Tokyo Smoke and the Threshold Required to Establish Bad Faith

Overview

On August 30, 2021, the Court of Appeal for Ontario released its decision in 2161907 Alberta Ltd. v. 11180673 Canada Inc (“Tokyo Smoke”).^[1]

This decision re-affirms previously established principles relating to contractual interpretation and the duty of good faith in long-term relationship contracts, which we previously discussed in our post “Wastech and the Franchising Context”.

While the Supreme Court of Canada’s landmark 2014 decision in Bhasin v Hrynew established good faith contractual performance as a “general organizing principle” of the common law of contract, the precise boundaries of this duty of good faith have thus far been difficult to practically define.

Helpfully, Tokyo Smoke provides some guidance on the type of conduct required for a finding of a breach of the duty of good faith in relation to the termination of an agreement.

Summary of Facts

2161907 Alberta Ltd. (“216” or “licensor”) holds the Ontario rights to the “Tokyo Smoke” cannabis brand and licenses it to various retail operators. 11180673 Canada Inc. (“111” or “licensee”) won a cannabis retail operator license in an August 2019 allocation lottery by the Alcohol and Gaming Commission of Ontario (“AGCO”).

In November 2019, 111 and AGCO entered into a License Agreement for the use of the Tokyo Smoke brand and an accompanying Sublease, whereby 111 rented the retail premises from 216 for the operation of a cannabis store. 216 offered 111 funding for start-up costs, including funds for the monthly rent of $105,409.03, and an approximately $2 million inducement to open under the Tokyo Smoke banner (the “Branding Fee”).

On June 1, 2020, two days before opening, a dispute arose over rent. 216 indicated that it would not be paying 111’s June rent. In turn, 111’s principal advised 216 that he would be laying off employees and not opening the store as planned if the rent issue was not resolved.

216 took the position that 111’s threat to cease business operations was an Event of Default under the License Agreement and terminated the parties’ relationship. On June 2, 2020, 216 pulled its staff from the store premises and delivered Notices of Default to 111.

On June 3, 2020, 111 opened the store despite the delivery of the Notices of Default. 216 subsequently delivered a Cease and Desist Notice to 111, but 111 took the position that it was not in default of the parties’ License Agreement and continued to operate the store.

Accordingly, 216 brought an application seeking a declaration that 111 had breached their various agreements, that the Branding Fee was not payable, and that 111 must vacate the store premises.

111 brought a counter-application seeking payment of the Branding Fee, and a declaration that 216 had wrongfully terminated the License Agreement and breached its duty of good faith in the performance and enforcement of the parties’ contractual relations.

Procedural History

Justice Gilmore of the Ontario Superior Court of Justice dismissed 216’s application, holding that 216’s termination of the License Agreement was not valid and ordering 216 to pay the Branding Fee.

Upon examining the surrounding context and interactions between the parties, the Court found that 216 had no valid reason to terminate its agreements with 111, as no breach of the Licence Agreement had occurred. 111’s principal’s communication to the effect that he would not be opening the store and would be laying off staff was not an Event of Default under the License Agreement, but merely “an emotional response to being given incorrect information at a critical time”.

Further, the Court held that 216’s termination of the agreements was done in bad faith. The Court found that, based on 216’s representative’s admission in cross-examination that on the morning of June 2, 2020, 216 was looking for a way to end the relationship with 111, 216 had “pounced” on the statement made by 111 as a way to terminate the relationship and avoid paying the Branding Fee. Therefore, 216’s termination of the agreements was not done in good faith.  The issue of 111’s damages for the breach was to be left to be addressed at a later date.

216 appealed to the Ontario Court of Appeal. Among other things, it argued that the application judge erred in finding that 216’s termination of the License Agreement was invalid, and that 216 had breached the duty of good faith in contractual performance to 111.

The Ontario Court of Appeal Decision

The Ontario Court of Appeal allowed the appeal in part. It upheld the application judge’s finding of breach of contract by 216 for wrongfully terminating its License Agreement with its licensee, 111, but it overturned the finding of bad faith conduct on the part of 216.

Breach of Contract Findings

Justice Rouleau, writing for the Court of Appeal, held that the application judge’s interpretation and application of the parties’ contractual terms were owed deference on appeal, and found that there was no basis to interfere with Her Honour’s findings.

