A new legal duty for contracts

Canada’s top court has enunciated a new legal duty in contract negotiations. Its effects are wide-ranging and controversial 

For the first time in common-law Canada, the Supreme Court has recognized a legal duty to perform contractual obligations honestly and with regard to the legitimate expectations of other parties.

The origin of that duty, the court stated in Bhasin v. Hrynew, could be found in a general “organizing principle” of good-faith performance.

Alan Mark of Goodmans LLP in Toronto says that Bhasin is part of a continuing trend in Canadian law.

“Courts have been moving away from rule-based analyses of contractual terms, rights and breaches toward a contextual analysis,” he says. “But a contextual analysis introduces uncertainty, so that the courts have become a bit of a casino if you’re looking to them to determine what conduct would be sanctioned and how to advise clients.”

Wendy Berman of Cassels Brock & Blackwell LLP in Toronto says that pre-Bhasin jurisprudence amounted to a “tangled mess” of case law.

“Sometimes there was a duty of good faith, sometimes there wasn’t, sometimes it was implied, sometimes it was statutory, sometimes it was a matter of contractual interpretation,” she says. “But in the end, you couldn’t give the clients definitive advice on whether such a duty existed. Now at least we know that all contracts are subject to a ‘general organizing principle’ of good faith.”

To be sure, the Bhasin court described its ruling as an attempt to make Canadian contract law more settled, fairer and more closely aligned with the reasonable expectations of the parties. But the disparate and sometimes tortuous commentary that followed on the decision’s release suggests that the judgment falls short of its goals.

 

Bhasin was about a renewal clause in a contract between an Alberta company that marketed education savings plans to investors and one of its agents, who sold the company’s product through his own business. The company had an absolute right to terminate its agreement with the agent after three years. In doing so, however, the company acted dishonestly, misleading the plaintiff about plans to merge his business with a competing business and about its efforts to have the plaintiff’s agency audited by the competing agency. In the end, the plaintiff’s objections to the merger and attempt to audit his records led to the non-renewal. Consequently, the plaintiff lost his business, with most of his own sales force moving to the competing company. When the plaintiff sued, the central issue was whether the defendant owed him a duty of good faith.

In its unanimous decision, the court recognized that Canada’s common-law courts had refrained from enunciating an underlying principle of good faith and a duty to act honestly in the performance of contracts for fear of creating commercial uncertainty and interfering with freedom of contract. But as the court saw it, it was the haphazard development of the law that had created the uncertainty. The failure to recognize the duty also failed to accord with reality, given that commercial parties would never accept contracts that allowed dishonesty in their performance. Finally, the modern trend, manifested in the US and Québec, was to recognize the obligation of basic honesty.

The “organizing principle,” not itself a duty, required parties to refrain from undermining other parties’ interests by acting in bad faith. The duties of good faith that existed in areas like franchise, employment, insurance and real estate law were examples of duties that arose from this principle. Bhasin’s twist was to leave open the possibility that new duties would emerge, the first one being the duty of honest contractual performance enunciated in the decision.

The upshot is that the decision is open-ended: think, perhaps, Donoghue v. Stevenson, the seminal decision in the common law of negligence that engendered a continuing evolution of new duties of care and duties of care in new contexts.

“You have to wonder how much we’re importing a sort of ‘good neighbor’ policy into contract law, using the duty of good faith as a basket into which the rules must fit as they develop,” Mark says.

 

So while Bhasin may provide certainty in the sense of putting an end once and for all to the debate about whether a principle of good faith exists, it creates uncertainty by failing to clearly establish the limits of that principle. Even with respect to the enunciated duty of honesty that falls under the principle, the court provides little guidance on what constitutes the “honesty” that good faith demands.

“We certainly don’t know the parameters of the duty, although we have a vague idea that contracts must be performed honestly and reasonably,” Berman says. “That means parties can’t lie and mislead, but what else does it mean? That’s a question the SCC has punted back to the provincial appellate courts.”

In attempting to limit its ruling, the SCC was careful to say that the duty of honesty is not a fiduciary duty, a duty of disclosure or a duty of loyalty and does not imply subordination of a party’s own interests. Instead, it imposes only “a minimum standard of honest contractual performance,” meaning that “parties must not lie or otherwise knowingly mislead each other about matters directly linked to the performance of the contract.”

Absent a bright line, lawyers are advising their clients to be more cautious in general and more careful in the answers they give to specific questions that are asked of them by parties to the contracts they negotiate.

To be sure, no one is suggesting that the good faith principle vitiates absolute discretion clauses in contracts as a matter of course. “The court is clear that parties can’t use the duty of good faith to elevate renewable contracts into perpetual contracts,” Mark says.

So financial institutions and other lenders, for example, can breathe a bit easier.

“For example, Bhasin does not imply that lenders must give or have reasons for calling demand loans,” says Eli Lederman of Lenczner Slaght Royce Smith Griffin LLP in Toronto. “But if they do give reasons, the reasons must be truthful.”

What is clear is that parties may not contract out of duties stemming from the organizing principle: they can, however, define or delimit them in a particular context so long as they maintain the minimum standard that a particular duty implies.

