Author: Corbin Devlin
A contract provision that permits an owner to withhold payment from a contractor is not a “penalty” clause.
Penalty Provisions
The courts do not like, and typically do not enforce, “penalty” clauses. For this reason, liquidated damages clauses in favour of the construction owner generally have to be based on a “genuine pre-estimate of damages” in order to avoid the court striking the liquidated damages clause down.
No Further Payment Provisions
In a recent Ontario case, Ottawa Community Housing Corp. V. Foustanellas, the contractor argued that a clause providing that (in certain instances of default) “the obligation of the Owner to make payments will cease” was a penalty clause, and therefore not legally enforceable. The contractor was overbilling the owner, and consequently the owner acted on a clause in the contract that permitted the owner to “take work out of the hands of the Contractor.” The owner then hired someone else to complete the work, but the Contractor sued to recover payment for the work it had performed before the owner took the work out of its hands.
Specifically, the contract permitted the owner, upon default by the contractor, to “take the whole operation, or any part of the operation out of the hands of the Contractor.” The owner relied upon that clause and a further clause stating: “…where any or all of the work has been taken out of the hands of the Contractor, the Contractor will not be entitled to any further payment, including payments then due and payable but not yet paid. The obligation of the Owner to make payments will cease, and the Contractor will be liable upon demand to pay the Owner an amount equal to all of the losses and damages incurred by the Owner for the non-completion of the work.”
The court decided this last clause did not erase the debt due to the contractor (if any). It suspended payments due to the contractor (if any) until a final accounting could be done, after the owner had the work completed by others. Since the clause only suspended payments, and it did not erase the debt, it was not a penalty clause. It was enforceable.
Debts Owing vs. Payments Due
This is not a surprising outcome or new law. But it is useful case authority for the interpretation of a fairly common contract provision. It is also a reminder of the distinction between a debt owing and a payment due. This is a deceptively simple distinction that is essential to proper interpretation of construction contracts and lien legislation. I frequently see misinterpretations of contract and lien legislation due to misunderstandings on this point. In the Foustanellas case, it appears that the contractor went to trial on the misinterpretation that the default provisions in the contract erased the debt, whereas the proper interpretation was that the default provisions merely suspended the payment obligation.
The court called this “a ‘stop payment’ provision. It is designed to halt the owner’s contractual obligation to make any payments to the contractor pending determination of the owner’s losses and damages arising from the contractor’s breach of contract.” In Foustanellas, the debt was erased, but not because of a penalty clause. The debt to the contractor was erased because the owner’s increased cost to complete the work as a result of the contractor’s default exceeded the value earned by the contractor prior to the default.
The courts do not like, and typically do not enforce, “penalty” clauses. For this reason, liquidated damages clauses in favour of the construction owner generally have to be based on a “genuine pre-estimate of damages” in order to avoid the court striking the liquidated damages clause down.
No Further Payment Provisions
In a recent Ontario case, Ottawa Community Housing Corp. V. Foustanellas, the contractor argued that a clause providing that (in certain instances of default) “the obligation of the Owner to make payments will cease” was a penalty clause, and therefore not legally enforceable. The contractor was overbilling the owner, and consequently the owner acted on a clause in the contract that permitted the owner to “take work out of the hands of the Contractor.” The owner then hired someone else to complete the work, but the Contractor sued to recover payment for the work it had performed before the owner took the work out of its hands.
Specifically, the contract permitted the owner, upon default by the contractor, to “take the whole operation, or any part of the operation out of the hands of the Contractor.” The owner relied upon that clause and a further clause stating: “…where any or all of the work has been taken out of the hands of the Contractor, the Contractor will not be entitled to any further payment, including payments then due and payable but not yet paid. The obligation of the Owner to make payments will cease, and the Contractor will be liable upon demand to pay the Owner an amount equal to all of the losses and damages incurred by the Owner for the non-completion of the work.”
The court decided this last clause did not erase the debt due to the contractor (if any). It suspended payments due to the contractor (if any) until a final accounting could be done, after the owner had the work completed by others. Since the clause only suspended payments, and it did not erase the debt, it was not a penalty clause. It was enforceable.
Debts Owing vs. Payments Due
This is not a surprising outcome or new law. But it is useful case authority for the interpretation of a fairly common contract provision. It is also a reminder of the distinction between a debt owing and a payment due. This is a deceptively simple distinction that is essential to proper interpretation of construction contracts and lien legislation. I frequently see misinterpretations of contract and lien legislation due to misunderstandings on this point. In the Foustanellas case, it appears that the contractor went to trial on the misinterpretation that the default provisions in the contract erased the debt, whereas the proper interpretation was that the default provisions merely suspended the payment obligation.
The court called this “a ‘stop payment’ provision. It is designed to halt the owner’s contractual obligation to make any payments to the contractor pending determination of the owner’s losses and damages arising from the contractor’s breach of contract.” In Foustanellas, the debt was erased, but not because of a penalty clause. The debt to the contractor was erased because the owner’s increased cost to complete the work as a result of the contractor’s default exceeded the value earned by the contractor prior to the default.
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