In the rapidly changing landscape of Canadian commerce, the basic idea of running a business is the dependability of business contracts. For many years, the rule of the road with commercial agreements between parties in Canada has been “freedom of contract”, implying parties are free to decide their contract terms, and the courts would only be very restrictive in enforcing these terms strictly per the written word. Still, recent developments in Canadian contract law show its growing recognition that a contractual relationship needs a minimum floor of honesty and mutual respect as support.
Central to the new development is the obligation to act in good faith. Whatever your reason for getting bound up, whether a long-term business lease agreement, supplier agreement signing, or employment negotiations, not having a firm grasp on this all-important concept of the law is like taking a gamble with the law and exposing your company. Courts in Canada don’t look kindly at businesses breaching their duty of good faith, so failure to realize this may result in unforeseen liabilities, lengthy court battles, and even loss of the business’ standing. This detailed resource sheds light on various facets of the duty of good faith in Canadian contract law, explaining what’s expected of a business when executing its contract performance, illustrating through court cases how the courts punish dishonesty, and giving a set of practical tips to make sure that your business is safe.
What Is the Duty of Good Faith?
The duty of good faith under the Canadian common law is an organizing principle which defines the manner in which the parties shall fulfill their contractual obligations and also how they shall exercise their contractual rights under the contract. Though the exact requirements may differ based on the nature of the contract, the key point that underlies the duty is that one party must not lie or mislead the other about matters connected with the performance of the contract.
The recognition of a general principle of good faith in all commercial agreements through common law was historically not a feature of Canadian common law. This was really changed by the historic decision of the Supreme Court of Canada (SCC) in Bhasin v. Hrynew, 2014 SCC 71. It was in this case that the SCC made good faith an organizing principle of the common law of contracts. As a result, the Court pointed out that there’s a duty for a party to do justice to the contract by acting honestly and reasonably rather than taking actions that are capricious, arbitrary, or based on whim.
It must be noted here that the common law is different from the statutory structure in Quebec. Whereas in Canadian law, through the civil system used in Quebec, the requirement of good faith is clearly expressed and included in the statutes. Article 1375 of the Civil Code of Quebec reads that good faith is an obligation of the parties during the creation, performance, and extinction of contractual obligations. Even so, the law in all jurisdictions in Canada is that one won’t be allowed to rely on the legal protection when one party has behaved dishonestly or when the whole issue is just pure deception.
What Does Good Faith Require From Contracting Parties?
Knowing the law is one thing; figuring out how to apply it in your daily business is quite another. In general, an operator must be in good faith, and that requirement is best manifested by two very different, though closely connected, doctrines: the duty to honestly perform a contract (honest performance) and the duty to exercise rights of contract in a manner consistent with good faith performance.
The Duty of Honest Performance
One of the key principles when it comes to honest performance is that the parties must not lie or knowingly mislead each other about matters directly linked to the execution of the contract. The obligation binds the two parties not to deceive each other as a standard of fair dealing, and they must adhere to their contractual duties regardless of the specific words used in the agreements. This fundamental principle is a requirement for all types of contracts. And in any case, the parties may not totally get rid of the principle, as the consequence of contracting away from it would be a negation of the essence of a promise between persons.
It’s also worth noting that acting in good faith doesn’t necessarily mean that you’re a fiduciary towards the other party. Putting their interests before your own doesn’t mean that you violate your contractual rights as long as you’re doing it lawfully. Then again, you’re still authorized to look for the opportunities that are agreed upon and made safe in the contracting language. Even so, you’re prohibited from deceiving someone in an active manner to obtain those benefits for yourself.
The Duty to Exercise Contractual Discretion in Good Faith
Many contracts empower one party to make decisions that affect both parties, approving a subtenant, setting bonus structure, or determining pricing, for instance. This power is termed contractual discretion and encompasses various contractual powers. The Supreme Court set a landmark with Wastech Services Ltd. V. Greater Vancouver Sewerage and Drainage District, 2021 SCC 7, by explaining that, when a contractual clause vests discretionary powers in a party, those powers have to be exercised within reasonable bounds and in the same spirit that guided contract formation.
