‘Why’d Ya Do It?’ The Supreme Court Of Canada Explains The Duty To Exercise Contractual Discretion In Good Faith – Corporate/Commercial Law

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The Supreme Court of Canada (“SCC“)
recently released its long awaited decision in Wastech Services Ltd v Greater
Vancouver Sewerage and Drainage District

(“Wastech“).1

The decision is the first time the SCC has provided guidance on
the scope of the duty to exercise discretionary contractual powers
in good faith.  Significantly, Wastech:

  • Confirms that the duty to exercise
    discretionary contractual powers in good faith, like the duty of
    honest contractual performance, applies to all contracts and cannot
    be excluded by the parties;

  • Clarifies that the duty is breached
    where a party exercises a contractual power
    “unreasonably”, meaning in a manner not connected to the
    underlying purposes for which the discretion is granted;

  • Mandates that when ascertaining
    whether an exercise of discretion is unreasonable, and therefore a
    breach of the duty, the court must interpret the contract (the
    “first source of justice between the parties”) as a
    whole.  The content of the duty is guided by the intentions of
    the parties as expressed in their agreement.  Where discretion
    is exercised in a manner that falls “outside the compass set
    by contractual purpose”, it is unreasonable and constitutes a
    breach of the duty.  Conversely, where discretion is exercised
    in a manner consistent with the purposes for which it is granted,
    it is reasonable and does not breach that duty.  In other
    words, the measure of fairness is what is reasonable according to
    the parties’ contract, and not what a court may regard as fair,
    moral or reasonable in the abstract;

  • Recognizes that the fact that a
    party’s exercise of discretion causes its counterparty to lose
    some, or even all, of the anticipated benefit under the contract,
    is not the standard for determining a breach of the duty. 
    While this can be relevant to show that discretion was exercised
    unreasonably, it is not a necessary precondition to finding a
    breach of the duty; and

  • Confirms that the common law
    recognizes that competition between parties regularly involves each
    of them taking steps to promote their interests at the expense of
    the other, and that, far from prohibiting such conduct, the law
    seeks to encourage and protect it.  This leaves room for the
    aggressive pursuit of self-interest and prevents the law of good
    faith from veering into judicial moralism or “palm tree
    justice”.  The role of the courts must only be to ensure
    parties exercise contractual discretionary powers in ways that are
    connected to the purpose(s) for which such powers are granted.2

Applying these principles, the SCC concluded that the defendant
in Wastech did not exercise the discretionary power at
issue unreasonably, and therefore, no breach of the duty to do so
in good faith occurred.

Background: Uncertainty Regarding the Exercise of Contractual
Discretion Following Bhasin

The duty to exercise contractual discretion in good faith is
well-established in Canadian common law. In Bhasin v Hrynew
(“Bhasin“), the SCC recognized
‘good faith’ as a general organizing principle of contract
law that requires a party to a contract to have “appropriate
regard to the legitimate interests of the contracting
partner.”3 This principle requires
parties, at minimum, to perform their contractual duties, and
exercise their contractual rights, “honestly, reasonably, and
not capriciously or arbitrarily.”4 The general organizing
principle is manifest in specific doctrines of good faith,
including the duty to exercise contractual discretion in good
faith.

In Bhasin, the SCC explained that “appropriate
regard” will vary depending on the context of the contractual
relationship. It did not set out, however, a standard for the
exercise of contractual discretion. This left uncertainty as to
whether the duty of good faith could limit a party’s freedom to
exercise its discretion in its own commercial interest where doing
so would deprive the other party of an anticipated benefit under
their agreement or cause them a loss. This issue came squarely
before the SCC in Wastech.

