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

Does Inaction Amount To Acceptance Of A Repudiation Of Contract?

Can inaction by a party to a contract amount to an acceptance of the repudiation of the contract by the other party?  That was the issue in the very recent decision of the Ontario Court of Appeal in Brown v. Belleville (City).

This is an important issue in construction law because of the critical effect of the acceptance or non-acceptance of contractual repudiation.  The acceptance of repudiation brings the entire contract to an end.  But if repudiation is not accepted then the contract continues.  So whether there has been an acceptance of repudiation can be of pivotal importance.

If the contract has come to an end by acceptance of repudiation, then contractual performance obligation may terminate, warranty periods and limitation periods may start running, and insurance rights may start or end.  So it is vital for a builder or owner to know whether the contract has been terminated.

Yet, a builder or owner may not have the time or inclination to respond to wrongful conduct by the other side.  But if an owner or contractor doesn’t respond, can they be taken, by inference, to have accepted the wrongful conduct and brought the contract to an end?  Does an owner or contractor in effect have an obligation to respond?  Can they leave matters up in the air without specifically dealing with a repudiation by the other side?  That was the issue in Brown v. Belleville (City).

 The Factual Background

In 1953 a municipality entered into an agreement with a farmer under which the municipality agreed to maintain and repair a storm sewer drainage system that it had constructed on and near the farmer’s lands.  Six years later, the municipality stopped maintaining and repairing the drainage system.  The lands affected by the drainage system were sold by the farmer’s heirs to a third party.

In the 1980’s, that third party tried to have the municipality maintain the drainage system.  The municipality refused to do so, clearly repudiating the agreement.  In 2003, the affected lands were sold to the Browns who asked the successor municipality, Belleville, to maintain and repair the drainage system.  Belleville refused to do so and repudiated the agreement.

The Browns then sued Belleville.  Belleville defended the action and one of the positions it asserted was that the Brown’s claim was barred by the limitation period.  Belleville asserted that the repudiation by it and its predecessor municipalities had long ago been accepted by the Browns and their predecessors, in effect by inaction.  Accordingly, Belleville said that the agreement had long since terminated and the limitation period had run.

 The Court of Appeal’s decision

 The Court of Appeal started its analysis by noting that a repudiation of a contract does not, in itself, bring the contract to an end.  Only if the innocent party elects to accept the repudiation does the contract come to an end.  The innocent party is not obliged to accept the repudiation, and if he or she does not so accept then the contract continues in effect.

The Court of Appeal then stated the test to determine whether there has been an acceptance of a repudiation.  The court said that the acceptance:

“must be clearly and unequivocally communicated to the repudiating party within a reasonable time.   Communication of the election to disaffirm or terminate the contract may be accomplished directly, by either oral or written words, or may be inferred from  the  conduct  of  the  innocent  party   in  the  particular  circumstances of  the  case.”(emphasis added)

The Court of Appeal quoted from another decision in which it was said that:

“mere inactivity or acquiescence will generally not be regarded as acceptance for this purpose.  But there may be circumstances in  which  a  continuing  failure  to  perform  will  be  sufficiently unequivocal to constitute acceptance of  a repudiation.”

The Court of Appeal agreed with the trial judge that the third party’s “silence or inaction in the face of [the municipality’s] repudiation of the Agreement falls short of satisfying the requirement of clear and unequivocal communication to the repudiating party of the adoption of a repudiatory breach or anticipatory repudiation of contract.”

The mere fact that the municipality did not exercise its rights did not mean that it could not have done so, nor did it mean that the Browns or their predecessors had precluded the municipality from doing so.  The Court noted:

“the municipality did not seek access to the affected lands to carry out maintenance or repair activities does not mean that such access was unavailable.”

The Court of Appeal stated that the burden of proving an acceptance of repudiation was on the municipality and there was no evidence of such acceptance by the Browns or their predecessors in title.

Comments

This decision is another example of appellate courts in Canada sticking to the fundamental principles of contract law.  The requirement that an acceptance of repudiation must be clearly made and clearly proven means that the wrongful party cannot benefit from its own wrongful conduct and induce a termination by its own repudiation.

