Supreme Court kills fundamental breach in enforcement of liability disclaimers in Tercon

IT lawyers know all too well that IT contracts can go awry. That is why so much time is spent arguing about limits of liability during contract negotiations. A recent example is the BSkyb Ltd & Anor v HP Enterprise Services UK Ltd & Anor (Rev 1) [2010] EWHC 86 (TCC) (26 January 2010) case where the UK court made a huge damage award against HP.

The Supreme Court had considered on several previous occasions the effect of a fundamental breach on limitations of liability terms. In Hunter Engineering Co. v. Syncrude Canada Ltd., 1989 CanLII 129 (S.C.C.), [1989] 1 S.C.R. 426, Dickson C.J. observed that the doctrine of fundamental breach had “spawned a host of difficulties”, the most obvious being the difficulty in determining whether a particular breach is fundamental.  The doctrine obliged the parties to engage in “games of characterization” which distracted from the real question of what agreement the parties themselves intended.  Accordingly, in his view, the doctrine should be “laid to rest”.  The situations in which the doctrine is invoked could be addressed more directly and effectively through the doctrine of “unconscionability”.

Wilson J. (concurring) disagreed.  In her view, the courts retain some residual discretion to refuse to enforce exclusion clauses in cases of fundamental breach where the doctrine of pre-breach unconscionability did not apply. Wilson J. considered it more desirable to develop through the common law a post-breach analysis seeking a “balance between the obvious desirability of allowing the parties to make their own bargains … and the obvious undesirability of having the courts used to enforce bargains in favour of parties who are totally repudiating such bargains themselves”.

Last week in Tercon Contractors Ltd. v. British Columbia, 2010 SCC  4 the Supreme Court sided with Dickson C.J and decided to lay to rest the doctrine of fundamental breach applied to limitation and disclaimers of liability. Although the Court split on the facts before the Court, all members of the Court agreed on the methodology to be applied in assessing the enforceability of a contract disclaimer. The test was set out by Binnie j., as follows:

“The present state of the law, in summary, requires a series of enquiries to be addressed when a plaintiff seeks to escape the effect of an exclusion clause or other contractual terms to which it had previously agreed.

The first issue, of course, is whether as a matter of interpretation the exclusion clause even applies to the circumstances established in evidence. This will depend on the Court’s assessment of the intention of the parties as expressed in the contract. If the exclusion clause does not apply, there is obviously no need to proceed further with this analysis. If the exclusion clause applies, the second issue is whether the exclusion clause was unconscionable at the time the contract was made, “as might arise from situations of unequal bargaining power between the parties” (Hunter, at p. 462).  This second issue has to do with contract formation, not breach.

If the exclusion clause is held to be valid and applicable, the Court may undertake a third enquiry, namely whether the Court should nevertheless refuse to enforce the valid exclusion clause because of the existence of an overriding public policy, proof of which lies on the party seeking to avoid enforcement of the clause, that outweighs the very strong public interest in the enforcement of contracts.”

It is apparent from the decision that henceforth, parties seeking to avoid contractual limitations of liability will have to find the clause inapplicable based on its limited intended scope, or by pointing to some paramount consideration of public policy sufficient to override the public interest in freedom of contact that would defeat what would otherwise be the contractual rights of the parties.  Binnie J, gave some examples of what might fall within the public policy exception:

“As Duff C.J. recognized, freedom of contract will often, but not always, trump other societal values.  The residual power of a court to decline enforcement exists but, in the interest of certainty and stability of contractual relations, it will rarely be exercised.  Duff C.J. adopted the view that public policy “should be invoked only in clear cases in which the harm to the public is substantially incontestable, and does not depend upon the idiosyncratic inferences of a few judicial minds” (p. 7).  While he was referring to public policy considerations pertaining to the nature of the entire contract, I accept that there may be well-accepted public policy considerations that relate directly to the nature of the breach, and thus trigger the court’s narrow jurisdiction to give relief against an exclusion clause.

There are cases where the exercise of what Professor Waddams calls the “ultimate power” to refuse to enforce a contract may be justified, even in the commercial context.  Freedom of contract, like any freedom, may be abused.  Take the case of the milk supplier who adulterates its baby formula with a toxic compound to increase its profitability at the cost of sick or dead babies.  In China, such people were shot.  In Canada, should the courts give effect to a contractual clause excluding civil liability in such a situation?  I do not think so.  Then there are the people, also fortunately resident elsewhere, who recklessly sold toxic cooking oil to unsuspecting consumers, creating a public health crisis of enormous magnitude.  Should the courts enforce an exclusion clause to eliminate contractual liability for the resulting losses in such circumstances?  The answer is no, but the contract breaker’s conduct need not rise to the level of criminality or fraud to justify a finding of abuse.

A less extreme example in the commercial context is Plas-Tex Canada Ltd. v. Dow Chemical of Canada Ltd., 2004 ABCA 309, 245 D.L.R. (4th) 650.  The Alberta Court of Appeal refused to enforce an exclusion clause where the defendant Dow knowingly supplied defective plastic resin to a customer who used it to fabricate natural gas pipelines.  Instead of disclosing its prior knowledge of the defect to the buyer, Dow chose to try to protect itself by relying upon limitation of liability clauses in its sales contracts.  After some years, the pipelines began to degrade, with considerable damage to property and risk to human health from leaks and explosions.  The court concluded that “a party to a contract will not be permitted to engage in unconscionable conduct secure in the knowledge that no liability can be imposed upon it because of an exclusionary clause” (para. 53).  (See also McCamus, at p. 774, and Hall, at p. 243).  What was demonstrated in Plas-Tex was that the defendant Dow was so contemptuous of its contractual obligation and reckless as to the consequences of the breach as to forfeit the assistance of the court.  The public policy that favours freedom of contract was outweighed by the public policy that seeks to curb its abuse.

Conduct approaching serious criminality or egregious fraud are but examples of well-accepted and “substantially incontestable” considerations of public policy that may override the countervailing public policy that favours freedom of contract.  Where this type of misconduct is reflected in the breach of contract, all of the circumstances should be examined very carefully by the court.  Such misconduct may disable the defendant from hiding behind the exclusion clause.  But a plaintiff who seeks to avoid the effect of an exclusion clause must identify the overriding public policy that it says outweighs the public interest in the enforcement of the contract.  In the present case, for the reasons discussed below, I do not believe Tercon has identified a relevant public policy that fulfills this requirement.”

It seems clear from his remarks that the public policy threshold is a high one. On the facts of the case, it was accepted that the respondent, the BC government, had acted in an unfair manner and contrary to required standards for tendering public sector contracts. However, Binnie J., made it clear that even breaching an implied duty of fairness in such contracts would not be enough to reach this threshold:

“If the exclusion clause is not invalid from the outset, I do not believe the Ministry’s performance can be characterized as so aberrant as to forfeit the protection of the contractual exclusion clause on the basis of some overriding public policy.  While there is a public interest in a fair and transparent tendering process, it cannot be ratcheted up to defeat the enforcement of Contract A in this case.  There was an RFP process and Tercon participated in it.

Assertions of ineligible bidders and ineligible bids are the bread and butter of construction litigation.  If a claim to defeat the exclusion clause succeeds here on the basis that the owner selected a joint venture consisting of an eligible bidder with an ineligible bidder, so also by a parity of reasoning should an exclusion clause be set aside if the owner accepted a bid ineligible on other grounds.  There would be little room left for the exclusion clause to operate.  A more sensible and realistic view is that the parties here expected, even if they didn’t like it, that the exclusion of compensation clause would operate even where the eligibility criteria in respect of the bid (including the bidder) were not complied with.”