The Facts in Wastech

The Plaintiff, Wastech Services Ltd.
(“Wastech“), provides waste
transportation and disposal services to the Greater Vancouver
Sewerage and Drainage District (referred to in the decision as
Metro“) under a 20-year long-term
agreement the parties entered into in 1996. The agreement is
complex and resulted from lengthy negotiations.5 Among other things, it gives
Metro the “absolute discretion” to direct waste to any of
three disposal sites.  Metro paid Wastech different rates
depending on the disposal site to which Metro directed waste be
hauled (and how far away the site was located).

Wastech’s compensation under the agreement was tied to a
“target operating ratio” that was based on historical
performance (the “Target OR“).
Wastech’s ability to achieve the Target OR depended in part on
the allocation of waste between the three disposal sites, one of
which attracted a higher rate due to its greater distance from
Vancouver. During their negotiations, the parties considered the
possibility that Metro would reallocate waste to the more
cost-efficient sites. They understood that such reallocation would
likely preclude Wastech from achieving its Target OR but declined
to include express protections for Wastech in such event.6

For the 2011 year, Metro directed Wastech to reallocate a
portion of waste from a disposal site located further away (and
more lucrative for Wastech) to the two sites that were closer,
resulting in Wastech recording an operating profit that was well
short of its target. Wastech commenced an arbitration against Metro
for breach of contract. It alleged, among other things, that Metro
breached its duty to exercise its contractual discretion in good
faith by reallocating the waste between sites in a manner that
precluded it from achieving its Target OR, and sought damages of
approximately $2.9 million.7

The Arbitrator’s Decision

In arbitration, Wastech conceded that the agreement provided
Metro the “absolute discretion” to allocate waste among
the three disposal sites. It claimed, however, that Metro’s
decision constituted a breach of contract in two respects. First,
Wastech argued that the contract contained an implied term
providing for a retroactive rate adjustment if the Target OR was
not achievable because of Metro’s waste allocation. Second,
Wastech argued that the duty of good faith prohibited Metro from
exercising its discretion in a manner that precluded Wastech from
achieving the Target OR.8

The arbitrator dismissed Wastech’s implied term argument,
finding that the parties had turned their minds to the possibility
that Metro would reduce the waste flows to the more expensive site
during their negotiations but decided not to include any provision
to address that risk. Regarding Wastech’s second argument, the
arbitrator accepted that Metro had no malign purpose in making its
reallocation decision and held that the basis for its conduct was
in furtherance of its own honest and reasonable business
objectives. However, the arbitrator concluded that Metro’s
behavior lacked “appropriate regard” for Wastech’s
legitimate contractual interests and was, in effect,
“dishonest”.9

The arbitrator interpreted the duty of good faith in
Bhasin to prevent Metro from exercising its contractual
discretion in a manner that is “wholly at odds with the
legitimate contractual expectations” of Wastech. Accordingly,
the arbitrator found that Metro failed to consider Wastech’s
expectation that Metro would not exercise its discretion in a way
that would prevent Wastech from achieving the Target OR.

The Lower Courts Set Aside the Arbitrator’s Decision

Metro appealed the arbitrator’s decision to the British
Columbia Supreme Court (“BCSC“) on the
basis that the arbitrator misapplied the organizing principle of
good faith set out in Bhasin. The BCSC allowed the appeal, holding
that the duty of good faith does not impose an obligation to have
“appropriate regard” for the interests of the other
contracting party unless specifically agreed to by the parties.10 By restricting Metro’s
discretionary contractual power, the arbitrator effectively ignored
a contractual provision reached between two sophisticated parties
who chose to exclude a term that might have provided Wastech with
additional protection.11

Wastech then unsuccessfully appealed to the British Columbia
Court of Appeal (“BCCA“). The BCCA
agreed with the BCSC’s ruling but substituted its own findings
regarding the arbitrator’s decision. Among other things, the
BCCA held that a breach of the duty of good faith requires some
subjective element of dishonesty, untruthfulness, improper motive
or “bad faith”.12 Wastech then
appealed to the SCC.