It may have taken a fair bit of chutzpah for the municipality to say: “we repudiated the contract, and you accepted it, didn’t you know!”   But that is the situation in which every exasperated contracting party finds itself when stuck with a contract that it has long since repudiated and wants to be rid of.  Unfortunately, it can’t unilaterally get rid of it, and the contract can go on, and on, and on, until the repudiation is accepted by the innocent party, if it ever is.

Besides being favourable to the innocent party, this state of the law protects the inactive party, the party that doesn’t have the time, inclination or resources to take the time to determine if it will accept the repudiation of the wrongful party, or simply doesn’t want to.

So, on a construction project, a serious wrong by one party does not mean that the contract comes to an end.  The law’s choice is that, in those circumstances, it is better that the contract continues and not come to an end.  It only comes to an end if the other party wants it to.

See Heintzman and Goldsmith on Canadian Building Contracts, 4th ed., chapter 1, part 4(c)

Brown v. Belleville (City), 2013 ONCA 148

Construction Contract  –  Termination  –  Repudiation  –  Acceptance  –  Limitations

Thomas G. Heintzman O.C., Q.C., FCIArb                                                         March 22, 2013

www.heintzmanadr.com

www.constructionlawcanada.com

 

An Insurance Clause Does Not Necessarily Bar A Claim By The Owner

When does an insurance clause in a construction contract bar a claim by the owner against the contractor?  Is it barred if the contract requires that the contractor obtain insurance and that the owner is to be named as an additional insured and that subrogation is waived against the owner?  That was the issue in the recent decision of the British Columbia Court of Appeal in Lafarge Canada Inc. v. JJM Construction Ltd.

The Background

The contract in question was for the charter of barges by the owner, JJM, to the charterer, Lafarge, but the principles in question appear to be no different than in a construction contract. The contract placed the sole responsibility on Lafarge for the barges’ good condition during the term of the contract.  The contract contained “insurance clauses” which required Lafarge to maintain insurance on the barges with loss payable to JJM and also required that the insurance name JJM as an additional insured and expressly waive subrogation against JJM as the owner.

When the barges were returned to JJM at the end of the contract they were damaged.  JJM repaired the barges, made a claim under the insurance and then claimed against Lafarge for the additional costs that it incurred over the insurance recovery. The parties agreed to arbitrate the claim.

In the arbitration, Lafarge argued that the “insurance clauses” barred any claim against it.  It relied upon a series of decisions of the Supreme court of Canada (Agnew Surpass v. Cummer-Yonge, Ross Southward v. Pyrotech Products, T. Eaton v. Smith and Commonwealth Construction v. Imperial Oil) and various lower court decisions which applied the principles in those decisions.

In some of those cases, claims by owners against tenants and contractors were dismissed based upon insurance clauses in which the owner had agreed to obtain insurance covering the building or project.  In other cases, the owners’ claims were dismissed based upon clauses requiring the tenant or contractor to contribute to the insurance premiums incurred by the landlord.  In both cases, the courts held that these clauses effectively passed the risk of loss to the owner, even in the presence of a general duty placed on the tenant or contractor to repair and maintain the building or project.

The arbitrator agreed with JJM that the insurance clause in question did not protect Lafarge.  The arbitrator’s decision was upheld by the British Columbia Supreme Court and Court of Appeal.

The Court of Appeal held that the prior decisions relied upon by Lafarge did not apply to the present circumstances.  Those cases involved two situations.

The first situation is a claim by the party which undertook the obligation to insure the other party.  That was the situation in each of the Supreme Court of Canada cases in which the owner, expressly or impliedly, undertook to obtain insurance on the building or project, and then sued the tenant or contractor when there was damage to the building.  The obligation to insure was express if the lease or construction contract stated that the owner would insure the building or project.  The obligation to insure was implied if the lease stated that the tenant would contribute to the insurance maintained by the landlord.  In either situation, the courts held that the owner had assumed the risk of damage to the building and could not sue the tenant or contractor.

