When are Penalty/Forfeiture Clauses Unenforceable?

Many commercial agreements contain clauses that provide stiff consequences for one party’s failure to comply with his or her end of the bargain. These sorts of clauses may, for example, require one party to pay a significant penalty or forfeit something of great value to the other party in the event of some breach by that first party. There are conflicting views on whether or not these types of clauses should be enforced. Subscribers to the notion of freedom of contract feel that if the parties agree on the terms of the penalty or forfeiture clause, then that clause should be enforced. Those people who have concerns about the fairness of these clauses, however, believe that such clauses should not be enforced because they are inherently unconscionable.

The Courts, while committed to freedom of contract, have traditionally refused to enforce contractual penalty or forfeiture clauses, unless the impugned clause represents a genuine pre-estimation of the damages that will be suffered by the non-breaching party, called “liquidated damages”. Although it is a challenging task to determine what one party’s fair and reasonable pre-estimation of damages may be for a breach that has not yet (or may never) materialize, a recent decision makes clear that the Courts will not enforce a penalty or forfeiture clause that results in a windfall to the non-breaching party.

Repurchase and Penalty Clauses

In Konialin v. Paletta, the Ontario Superior Court of Justice held that the provisions of an Agreement of Purchase and Sale that would result in a windfall of over $1 million to the vendor were unconscionable and therefore unenforceable as against the purchaser. This case dealt with the purchase of an estate lot in a luxury residential subdivision in Burlington, Ontario. The Agreement of Purchase and Sale provided for a price of $1,050,000 + HST for the lot and contained a list of requirements that the purchaser had to fulfill. These requirements included: constructing a home that had a footprint of at least 5,000 square feet, submitting architectural drawings to the vendor for approval, retaining a vendor-approved homebuilder, and complying with a construction schedule that included commencing construction within 6 months of the closing date and completing construction within 18 months thereafter.

An Option Agreement which was attached to the Agreement of Purchase and Sale provided that the vendor (a sophisticated land developer) would be entitled to repurchase the building lot from the purchaser at 25 percent of the purchase price (i.e. $262,500 of the $1,050,000 paid) and to receive a penalty of $1,000 per day from the purchaser (which amount at issue reached $270,000) for failing to adhere to the construction schedule. The vendor gave evidence that these clauses were necessary to send a message to the market that there will be consequences for breaching the terms of the contract and failing to comply with the development requirements. While the Court held that there should be consequences as a result of the purchaser’s breach of these terms, it also held that a message should be sent to developers that the terms imposed on their purchasers must be reasonable, that their conduct in the face of a breach must be fair, and that the consequences imposed under such contracts must be proportionate and equitable.

Construction Delays

Following closing of the land transaction in February 2017, the purchaser ran into a number of issues that inevitably delayed his construction project and prevented him from complying with an already stringent construction schedule. While the purchaser took immediate steps following closing to design an impressive 8,500 square foot bungalow which would surpass the stipulated minimum home size, the purchaser’s plans were eventually thwarted by a municipal building requirement to install a fire suppression system (arising from the combined effects of the home’s size and rural setting), which was found to be impractical and prohibitively expensive. The purchaser decided in February 2018 to start afresh with a more modestly sized two-storey design which did not require a fire suppression system but set his construction plans back one year and $150,000. In the meantime, the purchaser had a falling out with the vendor’s only approved homebuilder over a referral fee that the homebuilder had to pay to the vendor and that the homebuilder wanted paid out of the purchaser’s pocket. The purchaser ultimately engaged another homebuilder and obtained the vendor’s approval of that homebuilder in February 2019.

Shortly after the vendor approved the purchaser’s engagement of the second homebuilder, the vendor sent a notice to the purchaser that it intended to use its option to repurchase the lot from the purchaser pursuant to the Option Agreement on the basis that the purchaser had failed to commence construction by August 2017 and was therefore in breach of the construction schedule set out in the Agreement of Purchase and Sale.

Test for Unconscionability

The issue before the Court was whether or not the repurchase and daily penalty clauses of the Option Agreement constituted penalties or forfeitures that were unenforceable. The Court applied the following two-part test (which was adopted by the Ontario Court of Appeal in Redstone Enterprises Ltd. v. Simple Technology Inc., 2017 ONCA 282) to determine whether or not the clauses contained in the Option Agreement were unconscionable:

  1. That the penalty or forfeiture is out of all proportion to the damages suffered (i.e. grossly disproportionate); and,
  2. That is would be unconscionable for the vendor to retain the deposit or money to be paid.

Proportionality

On the first part of the test, the Court concluded that the clauses would lead to a disproportionate outcome. While the vendor made some arguments that the purchaser’s failure to adhere to the construction timelines would delay its ability to recoup deposits associated with the development of the subdivision, the Court reasoned that such deposits would not be recoverable by the vendor until completion of the entire subdivision. Since the vendor still had 2 vacant building lots to sell, the vendor was not yet in a position to seek the return of its deposits and was therefore not being delayed by the purchaser.