The SCC Dismissed Wastech’s Appeal

A six-justice majority of the SCC dismissed Wastech’s
appeal, with a three-justice minority concurring in the result. In
doing so, they set out important guidance as to how the duty of
good faith affects contractual discretionary powers. Significantly,
both the majority and minority held that the duty of good faith is
offended where a discretionary power is exercised in a manner that
is unconnected to the purpose(s) for which it was granted in the
relevant agreement.

The Majority Decision

As a preliminary point, the majority noted that Metro had not
breached its duty of honest contractual performance (a separate
legal doctrine within the organizing principle of ‘good
faith’). The majority generally agreed with the BCCA that a
breach of the duty of good faith must include some subjective
element of dishonesty. Metro had not, however, lied or otherwise
knowingly misled Wastech about its discretionary power to allocate
waste between the different sites.13

The SCC also disagreed with Wastech’s argument that Metro
breached the duty of good faith by unreasonably exercising its
discretion to reallocate waste between disposal sites in a manner
that substantially nullified Wastech’s ability to make a
profit.

The majority held that “substantial nullification” of
a contractual benefit or advantage is not the appropriate standard
for assessing whether a party has breached its duty to exercise
discretionary powers in good faith.14 The majority went on to note
that the fact that a party’s exercise of discretion may cause
its counterparty to lose some or even all of its anticipated
benefit under the agreement is not dispositive of whether that
power was exercised in good faith (though it may be relevant to
that question).15

Instead, a party must show that an exercise of discretion is
unreasonable in the sense that it is outside the bargain struck
between the parties. In other words, for a party to exercise its
discretionary power in good faith, it must do so consistently with
the purpose(s) for which the discretion was granted.16 Where the exercise of
discretion “stands outside the compass set by contractual
purpose”, it will be unreasonable and a breach of the duty of
good faith.17

Determining the reasonableness of a party’s exercise of
contractual discretion is an interpretive exercise. Sometimes, the
text of the discretionary provision will make its purpose clear.18 In other circumstances, the
purpose can only be understood by reading the clause in the context
of the contract as a whole.  The majority cited approvingly
from an English authority for the proposition that courts
“must construe the ambit” of a discretionary power where
it is entirely general: they must “form a broad view of the
purposes of the venture to which the contract gives effect”.19 This appears to mean that
courts should look to the overall purpose of the parties’
agreement rather than just the purpose of the discretionary
provision.

Importantly, the legal test does not involve examining whether
an exercise of discretion was “morally opportune or
wise”.20

The majority noted that, as a general guide, clauses that
restrict the exercise of a discretionary power on the basis of
objective criteria (such as operative fitness, structural
completion, mechanical utility or marketability) will give rise to
a smaller range of reasonable discretionary outcomes than clauses
that do not (such as matters involving taste, sensibility, personal
compatibility or subjective judgment).21

The majority found that Metro’s reallocation of waste was
consistent with the purposes for the discretionary power in the
agreement. Reviewing the agreement as a whole (including the
recitals, which described the intentions of the parties as
including: to incentivize each other to “maximize efficiency
and minimize costs” and to provide for the “maximization
of the municipal solid waste disposal capacity [at the disposal
site that was further away from Vancouver])”, the majority
concluded that the purposes underlying Metro’s discretion were
clear: to give it the flexibility required to structure the
disposal of waste in an efficient and cost effective manner.22

The majority also noted that Metro’s discretion exists
alongside a contractual framework to adjust payments towards the
goal of a negotiated level of profitability – which
contradicts Wastech’s argument that the parties intended the
discretion to be exercised in a way that provided Wastech with a
certain level of profit.  Moreover, the contract did not
guarantee Wastech would achieve the Target OR in any given year and
the complex adjustment mechanism contained therein, which only
applied where its actual operating revenue for a given year
deviates from the Target OR, demonstrates the parties understood
the Target OR would not be achieved in some years.23