The second situation is a subrogated claim by an insurer of the owner.  The claim may be against a tenant or contractor which was a named or unnamed insured under the insurance policy taken out by the owner.  Or the claim may be against a tenant or contractor which the owner agreed to name as an insured party in the insurance policy to be taken out by the owner, but the owner failed to take out that insurance. In both cases, the courts have held that the insurer could not maintain such a claim.

Neither situation existed here.  In this case, the claim was by the owner but the owner had not contracted to take out insurance.  Rather, it was the charterer, Lafarge, which had contracted to take out the insurance, and insurance naming the owner as an insured party.  Here, the claim was not by the insurer but by JJM for its uninsured loss after giving full credit to Lafarge for all insurance proceeds it had received.

Lafarge argued that a wider principle applied.  Effectively Lafarge was seeking to broaden the first category, namely, the implied obligation to insure arising from a contribution made by a tenant or contractor to the owner’s insurance premiums.  Lafarge argued that this implied obligation is based upon the principle that any time a party pays for insurance under a contract relating to a project or building, all claims arising from that project or building must be made under the insurance policy, and that all other claims against that party are barred.

The Court of Appeal rejected that argument.  It pointed out that Lafarge had cited no cases that supported its argument.  It also noted that, in the first category of cases on which Lafarge relied, the party suing (usually the owner) was the party which had an express or implied obligation to obtain insurance for the benefit of the other party (usually the tenant or contractor) .  In the present case, the party suing (the owner, JJM) had not undertaken to obtain insurance.  To the contrary, the party suing was the beneficiary of the insurance to be obtained by the other party.  Effectively, Lafarge was arguing that JJM should be deprived of a remedy by the very insurance that Lafarge had agreed to obtain for JJM’s benefit.

The Court of Appeal concluded that the other cases cited by Lafarge were all based upon claims made by insurers and were based upon two principles of subrogation.

First, the insurer could not sue the other party (usually the tenant or contractor) because the other party was a named or unnamed beneficiary of the policy under which the insurer had paid.  Under well known principles of insurance law, an insurer cannot bring a subrogated claim against another party insured under the same policy.

Second, another well know principle of insurance law is that the insurer has no greater subrogation rights than its insured (usually the owner).  If the owner had contracted to obtain insurance for the building or project and to name the other party (usually the tenant or contractor) as an insured and had failed to do so, then the owner had accepted the risk of damage and the insurer could be in no better position than the owner when maintaining a subrogated claim.

The present case did not fall within those principles.  JJM had not contracted to obtain insurance and the claim was not a subrogated claim.

This decision by the British Columbia Court of Appeal is a good reminder that “insurance clauses” do not necessarily create a water-tight regime which precludes claims by one party  against the other under insurance contracts.  The water-tight regime may apply to, and exclude, claims by the party (or its insurer) which agrees, either expressly or by implication, to obtain insurance on the project for the benefit of the other party.  But, without more, it may not apply to and exclude claims against the party which agreed to put that insurance in place.

The business logic of this decision is also sound.  As the Court of Appeal pointed out, it was Lafarge which arranged for the insurance, together with the terms and the deductible that resulted in JJM’s insurance claim not being paid in full.  In this circumstance, it seems only fair that Lafarge bear the risk of any uninsured shortfall.

This conclusion may have several unsettling implications for a party taking out insurance for a construction project.

First, the party agreeing to take out insurance (Lafarge in this case) undoubtedly conferred a benefit on the owner (JJM).  Wasn’t the amount of rent paid by Lafarge for the barges likely reduced, in some measure, by the cost of that insurance and the benefit conferred on JJM?  If so, isn’t that benefit akin to the contribution made by a contractor or tenant to the owner’s insurance premiums?  And if that is so, should that fact not give rise to an implied duty on JJM to accept that insurance as its sole remedy?

