The Ontario Superior Court of Justice (the “Court”) recently dealt with the question of what constitutes a breach of the duty of good faith contractual performance in the context of a construction contract. In Dominus/Cityzen Brampton SWQRP Inc. v. The Corporation of the City of Brampton, 2020 ONSC 5806 (“Dominus”), the Court held that the City of Brampton’s failure to consent to significant reduction in the amount of a security deposit when much of the contracted work had been completed because of a third party dispute amounted to a breach of the general (and in this case contractual) duty to act reasonably and in good faith in the exercise of contractual discretion.

While decided in 2020, the Court’s decision in Dominus remains consistent with the Supreme Court of Canada’s (the “SCC”) more recent decision in Greater Vancouver Sewerage and Drainage District v. Wastech Services Ltd., 2021 SCC 7 (“Wastech”),^[1]Wastech Services Ltd. v. Greater Vancouver Sewerage and Drainage District, 2021 SCC 7 [Wastech]. and provides a useful, construction-specific example of when a party is found to be exercising their discretion unreasonably and therefore contrary to the duty of good faith. In short, refusing (or choosing) to exercise contractual discretion based on an overly rigid interpretation is unreasonable and contrary to the duty of good faith.

Good Faith Principle and Discretionary Contractual Clauses

As outlined below, the general organizing principle of good faith contractual performance was first recognized by the SCC in Bhasin v. Hrynew, 2014 SCC 71 (“Bhasin”).^[2]Bhasin v. Hrynew, 2014 SCC 71, at para. 63. The organizing principle underlies and manifests various other more specific doctrines governing contractual performance. One such specific doctrine, as identified in Bhasin, is the duty of good faith performance in exercising contractual discretion. Despite being decided before the SCC’s more recent decision in Wastech, the Court in Dominus provides some useful and detailed commentary regarding the exercise of such discretion.

In Wastech, the SCC held that the duty to exercise contractual discretion in good faith requires that a party exercise their discretionary powers reasonably.^[3]Wastech at para. 67. Reasonableness is determined based on the purpose for which the discretionary powers were granted under the contract;^[4]Ibid, at para. 88. an unreasonable exercise of discretion is one which is unconnected to the contractual purpose and is a breach of the duty of good faith.^[5]Ibid, at para. 75. In Wastech, the Greater Vancouver Sewerage and Drainage District (“Metro”) was in a long-term contract for the removal and transportation of waste by Wastech Services Ltd. The contract gave Metro the discretion to choose which site to send the waste to and Wastech’s rate was dependent on the distance the waste was transported. Metro exercised their discretion by choosing the closer site, resulting in Wastech earning less revenue. Contrary to the ruling of the arbitrator, the SCC determined that the contract did not require Metro to use its discretion to ensure Wastech reached its target operating ratio in any given year. As such Metro, was not in breach of the duty of good faith because their exercise of discretion was connected to the purpose of the contract and was therefore reasonable.^[6]Ibid, at para. 100.

Summary of the Decision

Facts

Dominus CityZen Brampton SWQRP Inc. (“Dominus”), the developer, was contracted by the City of Brampton (the “City”) to complete an expansion of the Brampton City Hall. Dominus and the City entered into a Site Plant Agreement (the “SPA”) pursuant to the Planning Act.^[7]Planning Act, R.S.O. 1990, c. P.13. Under the SPA, the City had two roles: first as the owner of the lands and occupier of the City Hall constructed thereon, and second as the regulator acting on behalf of the community and public interests that are protected by the SPA. The Court was ultimately tasked with the interpretation of a security deposit provision of the SPA. Dominus was required by the SPA to post a deposit of $646,510.00 (the “Security Deposit”) as a performance guarantee for the estimated cost of all works required to be completed as part of the City Hall project.

Section 15 of the SPA provided that Dominus may, “from time to time, apply to the [City] for a reduction in the amount of the security by an amount up to ninety per cent (90%) of the value of the works for which security was deposited […]”.^[8]Dominus/Cityzen Brampton SWQRP Inc. v. The Corporation of the City of Brampton, 2020 ONSC 5806 at para. 26 [Dominus].

Further, section 29 of the SPA contained a provision requiring the parties to act reasonably and in good faith:

Where approval or consent is required hereunder, such approval or consent shall not be unreasonably withheld. Where something is required to be done hereunder to the satisfaction of or in the discretion or opinion of a party or official thereof, such party or official shall act reasonably in exercising such satisfaction, discretion or opinion.^[9]Ibid, at para. 30.

Dominus completed the redevelopment of the City Hall with the exception of two relatively minor items: a trench drain and a wooden privacy fence. Dominus took the position that it was unable to complete the two remaining items because of an ongoing suit that the owners of the neighboring properties had commenced against the City and Dominus for nuisance and trespass, claiming damages in excess of $2MM. Dominus requested that a portion of the Security Deposit be returned in amounts relative to the value of the work completed. However, the City denied Dominus’ request for two reasons:

1. Under the City’s interpretation of the SPA, all work must be completed before any release of funds would be considered or made;^[10]Ibid, at paras. 6 and 8. and,
2. Because of the presence of an indemnity provision contained in the SPA, under which the City was claiming a right to set-off the indemnity claims against the Security Deposit^[11]Ibid, at para. 6.