Based on the above, the majority concluded that the purposes of
the discretion was to give Metro leeway, based on its judgment as
to what was best for itself, to adjust the allocation of waste
among the three sites as required to ensure efficiency of the
operation.  Significantly, the SCC confirmed that the duty
does not require Metro to subordinate its interests to those of
Wastech. Metro will have complied with the duty of good faith as
long as it exercised the discretion in a manner consistent with the
purposes in the agreement. While Metro’s choice was
disadvantageous to Wastech, it was within the range permitted by
the purposes of the clause.  Because Metro exercised its
discretion within the range of conduct contemplated by the purposes
for the clause, the court concluded it acted reasonably and did not
breach the duty of good faith.24

The Minority Decision

The three concurring justices agreed with the majority that the
purpose of a discretionary power is the proper focus of the good
faith analysis, and that Wastech’s appeal should be dismissed.
They departed from the majority on a few issues, including the
scope of the reviewing court’s interpretative exercise in
identifying the purpose of a discretionary power.25 Importantly, they held that
a discretionary power should only be limited by its purpose
“where the purpose of a discretionary power arises from the
terms of the contract, construed objectively, having regard to the
factual matrix”. In other words, they would prefer a narrower
focus on the text and context of the agreement to determine the
purpose of the discretion. They would reject the majority’ view
that a court must “form a broad view of the purposes of the
venture to which the contract gives effect”.26 The minority were steadfast
in their view that the purpose for a discretionary power must
always be defined by the parties’ intentions, “as
revealed by the contract
“.27 The parties have the freedom
to immunize themselves from review by the courts by careful
drafting that establishes a standard for exercising discretion.
Where parties have granted unfettered discretion, there is no
obligation on the discretion-exercising party to subvert its
interest in favour of the other party.

Key Takeaways

  • Parties must exercise contractual
    discretionary powers in good faith. This duty, like the duty of
    honest contractual performance, is not an implied term but rather a
    general doctrine of law that applies to all contracts. 
    Parties cannot contract out of this duty by, for example, using the
    term “absolute and sole discretion” or words to that
    effect.

  • The duty to exercise discretionary
    powers in good faith is breached where the exercise of discretion
    is “unreasonable”, in that it is unconnected to the
    purpose(s) for which the discretion was granted.  In this
    regard, Wastech provides some much needed clarity and
    certainty as to when the duty may be found to have been breached,
    and when it will not.

  • What is “reasonable” is
    highly context-specific and depends primarily on the intention of
    the parties as disclosed by the language of their contract, not
    general notions of fairness or morality. The court will examine the
    contract as a whole to ascertain the purpose(s) for which
    discretion is granted, and thereby delineate the boundaries for
    assessing whether such discretion was exercised in a reasonable
    manner.  As the SCC put it: “Good faith does not
    eliminate the discretion-exercising party’s power of choice.
    Rather, it simply limits the range of legitimate ways in which a
    discretionary power may be exercised in light of the relevant
    purposes”.28

  • An exercise of discretion will be
    regarded as unreasonable (and therefore, contrary to the duty of
    good faith) if it is arbitrary or capricious, made for purposes
    extraneous or collateral to the contract, or where it is
    unconnected to the purpose(s) for which the contract granted the
    discretion (where it can be said to stand “outside the compass
    set” by the contract).

  • By contrast, an exercise of
    discretion will be regarded as reasonable (and therefore consistent
    with the duty of good faith) where it is consonant with the
    purpose(s) for which such discretion was granted.   Such
    an exercise of discretion will not violate the duty simply because
    it is motivated by self-interest, causes loss to the other party or
    is against the other party’s commercial interests.

  • Moreover, whether a party’s
    exercise of discretion substantially nullifies or eviscerates an
    anticipated benefit of its counterparty is not the standard for
    determining whether the duty is breached.  While this may be
    relevant to whether a party acted unreasonably, it alone is not a
    precondition to finding a breach of the duty.

