Duty of Good Faith Contractual Performance

Mergers and acquisition (“M&A”) transactions can involve a variety of written agreements and commitments between the parties. These agreements are drafted to, among other things, create as much certainty as possible around the deal. Parties to the M&A deal are not merely required to comply with their obligations as set out in the deal documents, however. They are also required to perform their contractual obligations honestly and in good faith. Understanding the duty of good faith contractual performance and how it applies to your M&A deal will mitigate risk to the transaction arising from allegations that this duty was breached.

The duty of good faith contractual performance generally involves the following four elements:

1. parties must perform their contractual duties honestly and reasonably;[1]
2. parties must have appropriate regard for the contractual interests of their contracting partner;[2]
3. parties must not lie or otherwise knowingly mislead each other about matters directly linked to the performance of the contract.[3] This prohibits not only overt lies but also “half-truths, omissions, and even silence, depending on the circumstances”;[4] and
4. contracting parties have a duty to exercise contractual discretion reasonably and in a manner consistent with the purposes for which the contractual discretion was granted.[5]
   

While the duty of good faith also requires that parties not evade contractual obligations in bad faith, a finding of bad faith will only result if the breaching party engages in any one of the following recognized sources of bad faith: (i) knowingly misleading the other party; (ii) ‘pouncing’ on a default by the other party that the party did not believe had occurred; (iii) attempting to evade performing contractual obligations, such as payment; or (iv) seizing upon a breach of its own making. [6]

As most deals require more work after the contract is signed, buyers and sellers should have regard for the following practical considerations to ensure they are meeting their good faith obligations.

Consider the Interests of the Deal Counterparty

The duty of good faith requires that parties to an agreement consider the interests of the other side. The interests of a party and the scope of the duty will vary depending on the circumstances. Contracting parties are not required to put the interests of the other side ahead of their own in a deal.

Disclose Changes to the Deal

At times, events may occur following the negotiation of an M&A agreement that are either unforeseeable, or out of one or all of the parties’ control. In such a circumstance, the party that becomes aware of the change to the deal should immediately consider whether they are required to disclose the new information to the other parties.

Exercise Contractual Discretion Reasonably

M&A agreements often include discretionary clauses or contractual powers assigned to one or all parties to the transaction. In the context of such clauses, parties must ensure they exercise any decision-making power they have reasonably.

Earnout provisions in particular, the proceeds of which are typically “earned” if the acquired business meets certain financial or other milestones, present some degree of risk for future disputes and/or litigation. As earnouts require only that the buyer pay a portion of the cost of the business upfront, any future compensation to the seller will be tied to the company’s performance. This arrangement can result in conflicting expectations about compensation between parties.

Similarly, conditions and covenants allow for risk sharing between the parties. Conditions allow buyers to use the “self-help” remedy of refusing to close a deal if certain conditions are not satisfied. If a buyer decides to take this route, they must be certain their rationale for backing out of a deal is reasonable before doing so.

Invalid Termination of an Agreement Does Not Amount to Bad Faith

M&A agreements typically contain termination provisions which allow the parties to end their legal relationship and/or discontinue the fulfillment of their obligations to one another. A parties’ wrongful termination of an agreement based on an honest mistaken belief will not necessarily result in a finding that it has violated its good faith contractual obligations. Instead, the terminating parties’ incorrect interpretation of a termination provision may be regarded as an error, so long as their decision is not made dishonestly, unreasonably, capriciously or arbitrarily.

Key Takeaway

Understanding the duty of good faith contractual performance, both generally and how that duty is engaged in the context of your deal, is important. Professional advisors can help you ensure that you have complied with your obligations and can help you determine whether your deal counterparties have done the same.

[1] Bhasin v. Hrynew, 2014 SCC 71 [Bhasin] at para. 63.

[2] Bhasin at para. 65.

[3] Bhasin at para. 73.

[4] C.M. Callow Inc. v. Zollinger, 2020 SCC 45 [Callow] at para. 91.

[5] Wastech Services Ltd. v. Greater Vancouver Sewerage and Drainage District, 2021 SCC 7 [Wastech] at para. 63.

[6] 2161907 Alberta Ltd. v. 11180673 Canada Inc., 2021 ONCA 590