Issues and Decision

In considering the parties’ submissions and arguments, the Court distilled the dispute into six key questions.^[12]Ibid, at para. 32. For the purposes of this blog post, we will focus on four of those questions:

1. Does the SPA Allow for a Partial Reduction of the Security for Completed Works When Some Remain Outstanding?
2. Was the City in breach of the SPA or any independent duty of good faith, or did it act unreasonably or in bad faith, by refusing to consider this request and/or for refusing to reduce the Security Deposit?
3. Did the Security Deposit cover, or could it be set-off against, the City’s right to claim indemnity?
4. If the entitlement to a reduction or refund is established, how much of the Security Deposit is Dominus entitled to receive?

Ultimately, the Court found the City’s refusal to release or reduce the Security Deposit was not reasonable in the circumstances and was contrary to the organizing principle of good faith in the performance of contracts, including under the specific terms of the SPA. Further, the Court held that the SPA did not give rise to any right of set-off against the Security Deposit, and ordered that the City release $596,510.00 plus pre-judgement interest.^[13]Ibid, at para. 78.

Analysis

In the result, the OSC found that a proper interpretation of the SPA based on the principles of contractual interpretation would allow for a partial reduction in the Security Deposit, as sought by Dominus.^[14]Ibid, at para. 38. The Court held that the City’s interpretation of the SPA was too rigid and therefore unreasonable,^[15]Ibid, at paras. 41 and 51. holding that the SPA did not link the Security Deposit to the indemnity provisions, nor did it expressly allow for setting-off of other claims against the Security Deposit.^[16]Ibid, at para. 72. Therefore, the presence of the indemnity clause was held to be not relevant to the City’s determination of whether the deposit should be reduced or released, such that its refusal to do same was in breach of its general and contractual good faith obligations.^[17]Ibid, at para. 72.

Did the SPA Allow for a Partial Reduction of the Security for Completed Works When Some Remain Outstanding?

The Court found that on a proper, contextual and purposeful interpretation of the SPA that a partial reduction of the Security Deposit for completed works was available even when some works remained outstanding.^[18]Ibid, at para. 7. The City argued that in their role as a regulator and holder of public funds they were entitled to insist on strict adherence to the requirements of the SPA because of the recognized overarching planning and public interest objectives of the SPA.^[19]Ibid, at para. 50. However, the Court determined that interpreting the SPA to allow for a partial reduction of the Security Deposit did not undermine the public interest or planning objectives associated with the SPA; instead, the Court held that such an interpretation “reflects an appropriate balance between the commercial realities of a significant contract such as this and the objective of securing the completion of the remaining outstanding works in furtherance of the planning objectives embodied in the SPA.”^[20]Ibid, at para. 40.

The Court reached the following conclusions regarding the proper interpretation of section 15 of the SPA:

Section 15.3 explicitly provides that Dominus may, from time to time, apply to the City for a reduction in the amount of the security by an amount up to ninety per cent (90%) of the value of the works for which security was deposited. The contemplation of applications from time to time suggests that more then one request may be made and considered before the 90% cap is reached.^[21]Ibid, at para. 38.

It makes common and commercial sense that these applications, from time to time, would correspond with the completion of certain works for which the certification requirements have been met to enable a partial release of the security deposit. Section 8 requires an engineering certificate prior to any reduction in security posted for public works purposes or occupancy of the building and section 13.5 requires an architect’s certificate prior to the release of any landscaping securities. The City emphasizes the word “any” in these provisions and says that it should be read as prohibiting “any” reduction in or release of security until all of the works have been completed. The word “any” could be equally read to be referring to any one of a number of potential requests for reductions or releases of the security. Reading the word “any” in this way is harmonious with the contemplation in section 15 that there may be releases or reductions to the security from time to time, for completed works that have received the necessary certifications.^[22]Ibid, at para. 39. [emphasis added]

Ultimately, the Court found that the City’s interpretation of the SPA, namely that it did not allow for any opportunity for Dominus to apply for and potentially receive a reduction in the Security Deposit until all work was completed, “is too rigid an interpretation and application of the SPA.”^[23]Ibid, at para. 41.

Was the City in breach of the SPA or any independent duty of good faith, or did it act unreasonably or in bad faith, by refusing to consider this request and/or for refusing to reduce the security deposit?

In addressing the issue of good faith, the Court cited Bhasin for the following general proposition regarding the duty of good faith in contractual discretion: “Failing to exercise contractual discretion without any reasonable justification is contrary the common law good faith principles in the performance of a contract.”^[24]Ibid, at para. 27.

The City made three main arguments as to why they had reasonable justification for their failure to exercise the discretion granted to them under the SPA:

1. Based on the overarching planning and public interest objectives of the SPA, they could insist on strict compliance with the SPA, such that all work must be completed before a reduction is to be considered;
2. The general language in section 21.5 of the SPA, “together with all other applicable provisions of the SPA” gave the City discretion to withhold the Security Deposit until all incomplete works had been completed; and
3. The existence of the third party tort claim triggered an indemnity by Dominus to the City.

