Contract law II: terms, defects, performance and breach

Forming a contract is only the beginning. Disputes usually arise later, over what the contract means, whether one party was misled into signing it, whether an unexpected event excuses performance or whether a failure to perform justifies ending the relationship. This lesson covers the content of contracts, including express and implied terms, interpretation, exclusion clauses and good faith; the defects that can make a contract voidable or void; how contracts are discharged; and how the law classifies breach. Remedies follow in lesson 5.

Express and implied terms

Express terms are those the parties stated, orally or in writing. Implied terms are added by law or by the courts. Courts imply terms in three main ways: terms implied by statute, such as the conditions of quality and fitness in sale of goods law (lesson 5); terms implied by custom or trade usage, when a practice is so well known in an industry that the parties must have intended it; and terms implied in fact, to give business efficacy to a contract when the term is so obvious that it goes without saying. Courts will not imply a term merely because it would be reasonable, and will not imply a term that contradicts an express one.

When the meaning of a written contract is disputed, Canadian courts read the words in their ordinary and grammatical sense, consistent with the surrounding circumstances known to both parties when they made the contract. In Sattva Capital Corp. v. Creston Moly Corp., 2014 SCC 53, the Supreme Court held that contractual interpretation is a practical, common-sense exercise that considers the factual matrix, but that the surrounding circumstances cannot overwhelm the words the parties chose. The parol evidence rule generally prevents a party from using evidence of prior or contemporaneous oral agreements to add to, vary or contradict a written contract that the parties intended as their complete agreement, which is why contracts often contain an entire agreement clause. If a term remains ambiguous, the contra proferentem rule interprets it against the party that drafted it.

Exclusion and limitation clauses

Business contracts commonly limit or exclude liability: a cap on damages equal to the fees paid, an exclusion of consequential damages such as lost profits, or a disclaimer of implied warranties. These clauses allocate risk and affect price, and courts generally enforce them between sophisticated parties. They are read narrowly, however, and they must clearly cover the loss in question. Consumer protection statutes often prohibit or limit them in consumer contracts.

In Tercon Contractors Ltd. v. British Columbia (Transportation and Highways), 2010 SCC 4, the Supreme Court of Canada set out a three-step test for exclusion clauses. First, as a matter of interpretation, does the clause apply to the circumstances? Second, if it applies, was it unconscionable when the contract was made, for example because of unequal bargaining power? Third, even if valid, should the court refuse to enforce it because of an overriding public policy, such as a supplier knowingly selling a dangerous product while hiding behind an exclusion? The old doctrine of fundamental breach no longer automatically defeats exclusion clauses. In Tercon, the province had excluded liability for claims arising from participation in a tender, but the court held the clause did not cover the province's acceptance of a bid from an ineligible bidder.

Good faith

Canadian contract law now recognizes good faith as a general organizing principle. In Bhasin v. Hrynew, 2014 SCC 71, the Supreme Court recognized a duty of honest performance: parties must not lie to or knowingly mislead each other about matters directly linked to the performance of the contract. In C.M. Callow Inc. v. Zollinger, 2020 SCC 45, condominium corporations that had decided to end a winter maintenance contract let the contractor believe the contract would be renewed, so it did extra summer work hoping to keep the business; the court held that this active deception breached the duty of honest performance even though the termination clause itself was valid. In Wastech Services Ltd. v. Greater Vancouver Sewerage and Drainage District, 2021 SCC 7, the court held that contractual discretion must be exercised reasonably, in line with the purposes for which it was granted. These duties do not require a party to put the other's interests first or to disclose all information, but they forbid lying and using discretion for an unconnected purpose. In Quebec, the Civil Code imposes good faith expressly.

Defects in formation

A contract that appears valid may be defective because of how it was made. A void contract never had legal effect; a voidable contract is valid until the innocent party chooses to rescind it. Rescission unwinds the contract and returns both parties to their original positions, so it is lost if that is no longer possible, if an innocent third party has acquired rights or if the innocent party affirms the contract after learning the truth.

