A comparative look at good faith and changed circumstances, hardship and more

Introduction

This article focuses on the Supreme Court of Canada decision in Churchill Falls (Labrador) Corporation Limited v Hydro-Québec 2018 SCC 461¹. To most Canadians, the mere mention of Hydro-Québec and Churchill Falls in the same sentence spontaneously evokes the long-term contract at issue in this case. That contract has been a very public bone of contention between the Province of Québec and the Province of Newfoundland for more than 40 years. The Supreme Court’s decision is used here as a launch pad for a broader discussion of good faith, changed circumstances and hardship, and the circumstances in which an arbitrator or judge may be called upon to alter the terms of a contract. These issues frequently arise in international arbitration.

The facts of the case

Background

The Churchill River is the longest river in Atlantic Canada. It flows toward the Atlantic in Labrador, in the easternmost province of Canada, Newfoundlandand-Labrador. The Churchill River basin has long been known as one of the areas with the greatest hydroelectric potential in the world. Among several locations with potential was Churchill Falls, in the Upper Churchill River. Until the 1960s, there were two obstacles to developing these water resources: the technical challenge of transporting electricity the great distance to the nearest markets in Southern Québec and the US without undue loss of power; and financing. To finance the project, its sponsors, Churchill Falls (Labrador) Corporation Limited (CF(L)Co) and its majority shareholder, had to find one or more creditworthy purchasers that would commit, on a take-or-pay basis, to purchase substantially all of the electricity generated by the plant. Hydro-Québec (H-Q) was one such potential purchaser. Moreover, in the 1960s, H-Q’s engineers had developed high-voltage transmission lines that enabled electricity transportation over long distances without substantial loss of power. However, H-Q had alternatives: The Province of Québec also has huge hydroelectric potential, which in the 1960s remained largely untapped. At the time, H-Q had several major hydroelectric projects underway and so required convincing that it would make sense to support the construction of a plant owned by a third party and to purchase its electricity, rather than build its own additional hydroelectric facility.

The Contract

After nearly five years of negotiation, CF(L)Co convinced H-Q to defer its own hydroelectric projects and support Churchill Falls. In 1969, CF(L)Co and H-Q signed a contract providing the legal and financial framework for the Churchill Falls hydroelectric project (the Contract). It was a huge project, involving issuance of what was then the largest ever bond offering, construction of the largest hydroelectric plant in the world at the time, and transmission lines to transport electricity some 1,300km.

In addition to investing capital and providing an unlimited completion guarantee, H-Q undertook to purchase, over a 65-year period, virtually all of the electricity the plant would produce, whether it needed it or not. That takeor-pay commitment allowed CF(L)Co to use debt financing to cover construction costs. In exchange, H-Q obtained the right to purchase electricity at fixed prices for the 65-year Contract term. Those prices reflected the project’s construction costs.

To assist CF(L)Co with servicing its massive debt in the early years of the Contract, revenues from the sale of electricity to H-Q were front-loaded, using a price schedule that declined over time, roughly tracking the reimbursement of the project debt. The last price reduction took effect in 2016, once the debt was retired, and the Contract provides for this price to remain fixed for the last 25 years of the Contract. This gave H-Q the kind of price stability and protection from inflation that it enjoys with its own projects, the key difference being that, at the end of the term, the Churchill Falls plant would remain the property of CF(L)Co.

The changed circumstances

Shortly after the Contract was signed, the oil price shocks of the 1970s brought major changes in the North American energy market. Then came the decline in public confidence in nuclear energy, following the Three Mile Island accident, in 1979. Beginning in the 1990s, there was a gradual deregulation of transmission systems in North America that liberalized access to the US market. These changes led to a substantial increase in the market price for electricity, which quickly far surpassed the Contract’s pricing terms. This allowed, and continues to allow, H-Q to purchase electricity from Churchill Falls at a very low price while selling electricity to third parties at a substantially higher price.

In 2010, CF(L)Co commenced court proceedings seeking a declaration that H-Q has a duty to renegotiate the Contract pricing terms. CF(L)Co also asked that, as H-Q refused to renegotiate, the court itself modify the Contract by imposing a price formula designed to share the unanticipated profits flowing from the Contract.

CF(L)Co’s case was that the fundamental changes in the energy market were unforeseeable and disrupted the equilibrium of the Contract. CF(L)Co argued that the benefits generated by the sale of Churchill Falls energy were so much greater than the parties could have foreseen when signing the Contract that H-Q’s windfall profits had to be reallocated and shared more equitably. CF(L)Co based its claim on a general duty of good faith recognized in Québec civil law, and on what it described as an implied duty to renegotiate, based on equity.

H-Q’s position was that CF(L)Co was seeking to introduce, through the back door of contractual good faith, the civil law doctrine of unforeseeability (la théorie de l’imprévision) which was never part of the law of Québec. H-Q maintained that CF(L)Co was receiving exactly what it bargained for, and that it was seeking to appropriate part of the benefits that rightfully belonged to H-Q under the Contract.

