April 20, 2016

Good Faith and Reasonableness: Two Limits on Canadian Freedom of Contract

Marco P. Falco

The ideas of good faith and reasonableness have informed the Canadian common law’s approach to contract law for many years. Despite the importance of these two principles, however, Canadian courts have struggled to determine their scope and application. 

The approach of Canadian courts generally has been to impose minimal requirements on parties to a contract not to act arbitrarily and capriciously. Using the language of good faith and reasonableness, the courts have attempted to strike a balance between freedom of contract and the law’s imposition of minimal behavioral requirements on all contracting parties. 

The Principle of Good Faith and Honest Contractual Performance 

In 2014, the Supreme Court of Canada released a landmark decision in contract law entitled Bhasin v. Hrynew, [2014] 3 S.C.R. 494. The Bhasin case resolved a debate in the Canadian lower courts regarding whether the principle of good faith governed the law of contract and, if so, how. 

Prior to Bhasin, courts across the country adopted a range of positions on how the concept of good faith applied to commercial contracts. Some decisions held that there was no freestanding duty of good faith between contracting parties; these decisions held that imposing such a duty would interfere with freedom of contract. Other courts held that the duty of good faith applied to all contracts in Canada, though its boundaries remained obscure. Courts also disagreed on whether good faith could be implied into the language of the contract or whether good faith was an independent legal doctrine that always applied, regardless of the intentions of the contracting parties. 

To a large extent, the Supreme Court of Canada put many of these questions to rest in Bhasin. First, Bhasin established that good faith was an “organizing legal principle” of the common law of contract. This means that a variety of legal doctrines that courts regularly apply to commercial contracts emerge out of the principle of good faith. Doctrines such as unconscionability, i.e., where one party takes advantage of an inequality of bargaining power over another, is one aspect of the principle of good faith. The court explained that there is an organizing principle of good faith that parties generally must perform their contractual duties honestly and reasonably and not capriciously or arbitrarily. According to the court, “[a]n organizing principle states in general terms a requirement of justice from which more specific legal doctrines may be derived. An organizing principle therefore is not a free-standing rule, but rather a standard that underpins and is manifested in more specific legal doctrines and may be given different weight in different situations.” 

Second, Bhasin recognized a new legal doctrine created out of the principle of good faith. The court held that a duty of “honest contractual performance” applied to contracting parties in Canada. This duty imposes an obligation on parties not to lie or mislead one another in the performance of an agreement. Although parties are free to loosen the requirements of honest contractual performance through clear and explicit language, the court held that honest performance was a common-law duty imposed independently by the courts. The court characterized its recognition of this new duty as a “modest, incremental” change to the law of contract, noting that under the new  duty of honesty in contractual performance, “parties must not lie or otherwise knowingly mislead each other about matters directly linked to the performance of the contract. This does not impose a duty of loyalty or of disclosure or require a party to forego advantages flowing from the contract; it is a simple requirement not to lie or mislead the other party about one’s contractual performance. Recognizing a duty of honest performance flowing directly from the common law organizing principle of good faith is a modest, incremental step.” 

The Effect of Bhasin on Contractual Discretion and Reasonableness 

Over one year later, the court’s decision in Bhasin has raised a number of questions. One of the more intriguing issues is whether Bhasin in any way changed the law governing the exercise of contractual discretion. Specifically, prior to Bhasin, Canadian courts imposed a duty on contracting parties to exercise any discretion under their agreements reasonably. Did the duty of honest contractual performance and the principle of good faith, as set out in Bhasin, change the reasonableness standard applied to contractual discretion? 

This issue came to the fore in a decision by the Ontario Superior Court in Data & Scientific Inc. v. Oracle Corp., 2015 ONSC 4178, which involved the discretion not to renew a long-standing commercial contract between two parties. 

Data & Scientific Inc. was a member of Oracle Corporation’s partner network from 1994 to 2014. Oracle is a large, multinational computer technology corporation. The contract between Data & Scientific and Oracle gave Oracle the choice to renew the agreement between the two parties at Oracle’s sole discretion. For twenty years, Oracle renewed its agreement with Data & Scientific. However, on December 15, 2014, without prior notice to Data & Scientific, Oracle advised that it had decided not to renew the contract. 