  • The duty does not require parties to
    provide their counterparties with benefits not contemplated by the
    contract, and cannot be used as a tool to rewrite contracts.
     Further, it does not require parties to put their
    counterparties’ interests before their own, or require them to
    act as a fiduciary.  The loyalty required by the duty is
    loyalty to the bargain, (meaning the contractual
    purpose(s) for which the discretion is granted), not loyalty to
    one’s contractual counterparty.29

  • Generally, the range of reasonable
    outcomes will be relatively smaller where the discretionary power
    at issue is susceptible to objective measurement. By contrast,
    where the discretion at issue is not readily susceptible to
    objective measurement, the range of reasonable outcomes will be
    relatively larger.30

  • Although parties cannot contract out
    of the duty to exercise discretionary powers in good faith, they
    can to a large extent immunize the exercise of such powers from
    court review through careful drafting.  Parties are
    accordingly advised to set out, in clear and express contractual
    terms, the circumstances in which discretion is to be exercised,
    the purpose(s) for which discretion is to be exercised and the
    breadth of such discretion.  This may be accomplished in the
    discretion-granting clause itself, or elsewhere in the agreement
    such as the recitals.  Recital clauses may be used, as they
    were in Wastech, as evidence of the parties’ intentions
    regarding both the purpose(s) of the contractual arrangement as a
    whole as well as those relating to specific discretion-granting
    provisions.

Footnotes

1 2021 SCC 7. The Wastech case is
the second of two SCC decisions in 2021 revisiting the duty of good
faith in contracts that that was recognized in
Bhasin v Hrynew. The SCC
heard the Wastech case together a companion case, C.M.
Callow Inc. v. Tammy Zollinger et. al

(“Callow“), which addressed the
duty of honest contractual performance.  Our commentary on the
Callow case is available here.

2 The Wastech decision also
presented the SCC with the opportunity to consider the standard of
review applicable to appeals of commercial arbitration
awards.  The majority, however, declined to do so, noting that
the parties did not make submissions on that point and, in any
event, the outcome of this appeal did not turn on whether the
standard is reasonableness or correctness.

3 Bhasin, 2014 SCC 71 at para
65.

4 Ibid at paras 63-64.

5 Greater Vancouver Sewerage and
Drainage District v. Wastech Services Ltd
., 2018 BCSC 605 at
para 8.

6 Wastech, supra note 1 at para 14;
2018 BCSC 608 at para 19.

7 Wastech, supra note 1 at para
18.

8 Ibid at para 20.

9 Ibid at para 24.

10 Greater Vancouver Sewerage and
Drainage District v. Wastech Services Ltd
., 2018 BCSC 605 at
para 56.

11 Wastech, supra note 1 at para
33.

12 Ibid at para 40.

13 Ibid at para 56.

14 Ibid at para 82.

15 Ibid at paras 83-84.

16 Wastech, supra note 1 at para
69.

17 Ibid, at para 71.

18 Ibid, at para 72.

19 Ibid, at para 72, citing P. Sales
“Use of Powers for Proper Purposes in Private Law”,
(2020), 136 LQR 384 at p. 393.

20 Ibid, at para 73.

21 Wastech, supra note at para
77.

22 Ibid, at paras 97-98.

23 Ibid, at paras 99 and
103.

24 Wastech, supra note 1 at paras
104-106.

25 The concurring minority’s reasons also
addressed the appropriate standard of review on appeal from an
arbitrator’s decision, the usefulness of comparisons with
notions of good faith under Quebec Civil Code and the
majority’s reference to the duty of honest performance, which
are not discussed in this bulletin.

26 Wastech, supra note 1 at paras 72
and 132.

27 Ibid, at para 133 emphasis
added.

28 Wastech, supra note 1at para
75.

29 Ibid, at para 107.

30 Ibid, at para 77.

The foregoing provides only an overview and does not
constitute legal advice. Readers are cautioned against making any
decisions based on this material alone. Rather, specific legal
advice should be obtained.

© McMillan LLP 2020

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