While the Court of Appeal accepted that the 111’s communications were, on their face, a threat not to open, nevertheless, the Court did not apply a literal approach to the License Agreement and rejected this possible interpretation of the License Agreement.^[2] Rather, the Court of Appeal endorsed the interpretation of the License Agreement made by the application judge that would require the threat to be objectively credible in order to trigger a default under the agreement.^[3]

In adopting this interpretation, the Court of Appeal emphasized that the application judge’s finding that the licensee’s emotional response did not constitute a threat for the purposes of meeting the requirements of the parties’ Event of Default termination clause was drawn from Her Honour’s “objective assessment of the parties’ exchanges in light of the language of the agreement and the factual context”.^[4] Thus, the Court of Appeal affirmed that determining whether the threat was objectively credible required this type of contextual analysis.

Upon reviewing the factual matrix[5], the Court of Appeal held that it was clearly reasonable for the application judge to find that 111’s statements did not meet the requirements of an Event of Default under the parties’ License Agreement.

Bad Faith Findings

Beginning at paragraph 40 of the reported decision, the Court of Appeal conducted its analysis of the application judge’s finding that 216 breached its duty of good faith to 111.

The Court of Appeal ultimately found that 216 did not act in bad faith, because it simply misunderstood its rights and acted on its mistaken belief in its rights when it wrongfully terminated the License Agreement.  While 216’s basis for terminating the License Agreement ultimately proved invalid in law, its position on termination was not so unreasonable, malicious, or inconsiderate of 111’s legitimate contractual interests as to constitute bad faith.

In conducting this analysis, the Court of Appeal considered and rejected four potential sources of bad faith conduct by 216:^[6] (i) that 216 knowingly misled 111; (ii) that 216 “pounced” on a default that it did not believe had occurred; (iii) that 216 sought to evade payment of the Branding Fee in bad faith; and (iv) that 216 seized upon a breach of its own making.

• 216 knowingly misled 111

Critical to the Court of Appeal’s finding that there was no bad faith conduct by 216 was the fact 216 was not found to have acted dishonestly^[7], capriciously^[8] or in a way that was so inconsiderate of 111’s legitimate contractual interests as to constitute bad faith.^[9] 216’s basis for terminating the License Agreement was not manufactured or concocted, it simply believed that 111’s purported threat was a breach it could act on.^[10]

Thus, although the Court of Appeal accepted that 216 had misled or misinformed 111, it did not find bad faith conduct because 216 had not “knowingly mislead” 111 about its intention with respect to the Branding Fee or the deferral of rent.^[11] 216 did not lie to 111 at any point, but simply changed positions given new information.

• 216 “pounced” on a default

In determining whether 216’s actions in “pouncing” on the alleged default by its licensee constituted bad faith, at paragraph 63 of Tokyo Smoke, the Court of Appeal described the type of conduct that would make “pouncing” on a default bad faith conduct:

…The breach he ultimately invoked was based on 216’s understanding that the threat was the type of threat contemplated by paragraph 26(c). That interpretation was wrong but, absent a finding that it was a position manufactured to achieve 216’s objective of ending the relationship, an unreasonable position, or a position taken capriciously or arbitrarily, it constitutes an error and no more.

Thus, the Court of Appeal concluded that 216’s erroneous belief that the circumstances gave rise to a right of termination does not amount to bad faith, regardless of 216’s underlying desire to end its relationship with 111. The termination right was part of the parties’ bargain and reflected the licensor’s legitimate interest in protecting its brand.

• 216 sought to evade payment of the Branding Fee in bad faith

The Court of Appeal also considered the argument that 216 had an improper motive for terminating the License Agreement, which reason constituted bad faith conduct. In paragraph 66, it re-affirmed the principle that “a party has a duty not to evade its contractual obligations in bad faith. As a result, a party that manufactures an artificial reason to terminate a contract in order to avoid future payment obligations would likely be found to have acted in bad faith.”^[12]

Here, 216’s alleged improper motive was to avoid the payment of the Branding Fee to 111. However, the Court of Appeal held that since the application judge did not reject the evidence of 216 that it was not seeking to evade that payment,^[13] there was no bad faith conduct. 216 did not manufacture an artificial reason to avoid paying the Branding Fee but believed its termination of the Licensing Agreement was justified. The fact that termination releases a party from making a significant payment does not amount to bad faith, even where a court later finds that the termination was invalid.

• 216 seized upon a breach of its own making

Lastly, the Court of Appeal considered whether the doctrine of invoking a breach of its own making as set out in the Supreme Court of Canada decision of Mason v. Freedman^[14] applied. The doctrine stipulates that a party should not be permitted to evade its contractual obligation by seizing upon the consequences of its own mistake.^[15]

In considering the doctrine, the Court of Appeal concluded that, unlike Mason, there was no deliberate attempt by 216 to create the conditions giving rise to 216’s right of termination. 216 misinterpreted the parties’ agreement when it made the statements that triggered 111’s “threats”, which 216 in turn perceived as an event of default.^[16] Thus, the doctrine did not apply.

