to the Court of Queen’s Bench for an order releasing the amount held in Court on the ground that Grey Owl was not entitled to register a lien under the Act on the ground that Grey Owl was not entitled to a lien as its engineering services were not provided in relation to an “improvement” as defined in s. 2(1)(h) of the Act.

As noted in my article of April 28, 2015, the judge of first instance decided that Grey Owl did not have a valid lien. The judge held that the storage tanks were capable of being moved, being part of a modular system that could be relocated to another oil field. They were not designed to be moved around the site, but they were capable of being moved beyond that site once the project was finished. Since the tanks were capable of being moved, the judge held that they were not an improvement, and since they were not an improvement, Grey Owl’s claim of lien was not valid. The judge ordered that the money paid by Propak into court be released to Propak.

Decision of the Saskatchewan Court of Appeal

The Court of Appeal allowed the appeal and re-instated Grey Owl’s lien. In doing so, it first engaged in an interpretation of the Act. It noted the definition of “services” and “subcontractor” in the Act:

“(q) “services” means any labour done or service performed on or in respect of an improvement and includes the rental of equipment and the wages of any operator provided with the equipment …

(t) “subcontractor” means a person, not contracting with or employed directly by an owner or his agent, but who provides services or materials to an improvement under an agreement with the contractor or under him with another subcontractor, but does not include a labourer …(Emphasis added)”

The court then stated:

“In short, it is a mistake to begin and end the inquiry with whether the storage tanks are the improvement. The issue is whether Grey Owl provided “services” “on or in respect of an improvement for an owner, contractor or subcontractor” within the meaning of s. 22 and, as part of this analysis, identify the improvement in question.”

The court applied the approach taken in its prior decision in Hansen v. Canadian National Railway (1983), 22 Sask. R. 126 and other Saskatchewan cases which followed Hansen or applied the same logic. The court described this approach as follows:

“This approach, which focuses on the main contract or contracts rather than its individual subcontracts and the work being done under them, has been consistently followed and applied in this jurisdiction…..Courts appear to have taken it as self-evident that the improvement was the work the owner was performing on the land and not the work performed by the various subcontractors and others contracting with them.”

In enunciating the policy reasons behind this broad approach, the court adopted words of the court in Hansen: “the principal object of this Act is to better ensure that those who contribute work and material to the improvement of real estate are paid for doing so”. The court expanded on this approach as follows:

“Two factors dictate the Saskatchewan Legislature’s approach to its builders’ lien legislation. The first factor is that, unlike any other commercial endeavour, the work, services and materials supplied to an improvement are provided on credit in a pyramidal structure, where payment often depends on whether the parties in the pyramid above the lien claimant are paid. The second factor is that the ordinary law of contract does not provide sufficient remedies to ensure that the contract funds flow from the top of the construction pyramid to those entitled to receive them. The statute supplements the law of contract and fosters the provision of credit in a complex piece of legislation designed to assist and facilitate construction….A restrictive reading of s. 22 does not serve the interests of those who provide services and materials on credit. To do so would not be in line with the protective purpose of the Act. Arguably, a restrictive reading of s. 22 does not serve the commercial interests of the owner and financier of an improvement either in that uncertainty as to who is or who is not entitled to a lien can only increase costs, either in the fixing of the contract price or in the litigation that will inevitably arise.”

The court then considered three questions: did Grey Owl provide “services”; were the services provided to a “subcontractor”; and were the services in relation to “an improvement”?

On the first issue, the court had no doubt: “First, it is clear that Grey Owl provided “services.” The definition of “services” includes “any labour done or service performed,” including equipment rental. The definition of “improvement” in s. 2(1)(h)(iii) also demonstrates the clear legislative intent to extend rights to those who provide design services.”

On the second issue, the court also had no doubt: “Second, it is also incontestable that Grey Owl contracted with a “subcontractor,” i.e., Advanced Metal.”

