Supreme Court of Canada Recognizes Duty of Good Faith in Exercise of Contractual Discretion

In Wastech Services Ltd. v. Greater Vancouver Sewerage and Drainage (Wastech), the Supreme Court of Canada (SCC) recognized a general duty to exercise contractual discretion in good faith. This bulletin summarizes the SCC’s decision, explains the content of the duty and provides some practical tips to avoid breaching the duty.

WHAT DID THE SCC HOLD?

The SCC affirmed that there is a duty to exercise any discretionary power in a contract reasonably, which it defined to mean in a manner connected to the purposes for which the discretion was granted. The exercise of discretion for an arbitrary, capricious or extraneous purpose will breach this duty of good faith. The underlying purpose of a discretionary power is a fact-specific analysis connected to the interpretation of the contract.

The SCC acknowledged that there is a range of reasonable outcomes that can result from the exercise of any discretionary power. The concept of a “reasonable” exercise of discretion does not mean that good faith can be used as a pretext for scrutinizing a party’s motive for exercising discretion in a particular way, or whether its decision was commercially wise. Moreover, parties are not obligated to subordinate their own interests to those of their contracting partners and remain free to act in their self-interest within the bounds set by the contract.

The majority of the SCC held that the duty to exercise discretion in good faith cannot be excluded by the parties in their contract. However, a minority was of the view that the parties should be able to create unconstrained discretionary powers in a contract, provided they do so in clear language.

WHAT HAPPENED IN WASTECH?

Wastech Services Ltd. (Wastech) entered into a waste disposal agreement with Greater Vancouver Sewerage and Drainage District (Metro). The contract gave Metro “absolute discretion” to direct waste to any of three disposal sites. Wastech would be paid a different rate depending on the disposal site chosen. The contract contained a target revenue-to-operating-cost ratio (Target OR) with adjustments to Wastech’s compensation if the Target OR was not met in a given year. However, the contract did not guarantee that Wastech would meet the Target OR.

In 2011, Metro re-allocated where to send waste among the three disposal sites, which resulted in a lower than expected profit for Wastech. Wastech alleged that Metro acted in bad faith and therefore breached the contract by exercising its discretion in a way that deprived Wastech of any opportunity to meet the Target OR.

The SCC dismissed Wastech’s claim and held that Metro did not violate the duty to exercise contractual discretion in good faith. The SCC held that the purpose of Metro’s discretion to allocate waste was to give it flexibility to maximize efficiency and minimize costs. The contract did not guarantee Wastech any specific level of profit and Wastech could not use good faith to obtain an advantage for which it did not bargain.

WHAT TYPES OF CONDUCT WILL BREACH THE DUTY TO EXERCISE DISCRETION IN GOOD FAITH?

The SCC was clear that the underlying purpose for which a discretion was granted is the primary consideration in determining whether an exercise of discretion is unreasonable. An exercise of discretion will be unreasonable (i.e., made in bad faith) where it:

• Is arbitrary or capricious

• Is made for purposes extraneous to the contract

• Falls outside a range of reasonable outcomes contemplated by the contract

However, a party is not required to subordinate its own interests to those of its counterparty or act as a fiduciary. An exercise of discretion will not breach the duty of good faith merely because it:

• Is motivated by self-interest

• Causes financial loss to the other party

• Is contrary to the other party’s commercial interests

• May be unwise from a business perspective

WHAT ARE SOME PRACTICAL TIPS TO AVOID BREACHING THE DUTY TO EXERCISE DISCRETION IN GOOD FAITH?

• Defining the nature and purpose of the discretionary power in the contract. Clearly setting out the nature and intended breadth of the discretionary power or the purpose for which it has been granted will help avoid uncertainty in the event of a dispute.

• Drafting contract recitals carefully. Recitals may be used as evidence of the purpose of the contract as a whole or of a specific discretionary clause. They may become important in interpreting the scope of a discretionary power or range of reasonable outcomes.

The Wastech appeal was heard together with C.M. Callow Inc. v. Zollinger, which addressed the duty of honest contractual performance. The Callow case is summarized in our Blakes Bulletin: Callow and the Duty of Honest Contractual Performance.

For further information, please contact:

Nicole Henderson                   416-863-2399
Christohper DiMatteo            416-863-3342
Catherine Beagan Flood        416-863-2269
 
or any other member of our Litigation & Dispute Resolution group.