Before examining how the Supreme Court resolved the question, it is instructive to consider how other jurisdictions and soft law instruments deal with the issue of changed circumstances.

Changed circumstances: a comparative overview

Civil law jurisdictions

German courts developed the possibility for a party to request adaptation of a contract upon changed circumstances on the basis of contractual good faith. The German law doctrine known today as “Interference with the Basis of the Transaction” can be traced back to the aftermath of World War I, when the German economy was devastated by the Deutsche Mark’s fall to one-trillionth of its former value. This had a catastrophic effect on fixed-price contracts. At the time, the German Civil Code only provided for relief in cases of absolute impossibility of performance. Nevertheless, German courts relied on the duty of good faith to develop a theory of unforeseeability that was later codified. Article 313 of the German Civil Code provides that if a change in circumstances that were foundational to the contract render its performance unsupportable for one of the parties, then the court may adapt the contract or, if not possible, terminate it. In assessing the changed circumstances, the court must consider whether the disadvantaged party can reasonably be expected to perform, taking into account the contractual allocation of risk.

Swiss courts also relied on the duty of good faith as the foundation for possible judicial alteration of a contract in the event of changed circumstances. Switzerland has however not codified this principle, which is sometimes referred to as “l’exorbitance”. Two basic conditions must be met to open this door under Swiss law: (1) occurrence of new, inevitable and unforeseeable circumstances; and (2) consequent imposition of an excessive burden on the debtor. If these are satisfied, the court will order renegotiation of the contract and, if renegotiation fails, the court may adapt the contract and impose the solution that the parties in good faith would have adopted had they foreseen the changed circumstances when the contract was negotiated.

In France, judicial intervention in the event of changed circumstances is possible under the théorie de l’imprévision (the doctrine of unforeseeability). The effect of this doctrine, which is recognized in a number of other civil law jurisdictions, is that parties can be required to renegotiate a contract if, as a result of unforeseen circumstances, performance of contractual obligations would be excessively onerous for one of them. Until recently, the theory applied to contracts with the State and state parties (administrative contracts) which, in France, are governed by principles distinct to those governing private law contracts and subject to the jurisdiction of a court system distinct from civil courts. However, under French private law, the doctrine of unforeseeability had been rejected. The leading authority was the Canal de Craponne case, decided in 1876, in which a company exploiting irrigation canals sought an increase in the usage rates originally fixed in a contract concluded in the 16th century. In rejecting the claim, the Cour de Cassation held that in no event may courts alter the parties’ agreement on account of time or changed circumstances. Attempts were made to rely on contractual good faith as a ground for a duty to renegotiate, but the French Supreme Court closed the door to that possibility in 2007, in the Les Maréchaux case, holding that the duty of good faith can be relied upon to control the conduct of a party under a contract, but never entitles a judge to modify the parties’ contractual rights and obligations. The position only changed in 2016, when, as part of a major revision of the law of obligations, the doctrine was incorporated into French private law.

Article 1195 of the French Civil Code now provides that if an unforeseeable change of circumstances makes the contract excessively onerous for a party, that party may ask for its renegotiation, and if the renegotiation fails, it may terminate the contract or ask a judge to alter it, provided the party had not accepted to assume that risk under the contract. A similar evolution is currently taking place in Belgium.

Soft law instruments

Hardship provisions in the Unidroit Principles of International Commercial Contracts entitle a party to ask for the renegotiation of the contract when unforeseeable events “fundamentally alte[r] the equilibrium of the contract”. If renegotiation fails, the arbitral tribunal or court applying the Unidroit Principles may terminate the contract or adapt it to restore the equilibrium. Other soft law instruments contain similar hardship provisions, most prominently the Principles of European Contract Law which include a provision on Change of Circumstances.

Common law jurisdictions

The position is markedly different under the common law. Under English law, the doctrine of frustration of contract allows for termination of a contract when an unforeseeable event fundamentally changes the nature of the obligations, or if the contractual obligation has become incapable of being performed. But this doctrine does not give rise to a duty to renegotiate the contract, nor provide for its alteration by the court. Moreover, hardship, inconvenience or material loss are not grounds for the principle of frustration to apply. In Canary Wharf (BP4) TI Ltd. v European Medicines Agency [2019] EWHC 335 (Ch), the English High Court decided that Brexit did not constitute a frustrating event for the purpose of a long-term commercial lease, even if Brexit resulted in the forced relocation of an agency of the EU outside of the UK. Slightly different principles apply in the US under the doctrines of frustration of purpose and impracticability of performance.

The law of Québec

When CF(L)Co commenced proceedings in 2010, the case law was clear: the doctrine of unforeseeability was not part of Québec civil law, even though a number of authors had argued that it should be and that a duty to renegotiate may arise from contractual good faith. In the early 1990s, Québec had modernized its civil code and the Revision Office in charge of the draft revised code had expressly recommended that the doctrine of unforeseeability be incorporated into the law of Québec.

