The reasonableness standard in commercial agreements

In drafting credit agreements, a borrower may qualify a consent or obligation of the lender with the standard of "acting reasonably." Financial services clients will often ask us to explain what is meant by the obligation to act "reasonably," the content of the reasonableness standard imposed on lenders in financing agreements, and what other standards may be available to a lender with regard to its obligations in financing documents. 

A lender's consent right is typically found throughout a financing document. It is important for a lender to understand what the implications of the reasonableness standard are, and what other standards may apply to its obligations.

Reasonableness Standard

The following sources are helpful in understanding the reasonableness standard:

Black's Law Dictionary

According to Black's Law Dictionary, the term "reasonable" is defined as "fair, proper or moderate under the circumstances."

Lewinson

Lewinson¹ describes the interpretation of contracts as the ascertainment of the meaning which the document would convey to a reasonable person having all the background knowledge which would reasonably have been available to the parties in the situation in which they were at the time of the contract.

In the interpretation of the specific concepts of reasonable time, reasonable price, and reasonable notice, the following principles are raised:

• Reasonable time: The party upon whom it is incumbent duly fulfills its obligation, notwithstanding protracted delay, so long as such delay is attributable to causes beyond its control, and it has not acted negligently or unreasonably.
• Reasonable price: Where price is not specified, the courts have determined that a reasonable price based on fair market value should be applied.
• Reasonable notice: Where no provision for terminating the contract has been given, the courts have concluded that a contract could be terminated on reasonable notice. Reasonable notice will vary depending on the facts and circumstances of the case.

Reasonableness of Withholding Consent

A common instance in which the "reasonableness" standard might be imposed on lenders is in relation to agreements that require the lender's consent for the assignment of rights and obligations, with such consent "not to be unreasonably withheld."

Cases tasked with interpreting the "reasonableness of withholding consent" in a commercial context have primarily arisen with respect to commercial leasing transactions — specifically in connection with the obligations of landlords with regard to the assignment of a lease by a tenant.

In 1455202 Ontario Inc. v Welbow Holdings Ltd ², for example, the Ontario Superior Court of Justice set out the following principles to apply in determining whether consent to an assignment of a lease has been unreasonably withheld:

1. The burden is on the party seeking consent to demonstrate that the refusal to consent was unreasonable. The question is whether a reasonable person could have withheld consent.
2. Information available to the refusing party at the time of the refusal is relevant to the determination of reasonableness, and not any subsequent facts or reasons
3. A refusal will be unreasonable if it was designed to achieve a collateral purpose that was wholly unconnected with the bargain reflected in the terms of the agreement
4. A probability that the proposed assignee will default in its obligations may be a reasonable ground for withholding consent
5. The financial position of the assignee may be a relevant consideration
6. The question of reasonableness is essentially one that must be determined in the circumstances of the particular case

The legal principles articulated in Welbow have been referenced by the courts when interpreting similar provisions found outside of the landlord/tenant relationship,³ and may be applicable in the financial services context.

Ultimately, it is important to remember that in deciding whether consent was reasonably or unreasonably withheld, the courts will take into consideration all the facts and circumstances of the case.⁴  

What a Lender Should Consider

The standard imposed on a lender under financing agreements is dependent on the wording of the contract. Terms of an agreement may (i) be qualified such that a decision is at "the discretion of" or the "sole discretion of" a lender, or (ii) have no qualification, or impose a standard of "reasonableness" on the lender.

Where the Contract Imposes a Discretionary Standard

Where the decision to carry out a term of the contract is at the "discretion" of the lender, it may be free to do as it wishes. 

For example, consent at the "sole discretion" of a party may be used if the lender wants to reserve its right to act arbitrarily. This can be useful if the lender relies on information or reasons that it does not wish to explain or disclose to the borrower. For example, this standard may be imposed if the grounds to refuse consent are strictly internal to the lender, or when the lender has access to privileged information that is not publically available. 