Key Takeaways 

Tokyo Smoke reaffirms that the conduct of the parties under an ongoing relationship contract must be viewed in context and that a contextual analysis is necessary to determine both the parties’ rights and obligations under the contract, as well as whether a breach of such rights did in fact occur.^[17]

Tokyo Smoke also establishes that:

• A finding of bad faith is not required for a determination of breach of contract: A breach of the duty of good faith is not a condition precedent to a finding that a party wrongfully enforced the termination provision in a long-term relationship contract. A party can be found to be in breach of an agreement in the absence of bad faith conduct.
  Although the Court of Appeal in Tokyo Smoke overturned the application judge’s finding that there was a breach of the duty of good faith, the Court of Appeal did not overturn the finding of a breach of the License Agreement and found that the conduct of the licensor was “quite simply a case of breach of contract”.^[18]

• The duty of good faith does not prevent a party from exercising its contractual discretion to terminate an agreement: A party is not prevented from exercising a valid right of termination simply because it desires to end a relationship, and “pounces” on what it views as an opportunity to do so.
• The duty not to evade contractual obligations in bad faith is breached when a party intentionally creates the circumstances it relies on to terminate the agreement: When a party manufactures an artificial reason to terminate a contract in order to avoid future obligations, it will likely be found to have acted in bad faith. Similarly, a deliberate attempt to create the conditions to trigger the other contracting party’s contractual default is a hallmark of bad faith.

Implications for Franchising

In the six Canadian provinces that have franchise legislation[19], parties to a franchise agreement owe each other a duty of fair dealing in the performance and enforcement of the franchise agreement.  In each of these provinces except Alberta, the fair dealing obligation is said to include the duty of good faith.  As such, these common law standards of what the duty of good faith entails are informative in understanding the statutory duty of fair dealing.  In addition, however, the duty of fair dealing is said to include the duty to act in accordance with reasonable commercial standards.  The demonstration of such standards may, in fact, further inform the duty of fair dealing and any “reasonableness” aspects of the good faith obligation.

At the lower court level in Tokyo Smoke, the parties argued whether the license agreement at issue was a “franchise agreement” as defined by Ontario’s franchise legislation, Arthur Wishart Act (Franchise Disclosure), 2000.[20] The court declined to determine the issue as the license agreement at issue contained a provision which expressly included an obligation on the parties to act in good faith in its performance.  The issue was not addressed further in the Court of Appeal.

It is unfortunate that the court did not address the issue of whether the license agreement was in fact a franchise agreement within the meaning of the legislation.  If the case, however, did not invoke any issues of reasonable commercial standards, then it is likely that the outcome of the decision would not have been different, whether the court was assessing the good faith obligation or the statutory fair dealing obligation.

Franchisors are well-advised to consider their franchise agreements and to include provisions which will define for the parties the nature and scope of their obligations and the purposes for which any contractual discretion is being retained.

At Sotos LLP, our lawyers regularly advise our franchising and licensing clients on matters relating to the preparation of and the performance and enforcement of their agreements.  Please contact the writer at 416-572-7306 if you wish to discuss the implications of evolving law of fair dealing and good faith to your business.

[1] 2021 ONCA 590 (“Tokyo Smoke”).
[2] Tokyo Smoke at paras 30-31.
[3]Tokyo Smoke at para 31.
[4] Tokyo Smoke at para 38.
[5] The context was that, prior to the alleged default, 216 wrongly advised 111 that it had no obligation to advance any further monies to it under the parties’ agreement, which would have left 111 unable to pay its rent and employees for the June opening month of operations. It was after receiving this wrong information from 216, that 111 made its “threat” to not open the store and lay off its employees, which “threat” was the default that 216 subsequently relied on to terminate the License Agreement between the parties. 111 correctly believed that 216 had breached their agreement by refusing to provide this funding and was consequently unsure whether the store would open in the face of an unexpected funding shortfall.
[6] Tokyo Smoke at para 48.
[7] Tokyo Smoke at para 57.
[8] Tokyo Smoke at para 59.
[9] Tokyo Smoke at para 58.
[10] Tokyo Smoke at para 58.
[11] Tokyo Smoke at para 50-51.
[12]Tokyo Smoke at para 66.
[13] Tokyo Smoke at para 68.
[14] [1958] S.C.R. 483 (“Mason”).
[15] Tokyo Smoke at para 69.
[16] Tokyo Smoke at para 71.
[17] Tokyo Smoke at para 32.
[18] Tokyo Smoke at para 71.
[19] Ontario, Alberta, British Columbia, New Brunswick, Manitoba, and Prince Edward Island.
[20] S.O. 200, c.3