Discretionary Powers in Contracts: The Duty to Act in Good Faith
February 2021 - 5 min read
Since 2014, Canadian courts and tribunals have struggled with the application of the duty to act honestly in the performance in contractual obligations, recognized by the Supreme Court of Canada ("SCC") in Bhasin v Hrynew. In attempts to clarify the doctrine of good faith in contractual relations, the SCC issued two recent decisions:
The Wastech decision reviews the duty to exercise discretionary powers in good faith and what conduct is an abuse of contractual discretionary powers. Discretionary powers are provided for in a wide variety of agreements, from employment agreements to complex commercial agreements, and this decision provides necessary guidance on how parties should negotiate, draft and exercise discretionary powers in contracts.
In 1996, Wastech Services Ltd. ("Wastech") and Greater Vancouver Sewerage and Drainage District ("Metro") entered into a 20-year agreement regarding the removal and transportation of solid waste from the Vancouver regional district. Metro would pay Wastech differing rates to remove and transport waste, depending on which facility the waste was taken to and the location of that facility. Wastech's compensation was structured around a target ratio of operating costs to total revenue. Metro would provide an annual estimate of the waste to be allocated, which would allow Wastech to plan its operating costs. The agreement did not provide any guarantee that Wastech would achieve its target ratio. Metro had "absolute discretion" to allocate waste.
In 2011, Metro reallocated waste to closer facilities, which significantly affected Wastech's target ratio. As a result of the waste reallocation, Wastech's contractual profit margin was negatively impacted (its operating profit was 7% below its target).
Wastech alleged Metro breached the agreement by exercising its discretion in bad faith by allocating waste to facilities in a manner that caused Wastech to fall below its target profit for 2011.
The dispute was initially referred to arbitration. The arbitrator concluded Metro had breached its duty of good faith and, therefore, Wastech was entitled to compensatory damages.
The arbitrator found Metro had the discretion to allocate waste between facilities and refused to imply a term into the agreement that restricted Metro's discretion. The evidence demonstrated that the parties had considered such a provision during negotiations and purposefully omitted it. In exercising its discretion, the arbitrator held that Metro's conduct was honest and reasonable, even though it acted in furtherance of its own objectives. There was no evidence that Metro exercised its discretion capriciously or arbitrarily.
However, the arbitrator concluded that Metro breached its duty of good faith by exercising its discretion without considering Wastech's legitimate contractual expectations. The arbitrator's view was that Metro could exercise its discretion in a manner that had a financial impact on Wastech but not to the extent that it deprived Wastech of the opportunity to achieve its target ratio.
Appeal to British Columbia Courts
Metro appealed to the Supreme Court of British Columbia ("BCSC"), and the BCSC set aside the arbitrator's award. Wastech appealed to the British Columbia Court of Appeal ("BCCA"), which dismissed the appeal.
The BCSC and BCCA concluded that any duty of good faith must be based on the terms of the contract itself. In contrast, the arbitrator improperly held that Metro's conduct was at odds with Wastech's legitimate expectations, notwithstanding the fact that those expectations were not included in the agreement. In other words, the terms of the contract must inform the analysis of legitimate expectations.
Supreme Court of Canada
Wastech appealed to the SCC. The Court dismissed the appeal and held that Metro's exercise of discretion did not constitute a breach of the duty of good faith. In doing so, the Court provided additional commentary on two components of the duty of good faith: the duty of honest performance and the duty to exercise contractual discretion in good faith.
Duty of Honest Performance
To exercise discretionary power dishonestly, within the meaning of Bhasin, is a breach of contract. However, in this case, Wastech did not allege that Metro's conduct was dishonest or misleading. As a result, the Court could not find a breach of the duty of honest performance. The Court clarified "[d]ishonesty is necessary to establish a breach of the duty of honest performance" (at para 55).
The Duty to Exercise Contractual Discretion in Good Faith
The duty to exercise contractual discretion in good faith is well-established in the common law and operates in every contract regardless of the parties' intentions. To find a breach of this duty, a party must exercise its discretion unreasonably, meaning in a manner that is not connected to the underlying purposes of the discretion granted by the contract. The exercise of discretion will also be unreasonable where it is capricious or arbitrary in light of those purposes.
This analysis is highly contextual and can be simplified into the following steps:
- Using principles of interpretation, interpret the contract to determine the purposes for which the discretion was granted; and
- Consider whether the exercise of discretion falls outside of the range of choices connected to its underlying purpose:
- If the exercise of discretion is outside the purpose of the contract, it is an unreasonable exercise of discretion and, therefore, a breach of the duty to exercise contractual discretionary powers in good faith.
- If the exercise of discretion is within the purpose of the contract, it is a reasonable exercise of discretion and, therefore, not a breach of the duty to exercise contractual discretionary powers in good faith.
In this case, the Court held that when interpreting the entire agreement between the parties, Metro was granted "absolute discretion" to structure the waste disposal services in a flexible, efficient and cost-effective manner given the operational variability anticipated by the parties. These objectives guided Metro's decision to reallocate waste to closer facilities. As a result, its exercise of discretion was within the range permitted by the purpose of the agreement.
The fact that the exercise of discretion may cause the other party to lose some or all of its benefit under the contract will not be determinative on the question of good faith. While Metro's discretion resulted in a significant loss for Wastech, the discretion was ultimately exercised within the range permitted by the agreement's purpose.
This decision provides some clarity concerning how parties should negotiate, draft and exercise discretionary powers in contracts.
- Discretionary powers must be exercised honestly, in good faith and in accordance with the purposes for which the discretion was granted in the contract. This analysis will always be context-specific, which provides a significant opportunity to debate the exercise of discretion.
- The duty to exercise contractual discretion in good faith has not been expanded to impose a higher standard of conduct than what the parties agreed to in the contract. Put another way, the reasonable expectations of the parties must be clear from the contract itself.
- Exercising discretion that undermines the other party's interests is not necessarily a breach of the duty of good faith.
- The importance of effective drafting of commercial agreements cannot be understated to ensure both parties' interests are accurately reflected in the event of a dispute.
If you have any questions about the exercise of discretion in good faith or any other contractual dispute matters, Rob Rakochey or any of the lawyers in Field Law's Litigation Group are available to answer your questions and advise you and/or your organization.