Written By Scott Bower, Michael Theroux, Ranjan Agarwal, Russell Kruger and Patrick Schembri

Good faith requires a party to a contract whose actions or words have created a false impression in the mind of a counterparty to take positive steps to correct it, the Supreme Court of Canada recently held in C.M. Callow Inc. v Zollinger, 2020 SCC 45. If a party to a contract remains silent when it becomes aware it has caused a counterparty to misapprehend a matter directly connected to the performance of the contract or the exercise of a contractual right, that party may be liable for a breach of the duty of honest performance.

Building on Bhasin

In Bhasin v Hrynew, 2014 SCC 71, the Supreme Court of Canada recognized the organizing principle of good faith in contract law and a new duty "to act honestly in the performance of contractual obligations." The Court explained this duty "means simply that parties must not lie or otherwise knowingly mislead each other about matters directly linked to the performance of the contract." In Callow, the Court expanded on this duty and confirmed it also applies to the exercise of rights under a contract.

Background

In Callow, a company, Baycrest, and its designated property manager managed the joint and shared assets of ten condominium corporations. In 2012, Baycrest renewed a winter maintenance services agreement with C.M. Callow Inc. and entered into a new summer contract as well. The winter contract had a two-year term, though it allowed Baycrest to unilaterally terminate the contract on ten days’ notice without cause. 

During the first year of the winter contract, in March or April 2013, Baycrest decided it would terminate the contract early, but did not inform Callow. Subsequently, a representative of Baycrest had communications with Callow that created the false impression that the winter contract would not be terminated early and in fact would likely be renewed for a longer term. Callow exceeded its obligations under the summer contract by providing free work to Baycrest in an effort to encourage Baycrest to renew the winter contract. Baycrest was aware of Callow's false impression, but took no steps to correct it. In September 2013, when it was too late for Callow to secure alternative winter work, Baycrest gave notice to Callow that it was exercising its right to terminate under the contract. 

The Lower Court Decisions

At trial, the Court held that Baycrest had breached the duty of honesty in contractual performance. The Court awarded damages, including a sum that represented the profit Callow would have received during the remaining term of the winter contract. The Ontario Court of Appeal reversed the trial decision. While acknowledging that Baycrest's conduct may have been less than honourable, the Court held it did not reach the "high level required to establish a breach of the duty of honest performance." 

The Supreme Court of Canada Decision

A five-member majority allowed the appeal. The majority held that when a party to a contract is aware its conduct or representations have created a misapprehension in the counterparty's mind in relation to the performance of an obligation or the exercise of a right under a contract, the duty of honesty requires that party to correct it. The determination of whether the duty was breached in this case turned on two central issues: (a) whether Baycrest knowingly misled Callow; and (b) if so, whether that dishonesty was "directly linked" to the performance of an obligation, or the exercise of a right under the winter contract. 

Knowingly Misleading

As for the first issue, the majority concluded that Baycrest had knowingly misled Callow. The majority reasoned that an outright lie, or a half-truth told in a knowingly misleading way, would breach the duty of honesty. On the other hand, a failure to disclose a material fact, without more, would not breach this duty. The majority explained:

… whether or not a party has "knowingly misled" its counterparty is a highly fact-specific determination, and can include lies, half-truths, omissions, and even silence, depending on the circumstances. I stress that this list is not closed; it merely exemplifies that dishonesty or misleading conduct is not confined to direct lies.

A party need not intend for the other party to rely on their dishonest conduct. The party's motives are not relevant to whether the duty of honesty is breached, unless such motives show dishonesty. 

Applying these principles to the facts, the majority concluded that Baycrest knowingly misled Callow in the way in which it exercised the termination clause. Baycrest had engaged in a series of acts and active communications it knew had caused Callow to misapprehend the likelihood that the winter contract would be terminated early, and then intentionally failed to correct that misunderstanding prior to exercising the termination clause. While the majority upheld the trial judge's conclusion that the duty of honesty had been breached, it clarified the trial judge had erred in stating the duty required Baycrest to inform Callow of perceived performance issues, and to provide prompt notice of its intention to terminate. This went beyond what was needed to comply with the duty of honesty. 

Matters Directly Linked to Performance

As for the second issue, the majority concluded that Baycrest's dishonesty was directly linked to the performance of the contract. Drawing on the civil law doctrine of abuse of rights, the majority stated that the requisite connection is established where "it can be said that the exercise of a right or the performance of an obligation under that contract has been dishonest." It is not enough for the dishonesty to occur during the performance of the contract alone. There must be a direct link to the performance of an obligation or the exercise of a right. The majority concluded that Baycrest's dishonesty led Callow to make the reasonable inference that Baycrest would not exercise the termination clause, and that this dishonesty was sufficiently connected to the actual exercise of the termination clause to establish the required link. 

Damages for Breach of the Duty of Honesty

The majority confirmed that a breach of the duty of honesty generally creates expectation damages, which are intended to place the wronged party in the position the party would have been in had the contract been performed without dishonesty. How the contract was to be performed is to reflect the least onerous means of performing the contract without dishonesty. Here, that would have been for Baycrest to correct Callow's misapprehension that the contract would not be terminated early. Had Baycrest done that, Callow would have had a chance to secure a different contract for the second winter and that new contract would have likely generated similar profits to those under the old contract.

Conclusion

The Supreme Court of Canada's decision confirms that the duty of honesty applies to the performance of obligations and the exercise of rights under a contract. Where a party knows that its conduct or representations have led a counterparty to hold a false impression in connection with the contract, the duty of honesty requires that party to correct the misapprehension it created. This holds true whether the party intended to create the false impression or not. Whether a party has knowingly misled its counterparty is a highly fact-specific determination that can include lies, half-truths, omissions and even silence, depending on the circumstances. Highly fact-specific determinations that depend on the circumstances often give rise to litigation. Parties will want to reduce this risk through careful drafting and managing expectations in advance of exercising contractual rights that may have significant, adverse effects on a counterparty, such as early termination rights.

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