Out of the penalty box: Ontario Court of Appeal upholds lender’s fee after finding it is not an unenforceable penalty

Contracting parties regularly deal with risks in their commercial relationships, but there are limits to managing risk, such as the common law prohibition on unconscionable or extravagant penalties. In 660 Sunningdale GP Inc. v. First Source Mortgage Corporation, 2024 ONCA 252 (Sunningdale), the Ontario Court of Appeal found that a contractual payment cannot itself be a penalty; a penalty must be a payment triggered by a breach of contract to be unenforceable as a penalty. As a result, the Court held that a facilitation fee for putting together a loan could not be a penalty because the fee was not triggered by the would-be borrower’s failure to close the underlying loan agreement.

What you need to know

• True penalty clauses are unenforceable. While courts typically uphold contractual provisions that require a breaching counterparty to pay a genuine pre-estimate of the innocent party’s damages, courts will not uphold penalties that are designed to strong-arm parties into complying with a contract for fear of paying an extravagant or unconscionable sum upon their breach.
• Breach required for a penalty. A contractual payment cannot be characterized as an unenforceable penalty unless the payment is triggered by a party’s breach of the contract.
• Lender’s fee was upheld. As a result, the Court enforced a lender’s fee in a loan agreement that had failed to close because the fee was not triggered by the would-be borrower’s breach of the agreement. Similarly, the Court did not grant relief from forfeiture, a concept which likewise requires a breach of an agreement to be triggered. In this case, the lender had earned the fee by arranging the underlying loan facility, so the concepts of penalty and relief from forfeiture could not apply.

The details

Background

660 Sunningdale GP Inc. is a commercial real estate developer that entered into a loan agreement for funds to develop a new project. As part of the loan agreement, Sunningdale agreed to pay the lender a fee equal to 2.75% of the principal amount of the loan as consideration for the lender’s costs incurred while preparing the loan. Sunningdale paid a portion of the fee upfront upon entering into the agreement and was required to pay the balance from the loan proceeds on closing.

Sunningdale decided not to proceed with the loan. It commenced an action against the lender for the return of the upfront portion of the fee that Sunningdale had paid to the lender—and for relief from paying the balance of the fee under the loan agreement—on the basis that the fee amounted to an unenforceable penalty. The lender counterclaimed against Sunningdale for the unpaid balance of the fee.

At first instance, the motion judge allowed the lender to keep the upfront payment, finding that it represented an enforceable pre-estimate of the lender’s damages. However, the motion judge found that the lender was not entitled to the unpaid balance of the fee because that balance amounted to an unconscionable and unenforceable penalty.

The lender appealed the motion judge’s decision. The key issue was whether a lender’s fee in a loan agreement amounted to an unenforceable penalty clause.

The Court of Appeal’s decision

The Court found that the fee was not an unenforceable penalty; it held that Sunningdale must pay the outstanding balance of the fee to the lender.

The Court drew an important distinction between the terms of Sunningdale’s loan agreement and the type of penalty clause that the law prohibits. The essence of an unenforceable penalty is an extravagant or unconscionable payment of money designed to threaten a contractual counterparty into performing the contract. A payment is therefore an unenforceable penalty only if it is payable upon a breach of contract. In other words, a payment that is not triggered by a breach of contract cannot be a penalty.

The Court found that the lender’s fee in Sunningdale’s loan agreement was payable regardless of whether Sunningdale actually breached the loan agreement—it was not a penalty. Rather, the fee represented an estimate of the costs that the lender had incurred by sourcing, investigating, underwriting and preparing the loan, and the lender had already earned the fee by the time the loan agreement was executed. This remained the case even though the loan agreement described part of the upfront portion of the fee as “liquidated damages”.

The Court similarly refused to find that the requirement to pay the lender’s fee amounted to forfeiture, again finding that this is a concept that requires a breach of an agreement in order to be triggered.

The Court also refused to relieve Sunningdale from paying the balance of the lender’s fee on the basis that the fee was unconscionable. The doctrine of unconscionability shields parties who are vulnerable in the contracting process. Sunningdale lacked the requisite vulnerability—it was sophisticated enough to handle a largescale commercial development, not a disadvantaged party that unconscionability looks to protect.

Implications

Sunningdale provides helpful guidance for parties seeking to manage counterparty risks in their commercial contracts. In particular, a contractual payment is unlikely to be characterized as an unenforceable penalty if it is a pre-existing contractual obligation instead of a consequence of breach of the contract. Lenders will find comfort that their fees are unlikely to be characterized as penalties—and that the costs they incur by preparing a loan are unlikely to be subject to closing risks—so long as the payment is not tied to the borrower’s breach.