Ontario Court of Appeal Clarifies Good and Bad Faith in Tokyo Smoke Decision​​​​​​​

In 2161907 Alberta Ltd. v 11180673 Canada Inc. (“Tokyo Smoke”), the Ontario Court of Appeal provides clarification on the duty of good faith and honesty in contractual relationships first established as a general organizing principle of common law by the Supreme Court of Canada (“SCC”) in Bhasin v Hrynew (“Bhasin”).

The Tokyo Smoke decision forms an addendum to the trilogy of prior SCC decisions establishing and expanding the good faith doctrine beginning with Bhasin.1 Rather than expand the doctrine, however, the Ontario Court of Appeal in Tokyo Smoke narrows its scope by assessing what constitutes “bad faith” with respect to the wrongful termination of an agreement based on a mistaken belief.

What You Need to Know About Tokyo Smoke

1. Though you cannot contract out of the duty of good faith, Tokyo Smoke limits the scope of the doctrine to preclude situations where the wrongful termination of an agreement is based on an honest but erroneous belief.
2. A finding of bad faith of a party requires more than merely breaching a contract – it requires knowledge and dishonesty of the party including: (i) knowingly misleading the other party; (ii) ‘pouncing’ on an alleged default by the other party that it did not believe had occurred; (iii) attempting to evade payment or responsibility in bad faith; or (iv) seizing upon a breach by the other party of its own making.

Summary of Tokyo Smoke

2161907 Alberta Ltd. (“216”), the licensor, and 11180673 Canada Inc. (“111”), the licensee, entered into an agreement to operate a cannabis store in Toronto called “Tokyo Smoke.” The agreement consisted of a license agreement and a sublease which included payment to 111 of a branding fee and funding to cover start-up costs. Days before the Tokyo Smoke store was scheduled to open, 216 and 111 had a dispute over which party was to pay the first month’s rent. 216 believed that the terms of its sublease with 111 did not include covering first month’s rent and refused to pay. However, 216 was mistaken – the sublease did in fact require 216 to pay the first month’s rent.

When faced with 216’s refusal to pay the first month’s rent, 111 responded that it would not be opening the Tokyo Smoke location and would instead lay off its staff. After reviewing the agreement and speaking with legal counsel, 216 concluded that 111’s response was a “threat to cease to carry on business” amounting to a breach of the licence agreement. 216 terminated its relationship with 111 and refused to pay the branding fee under the sublease.

216 sought a declaration that 111 had breached the agreement, that the branding fee was not payable to 111, and that 111 must vacate the retail premises. 111 brought a counter-application seeking payment of the branding fee and a declaration that 216 had wrongfully terminated the agreement and breached its duty of good faith. The application judge dismissed 216’s application and granted 111’s application, declaring that 216 had no valid reason to terminate the agreement and that it had acted in bad faith, and ordering 216 to pay the branding fee. However, on appeal, the Ontario Court of Appeal set aside the finding of bad faith.

The Court of Appeal considered four potential sources of bad faith on the part of 216: (i) 216 knowingly misleading 111; (ii) 216 ‘pouncing’ on an alleged default by 111 that it did not believe had occurred; (iii) 216 attempting to evade payment of the branding fee in bad faith; and (iv) 216 seizing upon a breach of its own making. However, the Court of Appeal found that in terminating the agreement, 216 did not seek to undermine 111’s interests in bad faith nor knowingly mislead or deceive 111. Though 216’s termination notice was based on a mistaken belief, the termination right itself formed part of the parties’ agreement and this was reflected in 216’s legitimate interest in protecting its brand – the very circumstances that the parties expressly stipulated would give rise to a right of termination.

The fact that 216 erroneously believed the circumstances were present to give it the right to terminate the agreement did not amount to bad faith. In addition, the fact that 216 did not lie to 111 or act dishonestly was critical in this determination. As a result, the Court of Appeal upheld the application judge’s finding that 216 wrongly terminated the agreement, but it reversed the finding that it was done in bad faith.

Conclusion

Though the trilogy of SCC cases expanded the scope of the duty of good faith in contractual performance, Tokyo Smoke limits its application. Parties to commercial agreements should take note of Tokyo Smoke and the role that knowledge and dishonesty play in the judicial analysis of bad faith conduct. Wrongly terminating an agreement due to a mistaken belief may be sufficient for a finding of breach of contract, but that alone does not constitute bad faith.

If you have any questions with respect to the matters discussed above, please contact Sanjeev Patel ([email protected]) or any other member of Wildeboer Dellelce LLP. The author gratefully acknowledges the assistance of articling student Jeff Arnold in the preparation of this update.

This update is intended as a summary only and should not be regarded or relied upon as advice to any specific client or regarding any specific situation.

If you would like further information regarding the issues discussed in this update or if you wish to discuss any aspect of this commentary, please feel free to contact us.

1 Please refer to our previous updates for summaries of the development of the good faith doctrine: Bhasin v Hrynew, C.M. Callow Inc. v Zollinger and Wastech Services Ltd. v Greater Vancouver Sewerage and Drainage District.