Did the Supreme Court clarify or muddy the duty of good faith?

Illustration by Tina Zellmer
Illustration by Tina Zellmer

In Bhasin v. Hrynew, the SCC tried to make Canadian contract law more settled, fair and closely aligned with parties’ reasonable expectations. But does the decision clarify the law or muddy the waters?

T
o the extent that clients want a simple answer to everyday legal problems, the Supreme Court of Canada’s landmark decision in Bhasin v. Hrynew – despite the unanimous court’s protestations to the contrary – hasn’t done much to help them.

“I think the judgment is disingenuous because the court says it won’t change anything, when in fact it changes everything,” says Nicholas Kluge of Gowling Lafleur Henderson LLP in Toronto.

For the first time in common-law Canada, the court recognized that contracting parties have a legal duty to perform their contractual obligations honestly and with regard to the legitimate expectations of the other parties. The origin of that duty could be found in a general “organizing principle” of good faith performance.

Alan Mark of Goodmans LLP in Toronto, citing the SCC’s “upending” of the law on fundamental breach and repudiation some time ago, says that Bhasin is part of a continuing trend. “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 will be sanctioned and how to advise clients.”

While the Bhasin court described its ruling as an attempt to make Canadian contract law more settled, fair and more closely aligned with the reasonable expectations of the parties, the disparate and sometimes tortuous commentary that followed on the decision’s release suggests that the judgment falls short of its goals. “The court does give some guidance but ultimately the guidance is confusing,” says Mark’s partner Neill May.

Going forward, the key question about the decision from a practical standpoint is whether and to what extent it would change the way parties behaved in the performance of their contractual duties. The answer, it turns out, is somewhat muddy.

“It seems to me that both colleagues and clients are confused,” Kluge says. “Some people think the sky is falling, some aren’t surprised, and some don’t necessarily see the decision as negative but are concerned about its impacts.”

When Lexpert asked the question, answers ranged from “Not at all most companies already have a reasonable expectation that contracts are being performed in good faith,” to “The decision enunciates a fine legal point that amounts to an incremental change in the law that will result in no more than incremental change in behaviour,” to “This is a decision with legs whose meaning parties will be spending a long time litigating.”

Understanding why the decision prompted such diverse views and just what its practical implications really are, then, invites further analysis.

 

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 he sued, the central issue was whether the defendant owed him a duty of good faith.

“This was a very sympathetic plaintiff who had been treated very poorly, and because his damages didn’t flow from a recognized category that would have given him a remedy, the court created one for him but it went farther than it had to,” Kluge says. “Arguably, it’s just another case of hard facts making bad law.”

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 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-neighbour’ 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.

“The court has said you can’t lie, but we’ll leave everything else to another day, which makes the dividing line between what fits into good faith and what doesn’t quite blurry,” says Tim Pinos of Cassels Brock & Blackwell LLP in Toronto. “So now people have to police their business and caution employees about blowing smoke for fear it could be construed as a lie.”

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: rather, 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.”

Nadia Effendi of Borden Ladner Gervais LLP in Toronto says this means that “active dishonesty is not permitted, but the failure to disclose a material fact appears to be okay.”

Still, it’s not as if there is a bright line.

“The court said not to worry about it because the duty of honesty is not tantamount to a duty to disclose, but in the real world these duties are close to each other and can overlap,” Effendi says. “The difficulty is that people might be more inclined to be silent, and that doesn’t do much for achieving consensus in business communications and negotiations.”

Consequently, BLG is advising its 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 their contracts.

“If you’re keeping your cards close to the vest when you’re being asked certain questions, you’ve got to be careful that you don’t respond with those little white lies that could be interpreted as misleading or dishonest,” Effendi says.

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 duty of good faith to elevate renewable contracts into perpetual contracts,” Mark at Goodmans 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 at Lenczner Slaght 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 various states, including New York, California, Texas and Illinois, which have had the duty in their laws in some cases for almost a century.