If a party exercises its discretion for a purpose which is entirely out of line with what the parties had originally intended through the contract, such a party has committed a breach of contract. The legislation clearly prevents any such action done out of pure arbitrariness or arbitrary conduct, which defeats the central purpose of the shared understanding. At a glance, good faith implies regular fair dealing. It expects that you’re respectful of the other party’s reasonable expectations as established by the contract, not being deceptive, and that you use your discretion only in the way for which it was allowed to protect your legitimate contractual interests.
Examples of the Duty of Good Faith in Business Contracts
To fully grasp how these principles impact contract enforcement, it is helpful to look at practical examples of how the duty of good faith operates in real-world scenarios.
- Example 1: Withholding Critical Information During Performance
Consider a situation where a manufacturing organization has an agreement with the supplier. The manufacturer knows that a critical component supplied by the supplier is going to be phased out because of new regulation changes and that it will make the supplier’s stock obsolete. However, the manufacturer continues to place orders and string the supplier along. The manufacturer is ensuring to have a steady supply until a new supplier is found and, at the same time, the supplier is incurring expenses which the manufacturer is concealing. That’s misleading conduct, and it constitutes a clear breach of contract.
- Example 2: Abuse of Discretionary Pricing Mechanisms
Consider a commercial leasing scenario where the landlord may use their discretion to determine how to allocate and compute common area maintenance (CAM) operating costs to tenants. Now, imagine a situation where the landlord has a strong resentment against a particular tenant and, as there is no business justification for the action, they unfairly impose the costs on that particular tenant. This action represents an improper purpose for the landlord, and the use of discretion is only meant for their own benefit. Such conduct would breach the duty of good faith, even if the agreement mentions the landlord having “sole discretion” in CAM matters, as the contract gives.
- Example 3: Misrepresenting Future Intentions
Franchisees or dealers can usually look forward to a continuing relationship, if not explicit renewal rights. A circumstance in which a franchisor has already decided to cancel a franchisee’s contract but then says to them, “Your future looks bright with us, keep investing in your storefront,” can be considered as committing acts of bad faith. That’s when one party has a contractual relationship and yet leads their partner on a journey down a beautiful path while, in fact, they have a plan to end all relations. This is a breach of the very principle of honesty by engaging in dishonest conduct regarding one’s intentions behind making decisions that are detrimental to a contract.
Does the Duty of Good Faith Apply When Terminating a Contract?
Yes, the good faith obligation definitely applies to ending a contract, which is a frequent point of conflict in commercial litigation as well as employment disputes, firmly established by landmark decisions like Honda Canada Inc. v. Keays, where the court heavily penalizes bad faith and lack of candour during dismissals. While exercising termination rights was once a free pass for a party wanting out, and they could use that to end the contract no matter what, nowadays the exercise of that right is strictly scrutinized under the good faith obligation.
This was made firm in the recent court case of Zollinger SCC 45. The defendant in this case, a condominium company, had a winter snow removal contract with the plaintiff, Callow Inc. The plaintiff’s client was able to terminate the contract with a single day’s notice. Even so, they decided early in the spring that there was going to be a cancellation of Callow’s winter contract. Surprisingly enough, that became the point where they started lying to the company. The corporations even went a step beyond that and kept the whole termination matter under wraps while they were leading Callow on, hoping for a renewal. As a result, Callow did a couple of small free landscaping services for them to impress the corporations further.