Data & Scientific commenced an action against Oracle seeking damages for failing to renew the agreement. At its core, the suit alleged that Oracle had a duty to exercise its discretion under the contract reasonably. By failing to provide Data & Scientific with notice of the nonrenewal, Oracle allegedly breached the long-standing agreement between the parties. 

Oracle brought a preliminary motion to strike the suit. Oracle argued that, even if a duty to exercise contractual discretion reasonably was an aspect of the principle of good faith, this duty no longer applied to cases of contract renewal in view of Bhasin

In particular, Oracle argued that all that Bhasin now required was that contracting parties were honest with one another in deciding whether to renew a contract; in light of Bhasin, there was no longer any duty on a contracting party to act reasonably when exercising the discretion of nonrenewal under an agreement. 

The court rejected Oracle’s argument and dismissed its motion to strike the suit. First, the court held that, in Canada, there is an obligation on parties to a contract to exercise any discretion under the contract reasonably. Following Bhasin, this duty is yet another aspect or “situational example” of the foundational principle of good faith. However, Bhasin did not in any way alter this duty – it merely “realigned” it under the umbrella of good faith. 

Second, the court’s analysis in Bhasin focuses on dishonesty, not unreasonableness. Bhasin imposes a duty of honesty in the performance of the contract. It does not speak to a duty to act reasonably where a party has discretionary powers under an agreement. The court in Data & Scientific explains that “[t]he Court’s concern and focus in Bhasin was dishonesty not unreasonableness. The Court said nothing about the situation that is before me on this motion: there is a long-term 20 year business relationship, no written notice requirement regarding non-renewal and the discretionary power not to renew is allegedly exercised not dishonestly but unreasonably, i.e., without any notice whatsoever.” 

Accordingly, Bhasin did not alter the long-standing requirement that discretionary contractual powers be exercised reasonably. This obligation on contracting parties applies even in the case of a contract renewal, where a party has “sole discretion” in deciding whether to renew the agreement. Oracle’s failure to provide Data & Scientific with notice of the contractual nonrenewal, even if it was entitled to do so by the terms of the contract, could very well amount to a breach of the duty to exercise contractual discretion reasonably. 

The court further noted that the categories of situations in which good faith did or did not apply was not “closed.” In doing so, the court left open the possibility of new “situational examples” in which a party’s conduct could amount to a breach of good faith. Oracle’s motion was therefore dismissed, and Data & Scientific was allowed to pursue its lawsuit. 

The court’s reasoning in Data & Scientific confirms that:

  1. Bhasin really had no impact on preexisting contractual duties imposed at common law on parties to an agreement.
  2. Many of these preexisting duties, such as the obligation to exercise contractual discretion reasonably, were simply realigned by Bhasin under the “organizing principle” of good faith.
  3. Good faith encompasses a range of legal doctrines and situational examples, such as the doctrine of unconscionability, the duty of honest contractual performance, and the requirement that contractual discretion be exercised reasonably.
  4. The categories of contractual legal doctrines emerging out of good faith are not closed. Courts have the power to recognize and create new legal doctrines as the context of the case demands. 

In many ways, Bhasin has created a spectrum of good-faith contractual duties in Canadian law. On the low end is the minimal duty of honest contractual performance, which requires simply that parties to a contract do not lie to each other during the course of the contract’s performance. On the high end exist doctrines such as unconscionability, which ensure that unscrupulous parties do not take advantage of an inequality in bargaining power. In the middle is the good-faith duty to exercise contractual discretion reasonably, which requires that where a party can choose to exercise a contractual power in a certain way, that party does so in an objectively reasonable manner. 

As contractual disputes continue to test the boundaries of Bhasin in courts across Canada, one lesson remains clear: the concept of good faith remains a powerful and necessary limit on the freedom of contract. Canadian courts will not hesitate to employ the principle of good faith to address clear unfairness in ordinary commercial agreements.

Additional Resources

For other materials on this topic, please refer to the following. 

Business Law Today 

Delaware Supreme Court Affirms Award of Expectation Damages Resulting from a Party’s Failure to Negotiate the Terms of a Final Agreement in Good Faith
By Gary W. Lipkin
Vol. 25 No. 7 March 2016

“Promise Not to Lie”: The Duty of Honest Contractual Performance in Canada
By Marco P. Falco
Vol. 24 No. 4 December 2014

Marco P. Falco

Marco P. Falco is a partner in the Litigation Department at Torkin Manes LLP in Toronto, Canada.