Second, to the extent possible owners and contractors usually want to create a water-tight insurance regime in the construction contract.  Each of them wants to ensure that the insurance regime provides the only remedies available to the other party.  How can they accomplish that result?

Clearly, this case tells us that the insurance clause and the insurance itself is not sufficient, at least so far as claims against the party which agrees to take out the insurance.  What is sufficient?  Must the contract provide that the insurance is the sole remedy of either party?  Is there any other way to create that “water-tight” regime so far as claims against the party taking out the insurance?  This case will have owners and contractors scratching their heads to come up with an answer.

See Heintzman and Goldsmith on Canadian Building Contracts (4th ed.), Chapter 5, Part 3

Arbitration  –  Construction Contract   –   Insurance  –   Subrogation

Lafarge Canada Inc. v. JJM Construction Ltd., 2011 BCCA 453

Thomas G. Heintzman O.C., Q.C.                                                                                                     February 20, 2012

www.heintzmanadr.com

How Does A Court Find And Interpret An Oral Construction Contract

Construction Contract  –  Interpretation – Oral Contract

A contract in the construction industry is usually in written form.  Often the contract will follow the CCDC form of contract.  But what principles should apply to the interpretation of oral contracts?  The British Columbia Court of Appeal recently addressed this issue in Copcan Contacting Ltd v. Ashlaur Trading Inc.

The alleged contract was for the logging of lands in British Columbia.  While the contract was not for the construction of a building, the principles that the court applied are the same that are applied to building contracts.

The parties did not agree that there was a contract, and if there was such a contract, what the terms of it were.  The plaintiff asserted that there was a contract and the defendant said that there was not.  The trial judge held that there was a contract.  An appeal was taken to the British Columbia Court of Appeal.

The parties acknowledged that the test to determine whether there was a contract was an objective test, that is, whether a reasonable bystander observing the parties would have concluded that they had made a contract.  In dealing with this question and with the question of what terms the contract (if made) contained, the Court of Appeal held that two principles applied.

 First, the Court must assume that the parties understand the business environment in which they were conducting their negotiations.  As the court said, the issue “must be viewed from the perspective of a reasonable person familiar with contracting practices in the British Columbia logging industry.”

Second, since the contract was an oral contract, the court would give a certain latitude or flexibility in determining what the terms of the contract were.  The court held that, having found there was an oral contract, the trial judge “was therefore entitled to exercise greater flexibility in the use of evidence in order to construe the contractual terms than can be utilized where the terms of the contract have been reduced to writing.”

In arriving at this latter conclusion, the Court of Appeal relied upon the reasoning in one of its prior decisions in which it had said that “this flexibility follows intuitively from the recognition that oral contracts must often be construed without the key interpretive tool used to understand written contracts – the words of the agreement.”

This decision demonstrates the inclination of a court to ensure that the reasonable expectations of the parties are not disappointed if, on the evidence, the court is satisfied that the parties made a contract.  Of course, the party asserting that a contract was made must demonstrate that fact on a balance of probabilities.  But if the court is satisfied that they did, then the court will be receptive to arguments about the contents of the contract in such a way that will give effect to the contract.

This decision is also a handy reference in relation to any dispute over an alleged oral contract.  It contains the three essential principles applicable to the existence and terms of the oral contract: the objective test to determine its existence; the industry perspective from which the parties must be assumed to be acting; and the flexibility with which the court will determine the terms of the contract.

See Goldsmith and Heintzman on Canadian Building Contracts, Chapter 1, Parts 1(b)-(c) and 3

Construction Contract  –  Interpretation  –  Oral Contract :

 Copcan Contracting Ltd v. Ashlaur Trading Inc., 2010 BCCA 597

Thomas G. Heintzman O.C., Q.C.                                                                           August 8, 2011

www.constructionlawcanada.com

www.heintzmanadr.com

Tenders in Construction Projects – Which Limitation Period Applies?

What is the limitation period for the commencement of an action arising from a tender in a construction project?

If the owner is a municipality or other public body, does a limitation period in its incorporating legislation apply to the tender?  These were the questions recently faced by the Prince Edward Island Court of Appeal in Central Roadways v. City of Summerside.

