Keynote Address: The Canadian Supreme Court’s decision in Churchill Falls (Labrador) Corporation Limited v. Hydro-Québec

Introduction

Keynote address given by Pierre Bienvenu, Ad. E at the LCIA North American Users’ Council Symposium on March 16, 2019.  

Ladies and Gentlemen,

Distinguished guests, 

Good afternoon.

It is a pleasure to be with you today and a privilege to deliver this address, which will focus on the recent decision of the Supreme Court of Canada in the case of Churchill Falls (Labrador) Corporation Limited v. Hydro-Québec.¹

To most Canadians, the mere mention of Hydro-Québec and Churchill Falls in the same sentence spontaneously evokes the long-term contract that was at issue in this case. This contract has been a very public bone of contention between the Province of Québec and the Province of Newfoundland for more than 40 years. Few, if any politicians have run for office in Newfoundland during that time period, whether provincially or federally, without first establishing his or her credentials by denouncing the Churchill Falls contract and pledging that if elected, he or she would seek to renegotiate the contract to get a better deal for Newfoundland.

While the Supreme Court’s decision is a fascinating read and could consume all of the time allocated to me, I propose to use it as a launch pad for a broader discussion of good faith, changed circumstances and hardship, and more specifically of the circumstances in which a judge or an arbitrator may be called upon to alter the terms of a contract. These issues frequently arise in international arbitration and many of you have been confronted to them.

My talk will be divided in three parts. First, I will summarize the facts of the case; then against that factual background, I will review how different countries and soft law instruments have approached the problem of changed circumstances, hardship and the demands of good faith in such scenarios. In my third and final section, I will summarize the Supreme Court’s reasons and seek to derive from those reasons and from our brief comparative law pilgrimage a few common principles of possible relevance to the practice of international arbitration.

I begin with the proverbial disclaimer: I represented Hydro-Québec in the appeal, as well as before the courts below; so I come with that baggage to the issues we will be discussing today.

Facts

1. Background

An exposition of the facts of this case must begin with a word on geography. Newfoundland and Labrador is the easternmost province of Canada. It joined the Canadian confederation in 1949 as Newfoundland, and in 2001 the province’s official name was changed to Newfoundland and Labrador.

The province is divided in two geographic regions separated by the Strait of Belle Isle: the first is an island in the Atlantic Ocean, where the vast majority of the population of the province resides; the other is a large area of mainland Canada, called Labrador, which shares its western border with Québec.

The longest river in Atlantic Canada flows in Labrador toward the Atlantic. It was known as the Hamilton river until 1965, when it was renamed the Churchill River by Joey Smallwood, the longest-serving Premier of Newfoundland, a great admirer of Winston Churchill and the force behind the hydro-electric project which is the subject of the contract we will be discussing today.

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 hydroelectric potential along the river was a site called Churchill Falls, located in the Upper Churchill River.

Up until the 1960s, two obstacles stood in the way of developing the water resources of the Churchill River. The first was the technical challenge of transporting electricity over the great distance separately Churchill Falls from the nearest markets in Southern Québec and the US, without undue loss of power. The second was financial. In order to finance the project, its sponsors had to find one or more credit-worthy purchasers that would commit, on a take or pay basis, to purchase substantially all of the electricity to be generated by the plant.²

Hydro-Québec was one such potential purchaser, and from the get-go it was a prime prospect for the sponsors of the Churchill Falls project. Moreover, in the 1960s, engineers at Hydro-Québec had developed high-voltage transmission lines that enabled the transport of electricity over long distances without substantial loss of power.

Now, Hydro-Québec was not the ideal partner, because it had alternatives. The province of Québec also has huge hydroelectric potential, which in the 1960s remained largely untapped. At the time, Hydro-Québec had several major hydroelectric projects underway and it had to be convinced that it would make sense to support the construction of a plant owned by a third party, and to purchase its electricity rather than building its own additional hydroelectric facility (para. 10).

