When exercising options, play nice – that’s the message the Supreme Court of Canada sent to contracting parties in a recent decision.
How does this impact contracting practices in the entertainment industries? One way, which will be the focus of this post, is that it constrains the conduct of parties in connection with contracts that contain discretionary options to exercise a right – a set of contracts that includes:
- Option agreements (i.e., agreements which give a party the exclusive right to acquire rights in a property, such as a screenplay)
- Any agreement that gives a party the option to extend the term of the agreement (such as a broadcast licence agreement)
- Any agreement that gives a party the option to obtain additional rights (such as a distribution agreement that gives a party the right to obtain exploitation rights in different territories or media than those originally acquired)
- Any agreement that contains a right of first refusal or first negotiation
Background – The duty of honest performance
You might assume that complying with a written contract simply means conducting yourself in accordance with what the wording of the contract obliges or allows you to do. So, for example, if you enter into a contract which says that you have the option of going on Tuesdays to buy widgets from ABC Corp., then you could “comply with the contract” by going on Tuesday to purchase your widgets, or deciding not to buy widgets on a particular Tuesday (and waiting for the next Tuesday). But, what if, on Friday, you told ABC Corp. that you were going to show up on the following Tuesday to buy widgets, but then changed your mind on Monday and didn’t show up on Tuesday? What if you lied on Friday when you said you were going to buy widgets on Tuesday, but never had any intention of buying them? Would you be in breach of contract then?
According to the Supreme Court of Canada’s articulation of the “duty of honest performance” found in C.M. Callow Inc. v. Zollinger (2020 SCC 45), yes, you would be in breach of contract.
The contractual duty of honest performance was first recognized by the Supreme Court in the 2014 case Bhasin v. Hrynew (2014 SCC 71). In that case, the Court held that contract law is underpinned by an “organizing principle” of “good faith,” which requires that parties “perform their contractual duties honestly and reasonably and not capriciously or arbitrarily” (Bhasin para. 63). While necessarily a context-specific analysis, the duty requires that parties to a contract conduct themselves with “appropriate regard to the legitimate contractual interests” of the other party to the contract (Bhasin para. 65), which manifests in a duty to “not lie or otherwise knowingly mislead each other about matters directly linked to the performance of the contract” (Bhasin para. 73).
The Callow v Zollinger decision – “Honest performance” covers misleading conduct and silences
In the Callow v Zollinger case, the defendant was held to have breached their duty of honest performance by misleading the plaintiff into thinking that the defendant was going to extend the term of the contract, despite the defendant having made a settled decision to not extend the term of the contract. In other words, despite the fact that defendant had, strictly speaking, complied with the express written provisions of the contract (they had provided the required ten days written notice to terminate the contract at the end of the term), they were nonetheless liable for breaching the contract. Because they had not conducted themselves honestly – they did not, in a phrase, “play nice.” Representatives of the defendant knew that they had decided to terminate the contract. They knew that the plaintiff was under the impression that the contract was going to be extended and they did nothing to disabuse him of that notion (even allowing the plaintiff to perform extra “freebie” work, which was performed in an effort to persuade the defendant to extend the term).
In short, while the duty of honest performance requires that parties “not lie or otherwise knowingly mislead each other,” the “misleading” can take the form not just of active, explicit false statements, but it can also take the form of “misleading conduct,” such as “half-truths, omissions, and even silence, depending on the circumstances” (Callow para. 91).
The decision to terminate the contract despite the plaintiff’s expectation that it would be renewed had negative consequences for the plaintiff – because he thought the contract would be renewed, he did not make efforts to secure other engagements for his services, and so he missed out on other opportunities to obtain revenue. The plaintiff was thus awarded damages made up of the profits the plaintiff could have made from other contracts that he would have entered into if he knew he was not going to be engaged by the defendants, plus the expenses that the plaintiff incurred in the expectation that he would be providing services to the defendants (such as equipment rentals).
Applying Callows’ lessons – Don’t mislead, don’t be capricious, don’t rag the puck
How should we apply the lessons of the result and reasons in Callow to the types of entertainment contracts noted above? To be as succinct as possible, when parties have discretionary option rights under a contract, they should take care to exercise them in as candid, forthright, and transparent manner as possible. This is particularly important in situations where the interests of the other party (the party giving the option) could be materially negatively impacted if the option is not exercised.
Below are some examples of how the lessons from the Supreme Court about the duty of honest performance can be applied:
- The most obvious lesson from Callow is that if you know you will not be exercising an option (such as to acquire rights or extend a term), then do not mislead the other party into thinking that you will – if you’ve made the decision not to purchase the screenplay, don’t tell the screenwriter that you will (only to then not exercise the option).
- While the foregoing point does not mean that you have to proactively disclose that you will not be exercising the option, if you are asked about your intentions, you have to provide an honest answer; and if you become aware of the fact that the other party thinks you will be exercising the option because of your words or conduct (for example, you begin discussing renewal terms or other changes to the contract which would only make sense in the context of you exercising your option), you have to take steps to correct their mistaken impression.
- Make sure that there is consistent communication from your side about the option exercise: everyone who is speaking to the counterparty about the option should be reading from the same playbook, otherwise the possibility of misunderstandings increases.
- Extrapolating from the decisions in Bhasin and Callow, the duty of honest performance seems to have significant implications for how parties conduct themselves in the context of rights of first refusal or first negotiation: if a party has a right of first refusal that must be exercised within 30 days, for example, but they know that they will not be exercising that right (i.e., they will not be purchasing the rights in question), then the party should not conduct feigned negotiations (or remain silent) in order to “run out the clock” – particularly where the delay occasioned by the sham negotiations (or silence) results in the other party losing an opportunity they otherwise would have enjoyed.
It is important to remember that “strict compliance” with the wording of a contract does not necessarily constitute compliance with the underlying duty of honest performance – parties need to “play nice” as regards their conduct in the exercise of their contractual rights and performance of their contractual obligations. That lesson from Callow applies equally to the exercise of termination rights and, as set out above, option rights.