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Landmark Decision Establishing New Duty to Act Honestly in Performing Contracts

Author(s): Larry Lowenstein, Jacqueline Code, Robert Carson

Nov 13, 2014

In a decision released this morning, Bhasin v. Hrynew, the Supreme Court of Canada recognized a new duty on parties to perform contractual obligations honestly. In the Court’s words: “This means simply that parties must not lie or otherwise knowingly mislead each other about matters directly linked to the performance of the contract.”

The Court’s general recognition of good faith contractual performance in all contracts, and the specific requirement to perform contracts honestly, is a change in the law in most areas of Canada (other than Québec). These principles have the potential to affect, among other things, the manner in which commercial parties structure agreements and the way that parties to a contract exercise existing rights, negotiate for future rights and generally communicate with each other. It remains to be seen whether this effect will be significant or whether the change is truly “incremental,” as the Court has said.

Good Faith as a General Organizing Principle

Prior case law was inconsistent regarding the existence of a duty of good faith in contract, the context in which it would arise and its scope. The Court held that, in order to resolve this piece-meal approach, it is time to take two “incremental steps” that are intended to make the law more coherent and just.

The first step is to acknowledge that there is a “general organizing principle” of good faith that applies. This is not intended to be a rule, but is a standard of behaviour which requires contracting parties to have “appropriate regard” for the interests of the other contracting party. Justice Cromwell, writing for the unanimous court, stated: “That organizing principle is simply that parties generally must perform their contractual duties honestly and reasonably and not capriciously or arbitrarily.”

What this organizing principle entails will differ in specific contexts. Importantly, it is not a duty of loyalty or a duty to put the interests of the other contracting party first. It is not intended to significantly displace the freedom of parties to pursue their own economic interests. Nor is it intended to be a basis for a court to scrutinize the motives of contracting parties or to impose its own sense of morality.

The Duty of Honest Contractual Performance

In the second – and more significant – incremental step, the Court held that there is a common law duty, which applies to all contracts, to act honestly in the performance of contractual obligations. Justice Cromwell explained:

         This means simply that 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. 

Justice Cromwell specifically distinguished the duty of honest performance from a positive duty of disclosure. The duty of honesty does not require a party to disclose material information to the other contracting party. However, a party cannot “actively mislead” or deceive the other contracting party in relation to performance of the contract.

The duty of honest contractual performance applies to all contracts and cannot be excluded by contractual language. However, in some circumstances, parties may establish their own standards for satisfying the duty, as long as they respect the core requirements of the duty.

Considerations

Given the breadth of the Court’s language, it can be anticipated that both the scope and implications of the general organizing principle of good faith and the specific duty of honest contractual performance will be the subject of significant debate by future courts seeking to interpret and apply these principles. In the meantime, the Supreme Court of Canada’s decision may have the following practical implications:

  • Drafting Agreements. Parties who are drafting agreements may want to consider including a provision that establishes their own standards of good faith performance for the purposes of the agreement. The contractual language that will be acceptable is not clear. Commercial practice in the United States may provide useful guidance.
  • Exercising Contractual Rights. The Court’s express recognition of the general organizing principle and duty of honest contractual performance could expand litigation risk and lead to increased lawsuits criticizing the manner in which a counterparty has exercised its rights under an agreement. It may be prudent for parties to document the process by which they arrived at discretionary decisions and exercised contractual rights, including the manner in which they took into account the interests of other parties.
  • Negotiating Future Rights. The Court did not address the existence of a duty to negotiate in good faith. Where the parties have agreed to negotiate future rights in good faith, a key issue that remains to be determined is how the duty of honest contractual performance can be reconciled with the adversarial nature of such negotiations. Parties likely would not be expected to disclose their negotiating positions, but they will certainly be required to avoid any action that could be viewed as actively misleading.
  • Communicating with Counterparties. Even though the Court is expressly concerned with conduct that is actively misleading or deceptive, and does not impose any positive duties of disclosure, many contracting parties could decide to be circumspect in what they say to each other in order to reduce litigation risk, at least until this duty is clarified. Such an effect may be counter-productive in fostering mutual cooperation between contracting parties. 

More information on Bhasin v. Hrynew, which contains an interesting point on appellate practice, can be found on Osler’s The Conduct of an Appeal blog.

 

By Larry Lowenstein, Jacqueline Code, Robert Carson

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