“Although the decision doesn’t give any specifics about when the parties can try to limit the need to communicate honestly, I do think it will change the way contracts are drafted,” Lederman says. “For example, lawyers might expand on absolute discretion by expressly stating that a right can be exercised for any reason at all or that no reason need be given for the exercise of a right.”

Certainly, the duty of good faith has impacted drafting and negotiating practice in the various states, including New York, California, Texas and Illinois, which have espoused the duty in their laws — in some cases for almost a century. It seems likely, then, that Bhasin will tend to complicate contract negotiations in Canada.

“What I’m starting to notice is that Bhasin is becoming a top-of-mind issue for in-house counsel, both when they’re entering into contracts and when they’re making the decision to terminate them,” Berman says.

 

According to Larry Lowenstein of Osler, Hoskin & Harcourt LLP in Toronto, that’s not necessarily a good thing.

“Parties will have to draft with precision on a point that was not previously problematic,” he says. “This sets off rounds of defensive lawyering that clients find difficult to understand and could produce results with which clients may find it difficult to comply.”

As Lowenstein sees it, however, the drafting problems aren’t the worst of it. “I just hope that this court, with the best of intentions, hasn’t set us on a road to hell,” he says. “Because even though the court may have intended its decision to be incremental, it has unwittingly unleashed something that the litigation Bar will feast on for at least a decade.”

The law regarding good faith was well established, at least in Ontario, says Lowenstein. Instead of creating an open-ended principle, he says, the court could have adopted a framework that required parties to carry out the contract to the letter of the law as objectively construed, and then confirmed that parties could not depart from that by refusing to act honestly and in good faith.

“Let’s say I agree to buy a house subject to financing, but I never make a real effort to come up with the money,” he says. “It’s bedrock law that I can’t do that.”

The court’s mistake, the lawyer adds, was to sever the concept of honesty from the concept of good faith. “That creates enormous terminological difficulties because good faith is normally defined in terms of the two key concepts of honesty and sincerity,” he says. “So decoupling the principle of honesty from the duty of good faith is a poor choice going forward.”

It’s hard to refute Lowenstein’s logic, given that generally speaking bad faith has not been a pervasive issue in contract litigation to date — certainly the common-law courts in Canada have not been swamped by such allegations.

While the SCC was at pains to point out that the sky had decidedly not fallen in jurisdictions where good faith was entrenched, good faith does seem to be a continuing staple of US litigation.

In Québec, the new Civil Code of Québec, which came into force in 1994, essentially codified the jurisprudence that had interpreted Article 1024 of the predecessor legislation, the Civil Code of Lower Canada, which did not explicitly refer to the duty of good faith. But as far back as 1962, the SCC’s decision in Cosmo Underwear Company Ltd. v. Valleyfield Silk Mills Ltd. confirmed that good faith was the essence of agreements in the civil law, governing not only their formation but also their performance.

The duty in Québec, however, is much broader than the one articulated in Bhasin: it goes beyond performance of the contract to its formation and throughout its term, and the standard for good faith is an objective one that goes beyond honesty to what a reasonable person would do.

That may explain why an automated search reveals that the three provisions in the current Civil Code of Québec have engaged more than 5,100 cases in 20 years, amounting to approximately 250 annually.

So while Bhasin did not, for example, purport to change the pre-existing law of good faith as it applies to employment contracts, it did open the door to new arguments. Some observers go so far as to say that the decision allows courts to become the moral conscience of transactions, opening broader avenues to fill any vacuum that judges perceive in the law.

That appears to be what has happened in California, where the duty of good faith has been ensconced since at least the 1980s. Still, it doesn’t appear to have created undue commercial uncertainty, largely because in general terms, courts adhere to the terms of contract as they are written. For the most part, the duty has been applied as a remedial gap-filler in situations involving egregious conduct that is inherently unfair.

 

Be that as it may, an increase in litigation is perhaps inevitable when a newly stated principle invites reference to hindsight.

“I believe that parties to litigation will look at the entire history of the contractual relationship with a view to finding a perceived dishonest act in the contract’s performance that will become the subject of a pleading invoking a breach of the duty of honest performance,” Lederman says.

Many lawyers believe, however, that Canadian courts will apply Bhasin only in exceptional circumstances in which there are extreme departures from parties’ reasonable expectations. Others have suggested that Canadian courts will apply the duty only when the dishonest conduct in question amounts to a “material element,” a limitation that could significantly reduce the volume of arguments about the scope of the duty of good faith.

So it may not be too long a time before things start to sort themselves out.

“I’ve already pleaded the decision in four different cases,” says Edward Babin of Babin Bessner Spry LLP in Toronto. “I’m also advising clients that it does present a potential argument that has some hope of success in a situation where I wouldn’t have given that advice before Bhasin came along.”

In other words, the duty of good faith suddenly has a general legitimacy in Canada that it lacked previously.

“The courts still have to shape the duty,” Babin says. “But there’s no doubt that Bhasin has already effected a change in litigators’ outlook.”

 

Julius Melnitzer is a freelance legal-affairs writer in Toronto.