In May 2008 the City of Summerside sought tenders for the resurfacing of city streets.  Two bidders, Central Roadways and another bidder, submitted tenders.  Central Roadways’ tender was the lowest, but on June 16, 2008 the City’s Council met and decided to award the contract to the other bidder, and advised Central Roadways the next day.

In November 2008, Central Roadways asked the City why its tender was not accepted and requested a copy of Council meeting minutes of June 16, 2008.  The City replied by letter and provided  a copy of the minutes but the minutes did not disclose any reasons why the other tender was accepted and not the tender of Central Roadways.

On February 20, 2009, Central Roadways commenced an action against the City.  The City brought a motion to dismiss the action on the ground that it was barred by the limitation period in s-s.46 (2) of the City of Summerside Act.

Section 45 and 46(1) of that Act provided that notice was to be given to the City in the case of damage sustained from unsafe conditions, or from nuisances or encumbrances, on City streets or sidewalks.  Section 46(1) then said that, except as provided in S. 46(1), all actions against the City were to be commenced within six months of the cause of action arising.

The City asserted that this limitation period applied to the claim arising from the tender, and the judge who heard the motion agreed.  But the P.E.I Court of Appeal reversed the decision.

The Court of Appeal examined the wording and history of the City of Summerside Act and concluded that the six month limitation period only applied to claims arising from City bylaws or claims relating to unsafe conditions or nuisances and encumbrances on City property.  Even though the word “all” in s. 46(2) was normally all-encompassing, it should not be so interpreted in light of these surrounding circumstances.

The Court of Appeal noted that the limitation period in P.E.I. for claims in contract is six years and that a limitation period of six months is a very different limitation period.  Since the shorter limitation period was found in a statute for the City’s benefit, it should be interpreted against the City in the event of any ambiguity.  The Court said:

“Interpreted to include all causes of action against the City, the very short six-month limitation period would seriously circumscribe the right of a person to commence any action against the City.  This being so, any ambiguity must be resolved in favour of a less restrictive limit on the time within which to commence an action.”

The Court of Appeal held that the claim by Central Roadways was in contract, since it arose from the alleged breach of its contract with the City inherent in its submission of a tender to the City’s invitation.   While there might be good policy reasons for the City to provide very short limitation periods for actions arising from slip and falls or other accidents on City streets,

“there is no valid policy reason why other actions against the City, like an action for breach of contract, should have the time for the commencement thereof limited to a very short six months…If the Legislature is of the mind that there are valid policy reasons for a shorter limitation period for the commencement of such actions against municipalities like the City, then it should express the policy more clearly in the Act  so as to specifically exclude these actions from the scope of the Statute of Limitations.”

This decision contains warnings about limitation periods relating to tenders.

The first warning is that a claim arising from a tender is a claim in contract and must be brought within the limitation period for a contract claim.  In addition, a tort claim relating to the tender must be brought within the limitation period relating to tort claims.

The second warning is this:  look for any limitation period contained in the tender documents. The tender documents may themselves contain a specific and shorter limitation period.  A shorter contractual limitation period may be permitted under the general limitation statute.  Thus, In Ontario, s.22(5) of the Limitations Act, 2002 permits the normal two year limitation period to be shortened in business agreements, but not consumer agreements.

And third, ensure that there are no other statutory limitation periods which may apply to the tender.  In Ontario, that is unlikely since s.19 of the Limitations Act, 2002 states that a statutory provision containing a conflicting limitation period is of no effect unless that provision is set out in the Schedule to the Limitations Act, 2002.  But if there is a limitation provision in another statute which is potentially enforceable, then depending on the origin and nature of that provision, the decision in the Central Roadways case may require that the limitation provision be read against the public body and only enforceable if it clearly applies to the tender.

Tenders – Limitation Period – Construction Contract – Actions – Breach of Contract – 

Central Roadways v. City of Summerside, 2011 PECA 4 (CanLII)  https://bit.ly/jnQhQk