Legal Blog

Penalty-Forfeiture

We have extensive jurisprudence regarding penalties, liquidated damages, relief from forfeiture, and unconscionability. The concepts are often jumbled together and their application becomes confusing. We deal with two cases that, depending on your viewpoint either alleviate the confusion or add to it. The first is 600 Sunningdale GP Inc. v. First Source Mortgage Corporation 2024 ONCA 252; the second is Kestenberg Siegal Lipkus LLP v. Royal and Sun Alliance Insurance 2024 ONCA 607.

Sunningdale

The outcome of this case depended on the interpretation of a financing commitment letter (the “loan agreement“). A developer and lender entered into the loan agreement for a $15M construction development financing. The loan agreement stipulated that the developer would pay a lender fee of $426,500, $100,000 upon its signing and the balance from the loan advance.

The developer was upset with some of the lender’s demands and ultimately decided not to continue with the financing. It did not pay the balance of the lender fee and demanded the return of the $100K it had paid.

After some initial wrangling, the developer paid the balance of the lender fee, to be held (presumably by a third party) in trust and the parties agreed to have the issues settled by way of a summary judgment motion.

The motion judge held that she was unable to determine whether the termination was the “fault of the lender”, but noted that the lender made the developer’s life difficult with its demands. The judge then held that the lender had a right to the $100K but not to the balance of the lender fee, reasoning that the balance was an unenforceable penalty, and also that relief from forfeiture should be granted under s. 98 of the Courts of Justice Act. In determining that the balance was a penalty, the judge noted that, because the loan was never advanced and much of the work associated with underwriting had not been done, the balance was not “earned”. The lender appealed.

Contract

The loan agreement contained the following terms:

• The lender fee was to be paid to the lender in consideration for the loan commitment.
• The lender fee was “a reasonable estimate of the Lender’s costs incurred in sourcing, investigating and underwriting, and preparing the Loan.”
• The initial $100K would be forfeit if the mortgage amount were not advanced for any cause other than the “default of the Lender.”
• If the loan were not advanced and the commitment terminated “through no fault of the Lender,” the developer was to pay the balance of the lender fee.

Law

1. A penalty is a payment of a stipulated sum on breach of a contract regardless of the damages actually sustained. It is used “in terrorem” to induce a contracting party not to breach the contract.

A stipulated remedy clause (i.e. a penalty clause) is unenforceable under common law if it is extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved to have followed from the breach.

2. A stipulated remedy clause is eligible for relief of forfeiture in equity if it would be unconscionable for the party seeking the forfeiture to retain the right, property, or money forfeited.

The doctrine of relief from forfeiture applies to relieve a party from the loss of a right, property, or money because of conduct resulting in the non-observance or non-compliance with the contract (e.g. non-refundable deposits, partial payments of a purchase price, loss of insurance coverage, etc.).

3. If a stipulated remedy is not a penalty or a forfeiture, then the law dealing with stipulated remedy clauses does not apply.

4. There is a general law of unconscionability. It is wholly unrelated to the law relating to relief from a stipulated remedy clause. It protects those who are vulnerable in the contracting process for loss or improvidence in the bargain that the party made. It requires proof of both an inequality in positions and an improvident bargain.

Findings

The court overturned, holding that

• The loan agreement did not have a stipulated remedy clause.
• The lender fee was not payable in consequence of a breach of the loan agreement; it was payable for the lender giving the commitment and was payable regardless whether (i) the developer breached the loan agreement or (ii) the lender advanced the loan proceeds (assuming the non-advance was not the lender’s fault). The balance of the lender fee did not have to be “earned”.
• Given the court’s finding that the lender fee (including the balance of it) was not payable arising out of a breach, the law dealing with penalty clauses (whether common law or equity) did not apply.
• The general law of unconscionability did not afford relief to the developer. The developer was a sophisticated commercial player (not a disadvantaged consumer).

Result

The lender received the balance of the lender fee and kept the original $100K payment. The motion judge had awarded the developer $50,000 for the costs of the motion; the court kept that amount but reversed the payment obligation. The court awarded $20,000 in costs to the lender in the appeal.

Kestenberg

A law firm sought excess professional liability insurance coverage against its insurers after a client brought a substantial negligence claim against it. The law firm already had primary and first‑level excess coverage, but the dispute before the court involved the second‑level excess policy; it covered losses only once $10 million of underlying coverage had been exhausted.

The policy was a claims-made policy (i.e. it was irrelevant who insured the law firm when the alleged negligence occurred; the policy covered if the claim was made in the year in which the policy applied).

As soon as the law firm knew of the potential claim, it immediately notified its primary insurer and instructed its broker to notify the excess insurers. The broker reported the claim to the first excess insurer but failed to notify the second excess insurers until about three years later and more than two years after the policy had expired.

The insurer denied coverage on the basis that, under the policy, coverage was available only for claims both made and reported during the policy period. The law firm applied for a declaration that coverage was available notwithstanding the late notice, relying on the statutory and equitable doctrines of relief from forfeiture.

The application judge dismissed the application, finding that the policy was a claims made and reported policy, meaning that timely reporting was a condition precedent to coverage and, because coverage had never been triggered, relief from forfeiture was legally unavailable.

Appeal

The law firm argued that the application judge misinterpreted the policy, asserting that only a “claims made” trigger applied, that the reporting requirement was not a condition precedent, and that relief from forfeiture should be available absent prejudice to the insurer.

The court upheld the application judge’s decision. The policy stated that it “only covers claims first made … and reported … during the policy period.” This language made timely reporting a condition precedent to coverage. The court emphasized that, although the reporting requirement did not appear in the insuring agreement clause itself, the policy must be read as a whole, and contractual reporting requirements, although not located in the insuring portion of the contract, created claims made and reported coverage.

The court also affirmed that relief from forfeiture is unavailable if the insured fails to satisfy a condition precedent that triggers coverage. Under a claims made and reported policy, reporting within the policy period is integral to the insured–insurer bargain. To grant relief would effectively rewrite the policy by expanding coverage to a risk for which no premium was paid. The law firm’s reliance on prejudice or the minor nature of the breach could not overcome the fundamental nature of the requirement. Because coverage was never triggered, the law firm could not invoke relief from forfeiture.

Broker

We know, you are saying to yourself “What about the broker; the broker was negligent; the law firm reported?” The action was in the law firm’s name, but the broker had accepted full liability.

 

Image courtesy of abirkhan006.

Written by Jonathan Speigel, the founding partner of Speigel Nichols Fox LLP, leads the litigation and construction practices.