The only issue was whether the services to the subcontractor were in relation to an “improvement.”   On this issue, the court said the following:

“As can be seen from the Stauth affidavit, Grey Owl was retained to provide engineering drawings with respect to storage tanks that were to be used by the contractor or principal subcontractor “as part of their oil extraction system.” In such circumstances, it is an error to ask whether the claimant claims a lien in the storage tanks as an “improvement.” Applying Hansen, the “improvement” with respect to which the legislation is concerned is the project that will lead to the extraction of oil.”

Having arrived at this conclusion, the court did not finally order that Grey Owl’s lien was valid. Rather, it said the following

“When this principle is understood, it is clear that Propak’s application could not be allowed. It is not sufficiently plain and obvious that Grey Owl’s lien is invalid on the basis put forward by Propak: that Grey Owl did not provide services “on or in respect of an improvement for an owner, contractor or subcontractor” in accordance with s. 22…..Having found error in the decision of the Chambers judge, it is necessary to determine the next step. As I have indicated, Grey Owl did not ask this Court to go on to make any other order, if we were to allow the appeal. Grey Owl maintains the position it took in the Court of Queen’s Bench that Propak’s application should be dismissed leaving the parties to pursue the usual remedies under the Act….In the end, the appeal must be allowed. The Chambers judge erred by not dismissing Propak’s application under s. 56(4). The effect of allowing the appeal is that the parties resume the same positions they occupied before the application was made. Grey Owl’s lien continues to be a charge on the funds in court according to s. 56 until further steps are taken by the parties dealing with the funds and until further order of the Court of Queen’s Bench.

Discussion

If this decision finally concluded the issue as to whether the services provided by Grey Owl were lienable services, as it appears to have, then it has stated, or re-stated, an important principle, at least in Saskatchewan. That principle is that, in determining whether the services provided by a sub subcontractor to a subcontractor in relation to something placed on the land by the subcontractor, one looks to the whole work on the site, not (just) the work or material of the subcontractor.

However, the Court of Appeal declined to make an order to that effect, and instead found that it was not plain and obvious that Grey Owl had no lien. Yet, there does not seem to be any further evidence that would be needed to arrive at the final conclusion. It appears that the only reason that the court did not make that finding is that Grey Owl did not ask for it, or that there might be other reasons that Grey Owl’s lien could be challenged so the court was not precluding any such debate.

The principle that the Court of Appeal has apparently adopted seems to leave sub-subcontractors who are instrumental in providing improvements in different positions. If the sub-subcontractor provides the physical improvement itself – in the present case, the tanks – then if those tanks are not attached to the land and are moveable, then the Court of Appeal seems to have assumed that they are not improvements and no lien could be registered by that sub-subcontractor. But if the sub-subcontractor provides services to the subcontractor in relation to the provision of the tanks, then according to the Saskatchewan Court of Appeal, those services are lienable because one looks to the overall project. In that context, the total project amounts to an improvement to the land and so the services to design or install the tanks are lienable because they are part of the overall improvement.

Why should the services in relation to something brought onto the land be lienable when that something itself is not lienable? Certainly the policy behind the statute is well expressed by the Court of Appeal, but why should that policy apply to the services in relation to that thing if the policy does not apply to the thing that is brought onto the land (and the person who brought it there)?

The Saskatchewan legislature has said that the Act (and its policy) do not apply to the thing itself if it is not an “improvement”. Section 2 of the Act includes within the definition of improvement the following words: “except a thing that is not affixed to the land or intended to become part of the land.” That is where the Act has drawn the line. If that is so, can the policy behind the Act draw the line at a different place for the services?

See Heintzman and Goldsmith on Canadian Building Contracts, (5th ed.), chapter 16, parts 4(a)(i))II and 4(a)(ii).

Grey Owl Engineering Ltd. v. Propak Systems Ltd., 2015 SKCA 108, 2015 CarswellSask 612

Construction and Builders’ liens – improvement – services – subcontractors

Thomas G. Heintzman O.C., Q.C., FCIArb                                                                       October 30, 2015

www.heintzmanadr.com

www.constructionlawcanada.com