A misrepresentation is a false statement of fact that induces the other party to contract. Opinions, predictions and sales puffery, such as "the best pizza in town", are not statements of fact, although an opinion from someone with special expertise may imply facts. Silence is not usually misrepresentation, but a half-truth is, and so is failing to correct a statement that becomes false before the contract is signed. Some relationships, such as insurance and fiduciary relationships, require disclosure, and consumer and securities laws impose disclosure duties.

Canadian courts apply unconscionability using the two-part test from Uber Technologies Inc. v. Heller: an inequality of bargaining power and a resulting improvident bargain that unduly advantages the stronger party or disadvantages the weaker one. Inequality can arise from a standard-form contract presented on a take-it-or-leave-it basis with terms the weaker party could not be expected to understand. Consumer protection statutes add statutory unfair practices, such as unconscionable representations, which let consumers rescind and claim damages (lesson 11).

Discharge: how contracts end

Most contracts are discharged by performance: each party does what it promised. Contracts can also be discharged by agreement, for example when the parties agree to end the contract (mutual release), to replace it with a new one (novation) or to accept a different performance (accord and satisfaction). A contract may also end through a condition: a condition precedent must occur before obligations arise, such as financing approval in a real estate deal, and a condition subsequent ends obligations when it occurs.

A contract is frustrated when, without the fault of either party, an unforeseen event makes performance radically different from what the parties contemplated, such as the destruction of the subject matter or a change in law that makes performance illegal. In Naylor Group Inc. v. Ellis-Don Construction Ltd., 2001 SCC 58, the Supreme Court described frustration as occurring when a supervening event alters the nature of the obligations so significantly that holding the parties to them would be unjust. Frustration is not available because performance becomes more expensive or less profitable, or if the contract already allocated the risk. When a contract is frustrated, both parties are released from future obligations; provincial statutes, such as Ontario's Frustrated Contracts Act, adjust money already paid and expenses already incurred.

Because these doctrines are narrow and unpredictable, well-drafted contracts include force majeure clauses. A force majeure clause lists events beyond a party's control, such as natural disasters, war, epidemics, government orders and strikes, and states the consequence: suspension of performance, extension of time or termination after a period. Courts interpret these clauses according to their wording; a party that relies on one usually must show that the event falls within the clause, that it caused the failure to perform and that the party took reasonable steps to mitigate. The COVID-19 pandemic produced a wave of litigation over whether pandemics or government orders were covered, and many businesses rewrote their clauses afterwards.

Breach of contract

A breach occurs when a party fails to perform as promised without lawful excuse. The consequences depend on the importance of the term broken. A condition is an essential term; breach of a condition lets the innocent party treat the contract as ended and claim damages. A warranty is a minor term; breach of a warranty gives only damages. Many terms are innominate: whether the innocent party can terminate depends on whether the breach deprives it of substantially the whole benefit of the contract. A party that clearly indicates in advance that it will not perform commits an anticipatory breach (repudiation), and the innocent party may either accept the repudiation, ending the contract and suing immediately, or affirm the contract and wait for performance, keeping it alive for both sides.

Privity and third parties

Under the doctrine of privity, only parties to a contract can enforce it or be bound by it. Canadian courts have created a principled exception: a third party may rely on a contract term, such as a limitation of liability, if the parties intended the term to benefit that third party and the activities the third party was performing were the very activities contemplated. In London Drugs Ltd. v. Kuehne & Nagel International Ltd. (1992), warehouse employees who damaged a transformer could rely on their employer's $40 limitation clause, and in Fraser River Pile & Dredge Ltd. v. Can-Dive Services Ltd. (1999) the court extended the exception to a waiver of subrogation in an insurance policy. Statutes also create exceptions, for example letting beneficiaries enforce insurance policies. Rights under a contract can generally be assigned to another person, with written notice to the other party, but obligations cannot be transferred without the other party's consent.