Later on, when the condo boards did exercise, per law, their 10-day termination right, Callow brought an action against them. The Court ruled in favour of Callow. The Supreme Court decided the matter in favour of one party, but the other party couldn’t be expected to act honestly. To businesses, the main idea is that although you can legally withhold the information at the moment about your intent to terminate a contract, at no point should you actively lie or engage in any deceptive behaviours to hide the exercise of your termination rights. If someone asks whether the contract is in effect anymore, you should either respond truthfully or say you can’t comment; make sure not to make a false statement to keep them under a contractual obligation.
How Can Businesses Protect Themselves From Good-Faith Contract Risks?
Because of the changing way of contract interpretation by Canadian courts, it’s wise to adopt risk management ahead of time. While the distinction between vigorous business negotiation and a claim of having been in bad faith may at times appear uncertain, the adoption of specific, well- thought-out steps can be a legal firewall to prevent businesses from having to bear liability.
- Draft Clear and Precise Contract Terms: The most effective way to shield yourself from conflicts over what’s reasonable is to have absolutely clear written agreements. All of the parties’ contractual obligations must be made explicit. It will help if you clearly explain what the exercise of a grant of discretion is based on or if you describe the purpose of that discretion. The more limited in terms and the more specific the discretion, the less chance will the other party have of asserting that it has been misapplied.
- Document Your Decision-Making Processes: Whenever contractual freedom is being exercised – which could range from rejecting an offer, determining a variable price, to changing allocation – internal documents should be maintained explaining the reasoning for the decision. Should your company be accused of arbitrary behaviour afterwards, you’ll have the best possible evidence of defence by having at your disposal records showing the decision was made based on legitimate business justifications.
- Train Your Team on Honest Communication: The root cause of a lot of honest disagreement isn’t so much what the CEO has done as it’s what project managers, sales reps, or procurement officers have done by over- promising or speaking recklessly. The employees should be taught the various legal implications of contract performance and that even as they represent the company’s interests, they must steer clear of half-truths, deceptive omissions and steering the business partner away from the truth.
- Audit Your Termination Strategies: Before you use termination rights, look back through a whole timeline of communications with the other party. Are they now expecting the contract is stable? Is this capital investment made after your team’s reassurances? You might also want to examine if, from the exit you’ve in mind, the other party might feel they’ve been deceived.
When Should a Business Speak to a Contract Lawyer?
Understanding the subtleties of commercial agreements goes well beyond the literal words on a page. One must have knowledge of the implied, common-law duties that dictate how such words are legally interpreted and enforced. The covenant of good faith is like a hidden companion in each contract you enter into, influencing the entire contractual structure.
A business should consult with an experienced contract lawyer in several critical scenarios:
- During the Drafting and Negotiation Phase: One of the main roles of a lawyer in a contract is to assist you in shaping agreements where your contractual discretion can be clearly laid out. That’s where they help you ensure that your rights are secure and that there isn’t an overwhelming level of ambiguity.
- Before Exercising Major Contractual Rights: A skilled attorney will provide the legal perspective necessary to guide you in terminating a key supplier, using a penalty clause, or rejecting a contract renewal. Through this legal expertise, they can review your messaging and communication strategy to ensure that every move is legal as per the standards set out by the Supreme Court.
- When Facing a Potential Dispute: There may come a time when you believe that your business partner is acting in a dishonest manner or is misusing their powers for an improper purpose. If such an instance occurs, you may consider taking legal action at an early stage to put a stop to the damage and safeguard your financial stake.
We understand that our customers prefer putting all their efforts into developing their businesses rather than dealing with lengthy and expensive legal disagreements. By working with knowledgeable and legal practitioners, you’ll know that the agreements have not only been approved by the regulations and lawyers, but that they contain the necessary clauses and words so that, if they become necessary, you can really be able to go ahead and enforce them. Also, they prevent legal threats coming from the high risks and nature of modern-day trade and commerce.
Obtaining proactive legal advice proves to be much more economical than having to salvage a failed situation in the later stage. If you wish to understand how the good faith obligation affects your current contracts, get in touch with us at Pacific Legal for better clarification and safeguard your future.