2. The Contract

CF(L)Co got Hydro-Québec to the negotiating table in 1965, and after nearly five years of negotiation, it succeeded in convincing Hydro-Québec to defer its own hydroelectric projects and to support Churchill Falls. This resulted in CF(L)Co and Hydro-Québec signing, in 1969, 50 years ago this year, a contract that provided the legal and financial framework for harnessing the hydroelectric potential of Churchill Falls.

It was a huge project, involving the issuance of what was, at the time, the largest bond offering ever. It contemplated the construction of what was then the largest hydroelectric plant in the world, at 5428 MW, and transmission lines to transport electricity over a distance of some 1300 km, from Churchill Falls to Hydro-Québec’s customers in Southern Québec.

In addition to investing capital in the project and providing an unlimited completion guarantee, Hydro-Québec undertook to purchase, over a 65-year period, virtually all of the electricity the plant would produce, whether it needed it or not. It is that take or pay commitment that allowed CF(L)Co to use debt financing for the construction of the plant.

In exchange, Hydro-Québec obtained the right to purchase electricity at fixed prices for the entire 65-year term of the Contract. These fixed prices reflected the project’s construction costs. In order to assist CF(L)Co with the service of its massive debt in the early years of the Contract, its revenues from the sale of electricity to Hydro-Québec were front-loaded, using a price schedule that declined over time, roughly tracking the reimbursement of its 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.

These pricing terms provided Hydro-Québec with 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 Contract term, the Churchill Falls plant would remain the property of CF(L)Co (para. 2).

3. 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 liberalised access to the US market (para. 17).

These changes led to a substantial increase in the market price for electricity, which quickly far surpassed the price level provided for in the Churchill Falls Contract. This situation allowed, and continues to allow Hydro-Québec to purchase electricity from Churchill Falls at a very low price while it sells electricity to third parties at a substantially higher price, thus reaping considerable profits (para. 3).

Early in 2010, CF(L)Co commenced proceedings seeking a declaration that Hydro-Québec has a duty to renegotiate the pricing terms of the Contract. In view of Hydro-Québec’s refusal to renegotiate the Contract, CF(L)Co asked that the Court itself modify it 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 that had occurred in the energy market were unforeseeable and had disrupted the equilibrium of the Contract. CF(L)Co argued that the benefits generated by the sale of the Churchill Falls energy were so much greater than the parties could ever have foreseen when they signed the Contract that the windfall profits being made by Hydro-Québec had to be reallocated and shared more equitably among the parties.

CF(L)Co based its claim on the general duty of good faith that is recognized in Québec civil law, and on what it described as an implied duty to renegotiate, based on equity.

Hydro-Québec’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 never formed part of the law of Québec, the Québec legislature having deliberately refused to incorporate it in Québec law. Hydro-Québec also maintained that, in any event, CF(L)Co was receiving exactly what it bargained for, and that what it was seeking was to appropriate part of the benefits that rightfully belonged to Hydro-Québec under the terms of the Contract.

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

Changed circumstances: A comparative overview

I begin with Germany, because the possibility for a party to request the adaptation of a contract upon the occurrence of changed circumstances was developed by German courts on the basis of contractual good faith, much like CF(L)Co was asking the Québec courts to do in the Churchill Falls case.

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 fall of the mark to one-trillionth of its former value. This extreme devaluation 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, the courts relied on the duty of good faith to develop a theory of unforeseeability that was later codified, and that can now be found in Article 313 of the German Civil Code³.

Under Article 313⁴ of the BGB, 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.

Switzerland is another civil law jurisdiction whose courts relied on the duty of good faith as the foundation for the possible judicial alteration of a contract in the event of changed circumstances. Contrary to Germany, Switzerland has not codified this principle, which is sometimes referred to as “l’exorbitance”. Two basic conditions must be met to open the door to an adaptation of the contract under Swiss law: (1) the occurrence of new, inevitable and unforeseeable circumstances; and (2) the consequent imposition of an excessive burden on the debtor⁵. If these conditions are satisfied, the court will order the renegotiation of the contract, and if the renegotiation fails, the court may adapt the contract, and impose the solution that the parties in good faith would have adopted had they been able to foresee the changed circumstances when the contract was negotiated.

In France, the judicial intervention in the terms of a contract in the event of changed circumstances is possible under the théorie de l’imprévision, which may be translated as “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 the obligations provided in the contract would be excessively onerous for one of them.

