Contracts often give one party discretion to make decisions that will affect the other party. For example, employment contracts can give the employer a discretion as to the quantum of a bonus. A lease can give the landlord discretion as to whether to accept a tenant’s request to sublease the premises. Often, one sees the words “absolute discretion” or “absolute and sole discretion.” Do these words mean that the party with discretion can exercise that discretion in any manner the party sees fit? The answer, in prior jurisprudence and according to the Supreme Court of Canada in Wastech Services Limited v. Greater Vancouver Sewerage and Drainage District 2021 SCC 7, is no.
Wastech, a contractor engaged in waste transportation and disposal, contracted with Metro, the entity administering waste disposal in Metro Vancouver Regional District. The parties entered into a long-term contract that discussed, among many other things, which waste disposal sites would be used and who would determine the quantity of waste going to those disposal sites. The contract gave Metro the “absolute discretion” to determine the minimum amount of waste that would be transported to one particular waste site in a given period.
Metro exercised that discretion so that, in one year, it reduced the waste going to that particular site and increased the waste going to another site. This resulted in Wastech having far less profit than the contract contemplated and triggered an adjustment clause in the contract. The clause required Metro to pay Wastech, based on a formula, a specified amount to compensate it, in part, for the profit reduction. Even with the adjustment, Wastech still had far less profit than the target, but Metro shared in the pain.
Wastech claimed that Metro’s right to allocate waste between the facilities was subject to a duty of good faith, which could not be exercised in a manner that would deprive Wastech of the opportunity to achieve the target profit. Wastech convinced an arbitrator that Metro had exercised its discretion improperly, but both the Supreme Court of British Columbia and the Court of Appeal disagreed.
A contractual discretionary power may not be exercised dishonestly. To do so is a breach of contract. Wastech did not allege that Metro lied or otherwise knowingly misled Wastech regarding a matter directly linked to the performance of the contract, including the exercise of Metro’s discretionary power to allocate waste. The exercise of that discretion might have been at odds with Wastech’s contractual expectation, but it did not establish dishonesty.
A discretionary power, even if unfettered, is constrained by good faith. To exercise it capriciously or arbitrarily constitutes a breach of contract. It has long been held by courts that a discretion must be exercised reasonably. The question becomes, what is reasonable? The court held that a duty to reasonably exercise a contractual discretion means that the party exercising the discretion must do so in a manner consistent with the purposes for which the contract granted the discretion If the exercise is unconnected to those purposes, the party has not exercised the contractual power in good faith.
Accordingly, one determines reasonableness only after interpreting the contract to understand the contractual purposes of the discretion. Sometimes it can be understood by reading only the text of the discretionary clause and sometimes it can be understood only by reading the clause in the context of the contract as a whole.
The court went to great pains to state that the role of the court was not to ask whether the discretion was exercised in a morally opportune or wise fashion from a business perspective. Competition between businesses regularly involves each business taking steps to promote itself at the expense of the other. Good faith should not be used as a pretext for scrutinizing motives. Accordingly, the courts must only ensure that a party does not exercise its discretion in ways unconnected to the purposes for which the contract grants that power; anything else is a form of ad hoc judicial moralism or palm tree justice.
The court contemplated that, in the exercise of discretion, a range of outcomes can be considered to be a reasonable exercise of discretion. There may well be differing, yet legitimate, ways in which a party can exercise its discretion as part of the contract. The range can be relatively broad if the matter to be decided is not readily susceptible to objective measurement (e.g. matters involving taste, sensibility, or personal compatibility or judgment of a party) and narrower if it is capable of objective measurement (e.g. operative fitness, structural completion, mechanical utility, or marketability).
The court summarised its findings on this issue as follows:
“In sum, then, the duty to exercise discretion in good faith will be breached where the exercise of discretion is unreasonable, in the sense that it is unconnected to the purposes for which the discretion was granted. This will notably be the case where the exercise of discretion is capricious or arbitrary in light of those purposes because that exercise has fallen outside the range of behaviour contemplated by the parties. The fact that the exercise substantially nullifies or eviscerates the fundamental contractual benefit may be relevant but is not a necessary pre-requisite to establishing a breach.”
Much of the parties’ argument revolved around a determination whether the duty to exercise discretion in good faith was implied by the contract. The majority put that argument to rest. It held that the source of the duty to exercise discretion in good faith is a general doctrine of contract law. Like the duty of honest performance, it does not find its source in an implied term of the contract; instead, it operates in every contract regardless of the intention of the parties. As a corollary, parties who wish to give a discretionary power cannot contract out of the implied undertaking that the power is to be exercised in good faith (i.e. in light of the purposes for which it was granted). The majority recognized that this inability to contract out of the duty will impinge on freedom of contract, but only in those rare cases in which the parties seek to authorise the exercise of contractual discretion in a manner unconnected with its underlying purposes.
The court then applied these principles. It noted that Metro was given the discretion to direct which waste sites would be used. The contract referenced concepts such as maximizing efficiency, minimizing costs, maximizing municipal solid waste disposal capacity of a particular landfill, and sensitivity to significant changes in operating standards, services, or system configurations. The contract also adjusted for the impacts that these factors might have on Wastech’s profitability by requiring Metro to share Wastech’s loss when it failed to meet the target level of profitability.
The court therefore concluded that the purposes of giving Metro discretion to determine waste allocation were clearly to allow the flexibility necessary to maximize efficiency and minimize operational costs. Granting this discretion, rather than fixing waste volumes, served the overall objective of allowing the parties to adapt to changing circumstances over the contract’s life.
Given this analysis, the court easily found that Metro’s exercise of discretion was guided by the contract objectives and that Metro acted reasonably. It also noted that the contract purposely included no guarantee of achieving the target profit, but, through the adjustment clause, shared the risk of unachieved profit.
The court noted that Wastech wanted Metro to subvert its own interests to accommodate those of Wastech, but that Metro was only Wastech’s contracting partner, not its fiduciary. Its loyalty, in the exercise of its discretion, was a loyalty to the bargain, not to Wastech.
Image courtesy of jarmoluk.
Written by Jonathan Speigel, the founding partner of Speigel Nichols Fox LLP, leads the litigation and construction practices.