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Long-term supply agreements and high inflation — what businesses need to know

Amid high inflation, a long-term supply agreement (“LTSA”) can be an albatross. Exiting LTSAs is difficult but not impossible under Canadian law. Just how difficult depends on the contract: its text and the circumstances surrounding its formation.

Here are some legal principles that apply.

First, consider the provisions of the contract

An LTSA may contain provisions that allow terms to be adjusted to reflect market conditions. For example:

  1. A price adjustment clause may empower parties to correct a contract price. Such corrections may be permitted if there are changes in the costs of manufacturing or supply of goods. A purpose of a price adjustment clause may be to ensure that the contract price accounts for market conditions and thus more accurately reflects the bargain struck in the contract. Such adjustments are generally based on pre-agreed terms concerning the adjustment formula and timing. In response to a triggering event, such as high inflation, a price adjustment clause may be activated automatically. Alternatively, a party may be required to invoke the clause and request the change.
  2. High inflation may also be grounds to invoke a price renegotiation clause. Such a provision may allow a party to require a counterparty to renegotiate an economic term of the contract in certain agreed circumstances. Whether high inflation qualifies will depend on the interpretation of the renegotiation provision.
  3. A termination clause may also offer a way out. If the contract prescribes a penalty for termination, or if the non-terminating party would be entitled to damages, the economic consequences of such a penalty or damages may be less significant than the savings realized by exiting the contract. The potential cost of litigation should factor into this assessment.

A force majeure clause in an LTSA is unlikely to relieve a party of its supply obligations even if the contract price makes contractual performance uneconomical. Such clauses require a unforeseeable, extraordinary circumstance beyond the party’s control to have made performance of the contract impossible, not just more expensive.[1] The same requirement applies under the doctrine of frustration: it is not enough that contractual performance has become more onerous — it must have become impossible.[2]

Second, consider whether a contractual term may be implied

Courts are hesitant to intervene to change the bargain of a contract; it is understood that the parties have agreed on price terms that allocate the risk of price fluctuations in accordance with the parties’ intentions.[3]

There may be limited circumstances in which courts allow terms to be implied into an LTSA. A term may only be implied “on the basis of the presumed intentions of the parties where necessary to give business efficacy to the contract”.[4] An implied price adjustment or renegotiation term could in theory be implied on this basis. In practice, this is unlikely.

The Churchill Falls case illustrates this. In 2018, the Supreme Court of Canada interpreted a 65-year contract by which Hydro-Québec committed to purchase most of the electricity generated by a hydro-electric plant in Labrador. In exchange for this commitment, Hydro-Québec received the right to purchase electricity at fixed prices for the entire 65-year term of the contract. Decades later, market prices for electricity had risen significantly above the contract price. The plant’s proponent (“CFLCo”) tried to obtain a court order requiring Hydro-Québec to renegotiate. It failed.

Though the case was decided under the civil law of Quebec, the Supreme Court’s approach to the contract is instructive. The Court rejected CFLCo’s argument that the parties had not intended to allocate the risk of electricity price fluctuations as significant as those that had occurred in recent decades. Instead, the Court concluded, “[t]he evidence … shows that the parties clearly intended Hydro‑Québec to bear most of the risks associated with the development of the Plant, including the risk of electricity price fluctuations, however large they might be”.[5]

Inflation is a risk to be allocated under any LTSA. Churchill Falls shows that, where the parties to an LTSA have made long-term price commitments to each other, a court is likely to interpret those commitments as part of the agreed allocation of risk under the LTSA. And a court is unlikely to relieve a party from bearing the consequences of a risk it has assumed.

