Contractual Discretion Must Be Exercised Reasonably: Supreme Court of Canada

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The Supreme Court of Canada (“SCC”) in two recent decisions has continued to clarify and explain the scope of the principle of good faith, which was recognized by the SCC in 2014 as an organizing principle of contract law. The first of these decisions, Callow v. Zollinger, 2020 SCC 45 (“Callow”) (discussed in a previous post), dealt with one aspect of good faith in contracts: the duty to perform contracts honestly (commonly referred to as the duty of honest contractual performance). More recently, the Court released its ruling in the companion case of Wastech Services Ltd v. Greater Vancouver Sewerage and Drainage District, 2021 SCC 7 (“Wastech”), which clarifies a second aspect of good faith in contracting: the duty to exercise contractual discretion reasonably.

What Happened in Wastech?

The parties in this case were Wastech Services Ltd. (“Wastech”), a waste transportation and disposal company, and the Greater Vancouver Sewerage and Drainage District (“Metro”), a statutory body responsible for the administration of waste disposal from the Greater Vancouver region (together, the “Parties”).

The Parties had a long-standing contract which governed the removal and transportation of waste by Wastech to three disposal facilities: one in Vancouver, one in Burnaby, and one in Cache Creek (the “Contract”). Wastech was to be paid a differing rate depending on which disposal facility the waste was directed to and how far away the facility was located (i.e. Metro paid Wastech a different rate for waste disposed at the Cache Creek facility relative to the other two, mainly because Cache Creek is farther away). Pursuant to the Contract, Metro had absolute discretion to allocate waste to each facility.

Wastech had a target operating profit of 11% under the Contract. If in a given year Wastech’s actual operating profit varied significantly from this target, the Contract had mechanisms that would bring the numbers closer together. For example, if Wastech’s operating costs exceeded the target operating costs by a certain amount, Metro had to pay Wastech half the difference. If Wastech’s operating costs were less than the target operating costs, then Wastech would similarly compensate Metro. While these mechanisms were designed to bring Wastech’s actual profit closer to its target profit, the Contract did not guarantee that Wastech would achieve the target profit in any given year.

In late 2010, facing budget constraints, and seeking to maximize the remaining life of the Cache Creek facility, Metro exercised its contractual discretion and changed the allocation of waste so that less waste went to Cache Creek and more went to the Vancouver and Burnaby landfills. The decrease of the Cache Creek allocation – roughly 31% in 2011 relative to 2010 – caused Wastech’s operating profit for the 2011 year to sink to 4%, 7 points below target, even after the adjustment payment described above was taken into account.

Wastech launched an action against Metro, claiming damages of roughly $2.9M –the additional amount it says it would have made in 2011 but for Metro’s reallocation. Wastech alleged that Metro breached the Contract by preventing it from hitting its target profit.

First, the dispute proceeded to arbitration. The arbitrator found for Wastech, holding that Metro breached its duty of good faith by using its discretion in a way that prevented Wastech from achieving its target profits, and accordingly, awarded Wastech compensation. Metro appealed the arbitrator’s decision. The judge overturned the arbitrator’s award, holding that the arbitrator erred by characterizing Metro’s duty of good faith in a way that contradicted the words of the contract itself. In turn, Wastech appealed the judge’s decision. The Court of Appeal upheld the judge’s decision on the grounds that, among other things, the arbitrator had over-extended the duty of good faith. Wastech again appealed, this time to the SCC.

What Did the Supreme Court of Canada Decide?

While in Callow, the SCC had dealt with the duty of honest contractual performance, the question in Wastech was different because it turned on whether Metro had breached its duty under another branch of good faith, namely, the duty to act reasonably in the exercise of contractual discretionary powers.

The Court unanimously dismissed Wastech’s appeal and clarified the duty on contracting parties to exercise discretionary powers under a contract “reasonably”. The Court found that the question of whether a party has exercised its powers or discretion under a contract reasonably is measured by reference to the purpose of the contract, and in particular the purpose for which that party was granted the discretionary power at issue.

An exercise of a right or power that is consistent with the purpose for which it was granted is reasonable. On the other hand, an exercise of a right or power that is unconnected to its purpose under the contract is unreasonable or arbitrary, and thus in breach of the duty of good faith.

The Court emphasized that the question of reasonableness is not about whether the court considers the party’s actions fair. Rather, courts must measure reasonableness against the parties’ own expectations as embodied in the contract. If the exercise of discretionary power is unconnected to the underlying purpose of the agreement, it is unreasonable and thus contrary to the requirements of good faith.

Determining the “underlying purpose” of the contract is a matter of contractual interpretation that may depend on the particular clause or provision in question, or may involve reading the contract as a whole, including any recitals, and considering the circumstances surrounding the formation of the contract.

The Court also pointed out that reasonableness in this context does not require contracting parties to place their counterparty’s interests ahead of their own. The Court acknowledged that it is not necessarily unreasonable for parties to perform their contracts in a way that furthers their own interests – even if that comes at the expense of the interests of a counterparty. So long as the exercise of the contractual discretion in question aligns with the underlying purpose of the contract for which the relevant discretionary power was granted, self-interested performance can be reasonable in a post-Wastech world.

In Wastech, the SCC held that Metro’s decision to allocate waste in a way that hurt Wastech’s financial interests was reasonable. Reading the contract as a whole, the Court found that the purposes for which Metro was given the discretion to allocate waste included maximizing the waste capacity of the Cache Creek facility, maximizing efficiency, and minimizing costs.

The Court found that Metro’s exercise of its discretion to allocate waste aligned with these purposes; it made the decision in furtherance of its own business objectives, by maximizing the efficiency of the landfills and operating the overall system in a cost-effective manner. Its exercise of discretion in this manner was not contrary to the purposes for which the discretion was granted because guaranteeing Wastech a certain percentage of profit was not one of the purposes of the Contract.

For these reasons, the Court was unwilling to conclude that Metro’s decision was a breach of good faith, and therefore a breach of contract, even though it made it impossible for Wastech to achieve its target profit for 2011.

Key Take-Aways: Wastech Not, Want Not?

  • Pre-contract: When drafting and negotiating a contract, parties may want to carefully consider whether to include statements about the overall purpose of the agreement, and the specific purposes of any discretionary powers or rights granted to one or more of the parties under the agreement, especially when that discretion is absolute. Recitals can help this to be achieved.
  • Post-contract: When deciding how to exercise rights or discretions granted to them under a contract, parties should think about whether their proposed course of action aligns with purposes for which they were given that discretion and the underlying purpose of the contract as a whole.
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