Bhatnagar v. Cresco Labs Inc.: Clarifying the Duty of Honest Performance and the Presumption of Loss

In this article, we consider the Court of Appeal for Ontario’s recent decision in Bhatnagar v. Cresco Labs Inc., 2023 ONCA 401, and its impact on the duty of honest performance, as articulated by the Supreme Court of Canada in Bhasin v Hrynew and Callow v Zollinger. As readers will appreciate, these cases have been significant in shaping the boundaries of acceptable conduct in contractual relationships.

In Bhatnagar, the Ontario Court of Appeal considered the issue of damages flowing from a breach of the duty of honest performance, and in particular, the burden of proof for proving such damages in case of breach. Ultimately, while Bhatnagar offers helpful clarification as to the appropriate measure of damages, it also raises a number of questions on how to remain compliant with the duty as set out by the Supreme Court of Canada in Bhasin and Callow.

Brief Factual Background

180 Smoke – a retailer of vaping products – was founded by Gopal Bhatnagar, Boris Giller, and Ashutosh Jha (the “Appellants“). Through a share purchase agreement (the “SPA“) dated February of 2019, 180 Smoke was sold to a company called Origin House for $25 million.

Under the SPA, Origin House provided the Appellants an opportunity to earn an additional $15 million: $2.5 million was to be awarded if 180 Smoke obtained a processing license within a specified period of time, and $12.5 million was to be awarded in installments if 180 Smoke met yearly revenue milestones over the first three years after closing (the “Revenue Milestone Payments“). Specifically, three “earn-out” periods were set for the 2019, 2020, and 2021 calendar years, where each year had a target payment of $4,166,667 (for an aggregate total of $12.5 million).

The SPA also included an “Unearned Milestone Payment Commitment” clause (“Commitment Clause”), which, broadly speaking, stipulated that if there was a change of control of Origin House during the three year “earn-out” period, then the Appellants would be entitled to the amount of all future unearned milestone payments (i.e., the balance of the $12.5 million).

In April of 2019, Origin House and Cresco Labs (“Cresco“) entered into an agreement where Cresco would purchase Origin House (the “Cresco Transaction“) – thereby transferring control of the company to Cresco. The Cresco Transaction was expected to take place before the end of 2019, triggering the earn-out period of all three years pursuant to the Commitment Clause.

Aware of the Cresco Transaction, the Appellants asked Origin House in June of 2019 what would happen to the Revenue Milestone Payments if the deal did not close in time. Origin House responded that there was no reason to believe that the deal would not close by the end of 2019. However, Cresco, in October of 2019, proposed to postpone the closing date to January of 2020. Origin House did not relay this information to the Appellants, and the Cresco Transaction proceeded to close on January 8, 2020.

Per the Commitment Clause, Cresco provided the 2020 and 2021 Revenue Milestone Payments to the Appellants ($8.333M). However, Cresco did not include the 2019 Revenue Milestone Payment as, in their view: (1) the Cresco Transaction fell outside the first earn-out period (i.e., after 2019 had concluded notwithstanding the original closing date), and (2) the Appellants did not meet the revenue target in 2019. Accordingly, the Appellants brought an application seeking an order directing Cresco to pay the 2019 Revenue Milestone Payment ($4.166M).

Decision of the Court

Before the application judge, the Appellants argued that their failure to achieve the 2019 revenue target was a result of breaches of contract by Origin House, and that they were denied the opportunity to obtain the processing license (also due to breaches of contract by Origin House). More specifically, the Appellants claimed that Origin House’s failure to advise them of the postponement of the Cresco Transaction’s closing to 2020 – after previously advising that the closing was expected to occur in 2019 – breached an unspecified “duty of good faith in contractual dealings”.

The application judge agreed with the Appellants’ argument, and held that Origin House’s failure to update them of the change in closing date constituted a breach of the duty of honest performance. In particular, although the application judge made no finding that Origin House had intentionally misled the Appellants about the closing date, the breach lay in Origin House’s failure to update the Appellants upon determining that the closing date was impossible.

Nevertheless, despite finding in favour of the Appellants, the application judge did not award any damages for the breach. According to the judge, even if the Appellants had been promptly advised of the change in closing date, the Appellants would not have been able to meet the revenue target by the end of 2019, nor could they have taken steps to force the Cresco Transaction to close by the end of 2019. Hence, the court decided that the Appellants were not entitled to damages, as there was no evidence of a lost opportunity, and no damages were inferred or proven to flow from the breach.

Having failed to receive any of the damages they sought, the Appellants appealed the decision of the application judge.

The Court of Appeal

On appeal, the Appellants argued that the application judge erred:

1. in failing to presume loss by the Appellants as a result of Origin House’s breach of the duty of honest performance;
2. in misapprehending the evidence of lost opportunity;
3. in failing to award damages on a basis other than expectation damages; and
4. by failing to find that Origin House breached its contractual duty of good faith by impeding the Appellants from achieving the milestones during the first earn-out period.