One potential route to relief is to ask the court to imply a term that an LTSA with an indefinite term contract may be terminated on reasonable notice.[6] In the Boise Cascade Canada case, the Ontario Court of Appeal held that:

The parties to an executory contract are often faced, in the course of carrying it out, with a turn of events which they did not at all anticipate — a wholly abnormal rise or fall in prices, a sudden depreciation of currency, an unexpected obstacle to execution, or the like. Yet this does not in itself affect the bargain they have made. If, on the other hand, a consideration of the terms of the contract, in the light of the circumstances existing when it was made, shows that they never agreed to be bound in a fundamentally different situation which has now unexpectedly emerged, the contract ceases to bind at that point — not because the court in its discretion thinks it just and reasonable to qualify the terms of the contract, but because on its true construction it does not apply in that situation.[7]

The distinction is between an unforeseen change in circumstances (no relief) and a change in circumstances that puts the parties in a situation in which they never agreed to be bound (possible relief). This offers a very limited scope for relief, however; in the paragraph quoted above, the Court of Appeal specifically identified “a wholly abnormal rise or fall in prices” as an unforeseen change in circumstances that “does not in itself affect the bargain [the parties] have made”. The Court of Appeal also emphasized elsewhere in its judgment that “the Court has no power to absolve a party from his contractual obligations simply because he finds them burdensome due to unforseen circumstances”.[8]

It is unlikely that the present rate of inflation could create a “fundamentally different situation” in which the parties “never agreed to be bound” on the standard endorsed in Boise Cascade Canada. Still, this jurisprudence may in extraordinary cases offer the possibility of a way out, depending on the evidence that can be marshalled about the surrounding circumstances at the time of the contract’s formation.

Bottom line

Inflation can be a serious problem for one party to an LTSA because courts are likely to consider rising market prices as a risk that the parties allocated as between themselves when they formed the contract. Courts will not reallocate that risk, even if an unforeseen change in economic circumstances has made performance of the contract economically unsustainable.

There are, however, certain types of contractual provisions and certain doctrines of contract law that may offer a means of escape. Parties should consider the express terms of the contract and — for the purpose of identifying the parties’ intentions — the evidence available about the surrounding circumstances of the contract’s formation.

For more information, please contact your McCarthy Tétrault advisor or one of the authors.

 

[1] Atlantic Paper Stock Ltd. v. St. Anne-Nackawic Pulp & Paper Co., 1 S.C.R. 580 at p. 583; The Impact of COVID-19 on Contractual Obligations: Force Majeure and Frustration, McCarthy Tétrault Blog (2020).

[2] Naylor Group Inc. v. Ellis-Don Construction Ltd., 2001 SCC 58; The Impact of COVID-19 on Contractual Obligations: Force Majeure and Frustration, McCarthy Tétrault Blog (2020).

[3] Samuel A Rea Jr, “Inflation and the Law of Contracts and Torts” (1982) 14:465 Ottawa Law Review 466.

[4] Energy Fundamentals Group Inc. v. Veresen Inc., 2015 ONCA 514 at para. 30.

[5] Churchill Falls (Labrador) Corp. v. Hydro‑Québec, 2018 SCC 46 at para. 42.

[6] Geoff Hall, Canadian Contractual Interpretation Law (Markham: LexisNexis, 2020), 3.183.18.4. See also: Shaw Cablesystems (Manitoba) Ltd. v. Canadian Legion Memorial Housing Foundation (Manitoba), [1997] M.J. No. 65 (Man. C.A.) at para. 15; Rapatax (1987) Inc. v. Cantax Corp, [1997] A.J. No. 313 (Alta. C.A.) at para. 19.

[7] Boise Cascade Canada Ltd. v. The Queen in right of Ontario (1982), 34 O.R. (2d) 18 (C.A.) [Boise Cascade Canada], quoting British Movietonews Ltd. v. London & District Cinemas Ltd., [1952] A.C. 166 (H.L.) at p. 185 (Viscount Simon) (emphasis added).

[8] Boise Cascade Canada, quoting Boise Cascade Canada Ltd. v. The Queen in right of Ontario (1979), 27 O.R. (2d) 216 (H.C.).

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