The Court rejected the three justifications provided by the City and found that they were unreasonable for the following reasons.

In response to the first justification, the Court found that the reasonableness of this justification is dependent upon whether the SPA allowed for a partial reduction in the Security Deposit.^[25]Ibid, at para. 50. As summarized above, the Court found that the City’s interpretation of the SPA was unreasonable, and therefore overarching planning and public interest objectives of the SPA did not give rise to a reasonable justification.^[26]Ibid, at para. 51.

In response to the second justification, the Court determined that the City’s interpretation of section 21.5 of the SPA as “granting unfettered discretion to say no to a reduction of the Security Deposit as long as any of the works remain incomplete” was also incorrect.^[27]Ibid, at para. 53. Under section 21.5 of the SPA, Dominus acknowledged that the City would not be required to reduce or release the Security Deposit until it was satisfied that Dominus had: (i) complied with the Construction Lien Act;^[28]Construction Lien Act, RSO 1990, c C-30 (now the Construction Act, RSO 1990, c C-30). (ii) paid and discharged any and all liens under same; and (iii) indemnified the City for any claims arising out of a failure to comply with the Construction Lien Act. Based on contractual interpretation principles, the Court reiterated that a general phrase “must be read to be qualified by the sections identified immediately before it.”^[29]Dominus, at para. 53. Therefore, the Court held that the general phrase in section 21.5 only applied to the specific lien claims contemplated in the sections regarding the Construction Lien Act, and did not provide the City with a general unfettered discretion to reject Dominus’ request.^[30]Ibid.

In response to the third justification, the Court found that “the security deposit does not apply to the tort claims, nor has the City even made an indemnity claim against Dominus in respect of the tort claims.”^[31]Ibid, at para. 58. Therefore, the existence of the third party tort claim did not provide the City with a reasonable justification to refuse or reduce the Security Deposit. This issue is discussed further below.

Ultimately, the Court concluded:

The City has, in this case, fettered the exercise of its discretion by too narrow an interpretation of the SPA (that unless all works are complete, nothing will be returned) and extraneous and irrelevant self-serving considerations (as security that was not contracted for or a set off for a contingent indemnity claim in tort). The City’s refusal to release or reduce the security deposit is not reasonable in the circumstances and is contrary to the organizing principle of good faith in the performance of contracts and section 29 of the SPA.^[32]Ibid, at para. 32. [emphasis added]

Did the security deposit cover, or could it be set-off against, the City’s right to claim indemnity?

Pursuant to the indemnity provision contained in section 20 of the SPA, Dominus agreed to indemnify the City for all actions arising based on Dominus’ performance of the contract.^[33]Ibid, at para. 66. However, the Court found that the SPA did not link the Security Deposit to the indemnity provision, noting that the SPA clearly “earmarked” the Security Deposit only to secure the cost of the work Dominus undertook to complete.^[34]Ibid.

The City also claimed that it was able to retain the Security Deposit based on a right of set-off. However, the Court noted that the parties did not make substantial submission in this respect. Nonetheless, the Court identified two somewhat tenuous instances that a right to set-off could exist, but which ultimately did not.^[35]Ibid, at para. 72. First, for a potential contingent indemnity claim against Dominus in respect of the tort claims.^[36]Ibid, at paras 69 and 70. However, the capacity in which the City was being sued in the tort claim and the capacity that the City had entered into the SPA (i.e. their two roles) may affect this right of set-off.^[37]Ibid. Second, the uncertain costs to access the neighboring land could result in a contractual claim under section 15.2, however the Court determined that such an interpretation would be a stretch of the indemnity language.^[38]Ibid, at para. 71.

If the entitlement to a reduction or refund is established, how much of the security deposit is Dominus entitled to receive?

Having found that the SPA allowed Dominus to be eligible for a possible reduction in the Security Deposit and that the City was in breach of the SPA for failing to exercise their discretion regarding same, the Court determined that Dominus was entitled to a receive a portion of the Security Deposit referable to the completed works.^[39]Ibid, at para. 73.

Pursuant to section 15.4 of the SPA, Dominus was eligible to receive up to 90% of the value of the completed works until the two-year warranty lapsed.^[40]Ibid, at para. 74. Given that five years had elapsed, the Court determined that Dominus would receive 100% of the Security Deposit, minus the value of the anticipated costs of the two uncompleted items.^[41]Ibid. Evidence was given regarding the estimated value of that uncompleted work to be $10,000.00. The Court then multiplied this number by four to allow for a significant buffer given the uncertainty surrounding the additional costs associated with completing the outstanding work. Therefore, the reasonable estimation of the outstanding work, which included a reasonable holdback for uncertain additional costs associated with such work, was held to be $50,000.00.^[42]Ibid, at para. 75. As such, the Court ordered the City to release $596,510.00 ($646,510.00 less $50,000.00) of the Security Deposit to Dominus.^[43]Ibid, at para. 78.