“Lawyers try to anticipate where issues of discretion or judgment will arise in the context of the contract, and then try to craft some definition to avoid running afoul of bad-faith allegations,” says David Wawro of Torys LLP in New York. “When drafting earn-out provisions, for example, people define very explicitly what the buyer will and won’t do in running the business so as to avoid allegations of bad faith. ‘Best efforts’ clauses now also define very carefully what ‘best efforts’ means.”

It seems likely, then, that Bhasin will complicate contract negotiations in Canada.

“Parties will have to draft with precision on a point that was not previously problematic,” says Larry Lowenstein of Osler, Hoskin & Harcourt LLP in Toronto. “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.”

The Supreme Court, Lowenstein says, simply didn’t grasp the operational consequences of its decision in Bhasin. “These are the smartest and most capable judges,” he says. “But one wonders how often they had to draft one of these contracts.”

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.”

But Lowenstein maintains that the law regarding good faith was well established, at least in Ontario. 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, he 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 two key concepts of honesty and sincerity,” Lowenstein 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 up until now certainly the common-law courts have not been swamped by bad faith allegations.

While the SCC was at pains to point out that the sky had certainly not fallen in jurisdictions where good faith was entrenched, good faith does seem to be a continuing staple of US litigation. “Good-faith arguments continue to come up in litigation quite frequently,” Torys’ Wawro says.

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, governing not only their formation but also their performance.

“So even though the 1994 legislation was the first specific codification of good faith, it was really a restatement of the law as it existed,” says Ian Rose at Lavery, de Billy's Montréal office.

As Rose points out, the duty in Québec is much broader than the one articulated in Bhasin v. Hrynew. “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,” he explains.

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

Ian Dick of Toronto, a lawyer at workplace law boutique Hicks Morley Hamilton Stewart Storie LLP in Toronto, observes that while Bhasin did not purport to change the pre-existing law of good faith as it applies to employment contracts, it did open the door to new arguments.

“Although the Supreme Court denied it, the device it created does allow the court to become the moral conscience of a transaction and so opens the door to expanding the law,” he says. “Courts dispensing equity now have broader avenues to fill any vacuums that they perceive.”

Dick’s view mimics the California experience, where the duty of good faith has been ensconced since at least the 1980s.

“We perceive the doctrine to be a gap-filler,” says Colin Murray of Baker & McKenzie LLP in its San Francisco office. “It extends to any situation where egregious conduct is inherently unfair, so it is essentially boundaryless and always requires a case-by-case assessment.”

Nonetheless, the doctrine doesn’t appear to have created undue commercial uncertainty. “Generally speaking, the courts will adhere to the terms of the contract as written,” Murray says.

 

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 of Lenczner Slaght says.

But Dalton McGrath, of Blake, Cassels & Graydon LLP in Calgary, believes that, as a practical matter, these types of cases will be the exception. “Typically, we’re not seeing many cases of the high-handed conduct that may attract this sort of analysis,” he says. “Good-faith litigation will be confined to the small minority of cases that reveal extreme departures from the parties’ reasonable expectations.”

It may just be a matter of time before things sort themselves out.

“Regardless of the experience in Québec, there is now a broader litigation dynamic to exercising contractual rights than the common law has traditionally afforded,” says Robin Schwill of Davies Ward Phillips & Vineberg LLP in Toronto. “That’s going to increase the litigation, at least for some period of time, because any time someone tries to exercise their right within the four corners of an agreement, they will come up against a good-faith argument.”

Eventually, Schwill predicts, the courts will confirm that the dishonest conduct must have a “material element,” and the argument about good faith will take shape and abate.

But whatever the future holds, there’s an inherent irony in the debate about whether Bhasin leaves a legacy of greater certainty or greater uncertainty.

“Cases settle when lawyers cannot give their clients confident advice about the outcome,” Mark says.

But settling is a good thing? No? It’s all very confusing. Like Bhasin.