Where the Contract is Silent, or Imposes a Reasonableness Standard

Under Canadian common law, all contracts entered into between a bank and its customers contain the implied duty of the bank to exercise reasonable care and skill in the performance of its banking services.⁵ Determining the standard of care of the "reasonable banker" is a contextual exercise, and the court will take into consideration factual evidence relating to both the impugned actions of the bank in the particular case, as well as evidence relating to industry standards and the practices of other bankers in the same context.⁶

Similarly, if consent is subject to the qualification of "reasonableness," then the lender is required to act in a manner that enables it to demonstrate that it arrived at its decision by considering, in some objective manner, all elements that a normal person in a similar circumstance would have considered.  This is in keeping with the lender's duty of fair dealing and to act in good faith — but it does not preclude the lender from acting in its own best interest.

As a general rule, credit or risk considerations are typically regarded as being reasonable criteria for a lender to withhold consent.  As mentioned, what is deemed unreasonable will depend on the individual circumstances of each case.

Good Faith in All Contracts

In addition to the principles noted above, it is important to note that contracting parties in Canada remain subject to the additional duty of good faith (in Québec), or the general organizing principle of good faith and the duty of honesty in the performance of contractual obligations (in the common law provinces).  Although the scope of these duties and principles may vary depending on the context, parties are not free to contract out of obligations.⁷ Those duties and principles may operate to impose a reasonableness standard on contracting parties even if an agreement is otherwise silent.  

Common Law Provinces

All contracts in Canada governed under the common law are subject to a general organizing principle of good faith and the duty of honesty in contractual performance. ⁸  These principles were incorporated into the common law by the decision of the Supreme Court of Canada ("SCC") in Bhasin v Hrynew,⁹ and, as a result, make the common law more consistent with the civil law of Québec, as described below.

In Bhasin, Justice Cromwell for the majority of the SCC noted that the general organizing principle of good faith requires that parties act "honestly and reasonably and not capriciously or arbitrarily" in performing their contractual duties.¹⁰  Interpreting the doctrine of good faith "calls for a highly context-specific understanding of what honesty and reasonableness in performance require so as to give appropriate consideration to the legitimate interests of both contracting parties".¹¹ 

Notably, Justice Cromwell went on to state that the principle of good faith should be applied in a manner that is consistent with the fundamental common law concepts of freedom of contract, and the notion that contracting parties are free to pursue individual or economic self-interest.¹² 

The principles and duties articulated by the SCC in Bhasin are unlikely to impose additional risks on lenders who already conform their practices to that of the "reasonable banker" in similar circumstances. 

Québec

In Québec, all contracts are subject to a statutorily imposed duty of good faith.¹³ Pursuant to the Civil Code of Québec, good faith must govern the relationship of all parties to a contract, commencing at the time the obligation is created until the time such obligation is performed or extinguished.

In Houle v Canadian National Bank¹⁴, the SCC stated that an abuse of rights may be found, and liability may arise, if a contractual right is not exercised in a reasonable manner (i.e., in accordance with the rules of equity and fair play). In this case, the lender recalled a loan payable on demand and realized its securities in accordance with its rights pursuant to the financing documents. The court determined that the bank's decision to recall the loan was based on objective economic factors, and was therefore reasonable.

However, the SCC determined that the very short length of the delay (of only a few hours) between the demand for payment and the realization of the securities or liquidation of assets was unreasonable.  It found that the bank had therefore abused its contractual rights to recall the loan and exercise its securities.

In writing for the Court, Justice L'Heureux-Dubé noted that the contract establishing the bank's right to realize on its securities stipulated that it could do so without notice. Nonetheless, the Court held that such a seemingly absolute right must be tempered by the principle of reasonable delay. Therefore, notwithstanding the absence of an explicit reasonableness standard in a financing document, a court will review the acts of a lender based on the principle of "reasonableness" in order to determine if the lender abused its contractual rights. 

The decision in Houle suggests that a court will look for the reasonableness in each act of a lender even if the contract between the parties includes language qualifying the right of a lender as being at the lender's "sole discretion."