Business Law

Good Faith and Honesty: Applicable Before and After Closing a Sale or Purchase Transaction

Mar 16th, 2015

By Daniel Frajman

Good faith and honesty obligations likely apply to the following three examples of possible transactional scenarios:

  1. Before due diligence is done on your company, you have signed a non-disclosure agreement, but it does not specifically prohibit the potential buyer from soliciting your employees. The transaction does not proceed to a binding offer. Now the former potential buyer wants to offer an employment contract to one of your key technical persons. Can they do so?
  2. You sign a binding offer to purchase a target company, subject to you “conducting due diligence”. You discover in your review an old environmental problem concerning the target’s main building, which objectively should reduce the purchase price by 10%. Can you pull out of the offer based upon the environmental problem?
  3. You are a seller and the deal closes, with the sale price subject to a bonus based on an earn-out provision linked to “sales” in the business during the first year post-closing. The business does well post-closing, but sales do not achieve the earn-out level due to the purchaser diverting resources to R&D. Can you claim the earn-out bonus anyway?

In my experience, there is a certain amount of uncertainty in all these examples. The best way to avoid uncertainty often is to have contractual terms that expressly address your concern, rather than hoping that a vague clause (or no clause) will play out in your favour. This is because although all contracts are subject to a general legal duty of good faith on the part of each party, good faith can sometimes be difficult to define. Therefore, it can instead be useful to expressly stipulate your expectations in the contract, which often allows the parties to operate with more certainty.

If however expectations are not expressly stated in the contract, it is important to look at the legal basis for the good faith obligation (difficult to define as it is) that relates to all contracts, especially since the good faith concept was dealt with late last year in a decision of the Supreme Court of Canada. Good faith in contracts is essentially based on the following:

  • In Quebec, the obligation to act in good faith and not abuse one’s rights under a contract seemed, under jurisprudence arising under the old Civil Code, to apply to all kinds of contracts. The new Civil Code of Quebec of 1994 confirmed this and indicates that rights may not be exercised with the intent of injuring another or in an excessive or unreasonable manner, and that the parties to a contract have a broad duty of good faith that applies to the formation, performance and termination of a contract. (See articles 6, 7 and 1375 of the Civil Code of Quebec.) Basically, this requires you to take into account the reasonable expectations of your counter-party;
  • In the United States, there is a similar obligation, as every contract or duty within the Uniform Commercial Code (“U.C.C.”) imposes an obligation of good faith in its performance and enforcement. (See section 1‑304 U.C.C.)
  • In the Canadian common law provinces (i.e., the provinces other than Quebec), in the past the good faith obligation has not been as broadly stated. Rather, although a good faith obligation has in the past been recognized in common law Canada in certain situations where there is often an uneven balance of power among the parties (ex., most employment contracts, most leases, and all insurance policies), it was only in November 2014, in the Bhasin v. Hrynew case (2014 SCC 71) (“Bhasin”), that the Supreme Court of Canada extended the good faith obligation to all contracts in common law Canada.

Although the Bhasin case is not necessarily a precedent outside the common law provinces, the statements in the case could catch on in Quebec, and are worth looking at. The main statements made by the Supreme Court can probably be summarized as follows:

  • There is an overriding general duty requiring parties to perform their contracts in good faith;
  • As a manifestation of this duty of good faith, parties must meet the “minimum core requirements” of performing their duties honestly, co-operating with their counter-party in achieving contractual objectives, exercising contractual discretionary powers reasonably and in good faith, and not evading contractual obligations through lies or activity misleading others. Furthermore, a party should have “appropriate regard” (depending on the context) for a counter-party’s interest (although on the other hand, it is recognized that a party can, at the same time, act in its own interest); and
  • As long as a contract meets these minimum core requirements, the parties are otherwise free to put in the contract the other terms and conditions of their agreement.

The abovementioned legislation and jurisprudence, including the recent Supreme Court case of Bhasin, underlines that rather than relying upon general notions of good faith and honesty to provide protection, transactional documents should instead be clear on all important elements of a transaction, including among other things regarding disclosure, due diligence, representations and warranties and pre-closing and post-closing conditions and obligations.

We would be pleased to help you properly prepare your transactional documents.

Daniel Frajman, a shareholder of Spiegel Sohmer, a Montreal law firm, negotiates and drafts contracts for business and real estate sales and purchase transactions, leases, debt and equity financings, shareholders’ agreements, trusts, wills, and for non-taxable non-profit and charitable businesses.