There is no presumption of loss as a result of the breach of the duty of honest performance

First, the Appellants submitted that if a court found that a party had breached its duty of honest performance, there existed a legal presumption of damages. Accordingly, the Appellants claimed that the Court must presume that Origin House’s breach caused the Appellants to lose the opportunity of reaching the 2019 revenue milestone target and that the Court’s only task would be to quantify damages resulting from the loss. The legal authority for this argument was derived from the words of paragraph 116 (“the Emphasized Words“) of Callow, which stated that:

[E]ven if I were to conclude that the trial judge did not make an explicit finding as to whether Callow lost an opportunity, it may be presumed as a matter of law that it did, since it was Baycrest’s own dishonesty that now precludes Callow from conclusively proving what would have happened if Baycrest had been honest. [Emphasis added.]

The Court of Appeal rejected the Appellants’ interpretation of Callow, and held that in determining damages, the claimant has the onus of providing that the breach resulted in “the claimant failing to have a fair opportunity to protect its interests or caused [the claimant] to lose an opportunity.”

Furthermore, the Court found that the Emphasized Words must be read in the context of paragraph 116 as a whole. The Emphasized Words contained the word “may”, indicating permissive language. Hence, the Appellants were incorrect in their submission that the Court was obligated to presume that the Appellants suffered a loss of opportunity – at best, the Court had the discretion to make such a presumption.

The Emphasized Words were followed by qualifying language. As explained by the Court of Appeal, it can be presumed that a party has lost an opportunity if the opposing party’s dishonesty precluded the claimant from conclusively proving what would have happened had the opposing party acted honestly. In this case, the findings of the application judge indicated that there was “little or no chance” for the Appellants to achieve the 2019 revenue milestone target in question, and as a result, the Appellants had no evidentiary foundation (unlike in Callow) to support their claim of a lost opportunity.

The application judge did not misapprehend the evidence relating to lost opportunity

Second, the Appellants submitted that the application judge erred in misapprehending the evidence relating to lost opportunity. However, this argument was summarily dismissed, as the Court of Appeal held that the application judge correctly concluded that there was no evidence before the court to support the Appellants’ claim of lost opportunity.

The application judge did not err in refusing to award damages on a basis other than expectation damages

The Appellants further claimed that the application judged erred in refusing to award damages on a basis other than expectation damages, which was warranted on the basis that courts have recognized the necessity of departing from the ordinary measure of damages in cases where expectation damages are difficult or impossible to calculate or where expectation damages would effectively allow the breaching party immunity, notwithstanding the breach.

Although not explicitly stated, it appears from the Court’s analysis that the Appellants had argued that in the alternative to expectation damages (i.e., the normal measure of damages for breach of contract, which puts the aggrieved party in the position that it would have been had the duty been performed), they ought to be entitled to punitive damages or disgorgement of the benefit gained by Cresco as a result of its breach.

However, the Court of Appeal also dismissed this submission, given that the “ordinary contractual measure” would be to award expectation damages, and the issue remained that the Appellants had no entitlement to expect anything given their inability to demonstrate they could have achieved the Revenue Milestone Payment. Moreover, the Court found that both punitive damages and disgorgement for breach of contract would be inappropriate measures – in relation to punitive damages, there was no evidence before the court to suggest that Cresco had been dishonest or untoward, and in relation to disgorgement, there was nothing exceptional about the Appellants’ interest that would justify such a remedy.

The application judge did not err in failing to find that Origin House breached its duty of good faith by impeding the Appellants from achieving the milestones

Finally, the Appellants argued that the application judge erred in failing to find that Origin House breached its duty of good faith.

Though not explicitly stated, this appears not to have been an argument based on a duty of honest performance, but rather a duty of avoiding interfering with a contractual counterparty. However, the fundamental nature of this claim appears to have been muddled by the fact that the Appellants’ relied upon the idea that Cresco undermined the Appellants’ “legitimate expectations and interests”, which concepts were discussed by the Supreme Court in Bhasin v Hrynew in the context of the organizing principle of good faith rather than the duty of honest performance.

In any event, the Court of Appeal also dismissed this argument in short order. Without engaging in or clarifying the nature of the foregoing submission, the Court more straightforwardly observed that the Cresco Transaction could not be contrary to the Appellants’ expectations when it was specifically contemplated in the SPA.

Furthermore, certain provisions of the SPA allowed the Appellants to give notice of a complaint, which they failed to do.

The Cross Appeal

In addition, Cresco cross-appealed that the application judge erred in concluding that Origin House breached its duty of honest performance. Cresco submitted that the application judge erred:

• in finding that Origin House had “repeatedly” advised the Appellants of a 2019 closing date, when only two occasions were referred to by the judge; and
• by incorrectly finding that the Appellants were not aware that the closing date was delayed.

The Court of Appeal acknowledged that referring only to two occasions may not amount to Origin House “repeatedly” advising the Appellants of the closing date. However, the Court of Appeal nevertheless held that there was sufficient evidence to make such a finding, and that “judges do not need to discuss every item of evidence in their reasons.”