The Québec legislature rejected that recommendation. Québec courts relied on that rejection to reaffirm that the doctrine of unforeseeability did not form part of the law of Québec. (This explains why CF(L)Co based its case on contractual good faith rather than the doctrine of unforeseeability.)

The Supreme Court decision in the Churchill Falls case

CF(L)Co’s appeal was dismissed by a majority (7:1). The Court held that H-Q did not have a duty to renegotiate a contract that provided it with substantial unanticipated benefits. The majority reasoned that it was not the Court’s role to second-guess the Québec legislature’s deliberate decision not to incorporate the doctrine of unforeseeability into the law of Québec, which turned on social policy considerations best left to the legislature. Further, the Court noted that even in jurisdictions where the doctrine of unforeseeability is available, it cannot be applied when the aggrieved party has accepted the risk of unforeseeable events, nor when the effect of the changed circumstances is merely to make the contract more beneficial for one party without making it more onerous for the other. Here, the parties had intentionally allocated the risk of price fluctuation to H-Q. The trial judge had found that the risk of future price fluctuations was a “known unknown” and that the parties had specifically contemplated and rejected the inclusion of a price escalator in the Contract. Moreover, the changed circumstances did not increase CF(L)Co’s cost of performing the Contract nor diminish the value of what it receives. On the contrary, CF(L)Co has continued to receive exactly what it bargained for.

Addressing the duty of good faith, the Court held that while it may serve to protect the equilibrium of a contract, it cannot be used to change that equilibrium and impose a new bargain. Like the Court of Appeal, the Supreme Court refused to rule out the possibility that good faith may be the source of duties in the event of true hardship, but all indications are that this would likely be restricted to instances of bad faith or abuse of right.

Relevance in international arbitration

Except for contracts that call for instantaneous performance (such as tanking at a gas station) most contracts involve commitments in relation to the future, which by definition is uncertain. Although special challenges obviously arise in the case of long-term contracts, contracts must be seen for what they are: instruments to allocate risks and rewards in respect of an uncertain future. The Churchill Falls Contract has a 65-year term. To get a sense of how uncertain the future was for the parties when signing the Contract, consider the economic and technological changes that had taken place in the preceding 65 years (1904 to 1969): the Wright brothers took their pioneering flight; Neil Armstrong took man’s first step on the moon; there were two world wars and the Great Depression. Surely these inform the scale of changes CF(L)Co and H Q could have reasonably anticipated during the Contract term.

In international commercial contracts, hardship is often addressed through hardship clauses, which are an important tool to deal with unforeseen circumstances. But different options exist as to the role to be played by arbitrators in responding to hardship. The 2003 ICC model clause on hardship, for example, provides that in the event the parties are unable to negotiate alternative contract terms in response to changed circumstances resulting in hardship, the aggrieved party is only entitled to obtain that the contract be terminated. The model clause does not empower the arbitrator to adapt the contract. Indeed, it seems that the alteration of the contract by an arbitrator is only admitted if: (i) parties expressly provide for it in the contract, (ii) the applicable legal provisions governing hardship provide for it; or (iii) the arbitrators are specifically empowered to act as amiables compositeurs.

Common principles that can be derived from the above comparative review

Beginning with hardship, the following criteria are generally recognized as essential prerequisites for the exercise of arbitral or judicial power to order renegotiation or modify contract terms in the event of changed circumstances: (1) the change must be unforeseeable and beyond the parties’ control; (2) it must fundamentally alter the contractual equilibrium, either by: (i) rendering performance excessively onerous for a party, or (ii) diminishing the value of the consideration received by a party; and (3) the risk of the change must not have been contractually allocated to one of the parties.

As regards the duty of good faith, it is, in civil law, a standard that relates to the conduct of the parties under the contract, not one that can generally be used to evaluate the fairness of the contract itself, nor to change the parties’ substantive rights and obligations thereunder. The purpose underlying the duty of good faith is to ensure that each of the contracting parties receives the benefit to which it is contractually entitled. It serves to protect the negotiated contractual equilibrium, and to provide a remedy when the conduct of a party disrupts that equilibrium.

Conclusion

Properly understood, the principle of good faith is an instrument of corrective justice that allows a tribunal or court to remedy breaches of the contractual equilibrium agreed by the parties. Corrective justice is also what is dispensed by a tribunal or court when asked, pursuant to a hardship clause or by applying a law that recognizes the doctrine of unforeseeability, to adapt a contract to restore the original equilibrium.

In contrast, asking an arbitrator or judge to modify the allocation of risks and benefits that flow from a contract in order to redistribute them between the parties improperly seeks to transform the principle of good faith from a corrective justice mechanism into one of distributive justice. Unless specifically empowered to do so by the parties, courts and arbitrators have in common to dispense corrective justice, and they should be wary to venture into the realm of distributive justice.

This article has been adapted from a Keynote Address given by Pierre Bienvenu, Ad. E. at the LCIA North American Users’ Symposium on March 16, 2019. Read the full address here.