In addition, the Court found the repurchase price of 25 percent—an arbitrary figure selected by the vendor—did not constitute a genuine pre-estimation of damages. This was evidenced by the fact that the vendor had been selling building lots in that same subdivision since 2003 when the lots were priced at $350,000 and had not given any thought to updating the repurchase clause when prices rose to over $1 million years later.

In essence, the Court held that the vendor would not suffer any damages at all. By contrast, the purchaser was faced with a loss of 75 percent of the purchase price of the land (being $787,500), daily penalties amounting to $270,000, and losses in excess of $150,000 associated with the design of the two homes, building permit application fees, and the legal costs of the real estate closing.

Unconscionability

After finding that the clauses would lead to a disproportionate outcome, the Court moved on to find that it would be unconscionable for the vendor to retain the forfeited lot and penalities:

The substantial disparity between the value of the property forfeited, the quantum of the penalty and the lack of any damage caused by the breach makes it unconscionable for [the vendor] to retain this windfall.

Other factors that influenced the Court’s finding of unconscionability included the following:

Conduct of the Parties

The Court found that the vendor did not act like a party that was suffering damages as a result of the purchaser’s delay in commencing construction. The vendor had not said or done anything after the purchaser missed the first deadline, instead sitting by “silently in the face of the breach that should have been obvious.” By the vendor’s own admission, he did not strictly enforce the first construction deadline, allowing at least 3 other purchasers in the subdivision to commence construction beyond the initial 6-month deadline.

Sophistication of the Parties

While the Court did not find the purchaser to be unsophisticated (he had prior experience with new construction and with severance and rezoning applications), it held that the vendor’s sophistication had exceeded that of the purchaser. The purchaser’s initial concerns about the unrealistic 6-month deadline to commence construction were assuaged by the first homebuilder, who told the purchaser that the clause only existed in the Agreement of Purchase and Sale to prevent speculation in the building lots. The Court accepted the purchaser’s evidence that the purchaser would not have signed the Agreement of Purchase and Sale had he known the vendor would strictly enforce the 6-month deadline.

Inequality of Bargaining Power & Absence of Bona Fide Negotiations

The Court accepted the purchaser’s evidence that the Agreement of Purchase and Sale was presented as a ‘take-it-or-leave-it’ proposition where there was no opportunity to negotiate its terms. This imbalance of bargaining power was exemplified by the vendor’s conduct at closing: the vendor declined to answer proper and reasonable requisitions made by the purchaser’s lawyer prior to closing (including providing a copy of the survey, a statement of adjustments, and evidence regarding title). Instead, the purchaser was pressured by the vendor to withdraw his lawyer’s requisitions in order to close the real estate transaction.

Unreasonable and Unfair Terms

The Court acknowledged that the homes being built on these estate lots were not “cookie cutters” and that a 6-month deadline to commence construction on the bespoke home was “unreasonable, bordering on the impossible.” Moreover, the Agreement of Purchase and Sale did not provide for the extension of time to commence construction in situations where the delay is caused by external factors outside of the purchaser’s control (such as the purchaser not being alerted to the requirements of a fire suppression system until in late-2017).

Incentive for Vendor to Allow Breach to Continue

Lastly, the Court considered the fact that the clauses created an incentive for the vendor to continue to ignore the purchaser’s breach, or to sit silently in the face of it, for as long as possible while the daily penalties accrued.

Unconscionable Penalty/Forfeiture Clauses Are Not Enforceable in Ontario

Upon finding that the clauses at issue met both prongs of the test for unconscionability, the Court concluded that the clauses were unenforceable. Cautious not to rewrite the contract between the parties, the Court ordered that the purchaser commence construction within 6 months of the date of Judgment, the purchaser complete construction within 18 months thereafter, and if the purchaser fails to comply with these terms, then the vendor may exercise an option to repurchase the building lot from the purchaser at 80 percent of the purchase price paid by the purchaser.

This case makes it clear that it is not enough to refer to a penalty or forfeiture in a contract as “liquidated damages”. The Court will examine the substance of the provision and ultimately decide whether or not it is unconscionable, and decline to enforce it if it is. The amount stipulated must actually reflect a genuine pre-estimation by the non-breaching party of the damages he or she will suffer as a consequence of the breaching party’s conduct. If the amount stipulated is disproportionate to the loss suffered by the non-breaching party or results in a windfall, then it is likely a penalty or forfeiture that will not be enforced by the Court. Caution should therefore be taken when drafting clauses that seek to keep the parties in check with their obligations.

If you have any questions about liquidated damages clauses, repurchase options or other similar “developer’s covenants” in an agreement, contact the lawyers at Duncan, Linton LLP. Our real estate, business and construction lawyers have extensive experience in advising clients on the negotiation and drafting of such clauses in construction agreements, agreements for the sale of land, and development agreements, and the commercial litigation team has been successful in enforcing, and defending against, claims made on such clauses. Call us at (519) 886-3340 or contact us online to schedule a consultation.