Regarding the second error, the Court of Appeal examined a letter from the Appellant’s counsel from November of 2019, which stated in relevant part as follows:

The [Appellants] are nevertheless prepared to refrain from taking legal action to enforce their rights under the [SPA] upon receiving your confirmation that in the event that the [Cresco Transaction] fails to close by January 30, 2020, the [Appellants] will receive the Milestone Payments in the total amount of $12,500,000 and the License Milestone payment in the amount of $2,500,000 to be deposited into their account no later than the close of business on January 31, 2020. [Emphasis added.]

Based on the letter, the Court of Appeal found that the Appellants were aware in 2019 that the closing of the Cresco Transaction could be delayed. Furthermore, this was an error that could not support the application judge’s finding that Origin House breached its duty of honest performance. As a result, the Court reversed this decision and held that Origin House did not breach this duty.

Relatedly, Cresco also sought to introduce fresh evidence.[1] However, the Court dismissed the motion as the evidence at hand did not meet the criteria for admission under the Palmer test.[2] Furthermore, the Court held that admitting such evidence would be contrary to the interests of justice.

Accordingly, the Court of Appeal dismissed the appeal, and granted the cross-appeal.

Analysis and Commentary

Bhatnagar provides a welcome insight in interpreting the duty of honest performance. Importantly, this decision suggests that Callow does not create a presumption of damages for a breach of the duty of honest performance, but rather, the claimant must show that on a balance of probabilities, the breach of the duty deprived the claimant of an opportunity to protect its interests or else caused it to lose an opportunity to realize a gain.

This conclusion appears to be a common-sensical one, insofar as the general proposition is that a party must prove its damages (i.e., that the onus of proof rests with the claiming party). It is not clear why any particular contractual duty would deviate from this norm, particularly on the basis of a single clause within one sentence of Callow. To the extent that the burden of proof were to be altered, it stands to reason that such a change must be clearly discussed and established by an appellate court.

However, the Appellants did identify what, in isolation, would appear (at least at first blush) to support arguments for such a deviation. As a result, it would be beneficial for the Supreme Court to clarify this point if and when the opportunity arises.

In any event, one takeaway from Bhatnagar is the need for parties and their lawyers to deliver appropriate evidence when seeking damages for lost opportunity based on a breach of the duty of honest performance. The application judge and Court of Appeal’s conclusions were both fundamentally premised upon the lack of evidence before the Court in that regard.

In addition, the Court’s discussion of the proper measure of damages recalls the discussion between the majority and the concurrence in Callow, whereby the majority concluded that the expectation interest was the appropriate measure of damages (i.e. the claimant should be put in the position it would have been in had the duty not been breached), while the concurrence concluded that the reliance interest was the appropriate measure (i.e. the claimant should be entitled to the loss caused by relying on the dishonesty). Although in practice, these two measures may often be the same, Bhatnagar raises the interesting question of whether reliance damages might be appropriate in circumstances where expectations damages cannot be proven.

At a minimum, such an approach would be more palatable than the possibility of punitive damages or disgorgement, both of which rely on very different justifications than the standard rationale for compensatory damages for breach of contract.

That being said, Bhatnagar also warrants further caution from parties in future. In particular we note as follows:

• the application judge found that Origin House was not dishonest about the potential for a ‘change of control’ transaction;
• the application judge did not find that Origin House misled the Appellants about the closing date, and
• there was no suggestion that the delay in the Cresco Transaction was intentional or the fault of any action or inaction on the part of Origin House and/or Cresco.

Taken together, these findings suggest a lack of intentional misconduct on the part of Origin House and Cresco, yet the application judge nevertheless found a breach of the duty of honest performance based on an objective failure to correct the misrepresentation that the transaction would close in 2019.

Notwithstanding that the Court of Appeal overturned the application judge on this point, the foregoing nevertheless supports a recommendation that parties be vigilant in ensuring that their representations to counterparties are, and remain, accurate. Bhatnagar does not suggest that Origin House or Cresco intentionally failed to correct their statements that had become incorrect, yet such unintentional failure may nevertheless be the basis for finding a breach of such a duty.

Similarly, Bhatnagar raises the question of whether the duty of honest performance can be indirectly satisfied. Before the Court of Appeal, Cresco sought to introduce fresh evidence demonstrating that even though Origin House may not have advised the Appellants directly of the delayed closing date, Origin House had publicly released this information to the market though press releases and other documents. Although this evidence was not considered and the Court refrained from addressing this question, it will be interesting to see in future cases if indirect means of communication may fulfill the duty of honest performance. Ultimately, parties should continue to strive to be transparent and forthcoming in their communications with contractual counterparties.

Eric Lee, summer student, assisted with the preparation of this article.

[1] Evidence that existed at the time of the trial, but was not before the trial judge.

[2] Briefly put, the Palmer requires that the additional evidence (1)   should generally not be admitted if, by due diligence, it could have been adduced at trial; (2) must be relevant, in the sense that it bears on a decisive or potentially decisive issue in the trial; (3) must be credible, in the sense that it is reasonably capable of belief; and (4) if believed and when taken with the other evidence adduced at trial, could reasonably be expected to have affected the result.

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