Until recently, the theory applied first and foremost to so-called administrative contracts. As many of you know, contracts with the State and state parties in France are governed by a completely distinct set of principles than those governing private law contracts, and are subject to the jurisdiction of a court system distinct from the civil courts.

The situation was radically different under French private law, where the doctrine of unforeseeability had been rejected. The leading authority was the famous Canal de Craponne case, decided in 1876. In that case, a company exploiting irrigation canals was seeking an increase in the usage rates that had been 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 circumstances⁶.

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 case of Les Maréchaux. The French Supreme Court held in that case that while the duty of good faith can be relied upon to control the conduct of a party under the Contract, it never entitles the judge to modify the rights and obligations of the parties under the contract.

The position as regards the doctrine of unforeseeability was changed in France 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 that the party had not accepted to assume that risk under the contract.⁷ A similar evolution is currently taking place in Belgium.⁸

Turning to soft law instruments, I mention the hardship provisions of the Unidroit Principles of International Commercial Contracts, which entitle a party to ask for the renegotiation of the contract when unforeseeable events “fundamentally alte[r] the equilibrium of the contract”. If the renegotiation fails, the court or the arbitral tribunal applying the Unidroit Principles may terminate the contract, or adapt it to restore the equilibrium. Other soft law instruments also contain similar hardship provisions, most prominently the Principles of European Contract Law which include a provision on Change of Circumstances.⁹

The position is markedly different under the common law. Under English law, the doctrine of frustration of contract allows for the 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. However, this doctrine does not give rise to a duty to renegotiate the contract, nor does it provide for its alteration by the court.¹⁰ Moreover, it is clear that hardship, inconvenience, or material loss are not grounds for the principle of frustration to apply. Approximately three weeks ago, the English High Court decided that Brexit did not constitute a frustrating event for the purpose of a long-term commercial lease at Canary Wharf, even if it resulted in the forced relocation of an agency of the EU outside of the United Kingdom¹¹. Slightly different principles apply in the United States, under the doctrines of frustration of purpose and impracticability of performance.

I now turn to the law of Québec. When CF(L)Co instituted its proceedings, in 2010, the case law was quite clear: the doctrine of unforeseeability was not part of Québec civil law, even though a number of authors, de lege feranda, had argued that it should be, and that a duty to renegotiate may arise from contractual good faith.

A relevant historical event must be mentioned. Québec modernized its civil code early in the 1990s. The Revision Office that was in charge of preparing a draft revised civil code had specifically recommended, in its report, that the doctrine of unforeseeability be incorporated into the law of Québec. Importantly, that recommendation was rejected by the Québec legislature, and Québec courts had pointed to that deliberate rejection to reaffirm that the doctrine of unforeseeability did not form part of the law of Québec. This is relevant to understanding why CF(L)Co had decided to base its case on contractual good faith rather than on the doctrine of unforeseeability.

The Supreme Court's Decision in Churchill Falls

Which brings me to the Supreme Court’s decision in Churchill Falls.

Seven of the eight justices who participated in the judgement dismissed CF(L)Co’s appeal and held that Hydro-Québec did not have a duty to renegotiate a contract that provided it with substantial unanticipated benefits. Breaking from the majority, Mr. Justice Rowe would have granted the appeal and given the parties six months to negotiate a price adjustment formula, failing which the formula would be established by a judge upon submissions by the parties.

The majority’s analysis focused on CF(L)Co’s two main arguments: the principles of good faith, and equity (para. 5).

In light of the Québec legislature’s decision, when adopting the new Civil Code, to decline to incorporate the doctrine of unforeseeability in the law of Québec, the majority held that it was not the Court’s role to second-guess this deliberate choice, which turned on social policy considerations that are best left to the legislature (para. 97).

Citing as examples the new Article 1195 of the French Civil Code as well as the Unidroit Principles, the majority 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.

On the facts of the case, the Court noted that the parties had intentionally allocated the risk of price fluctuation to Hydro-Québec. 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. The Court also noted that the changed circumstances relied upon did not have the effect of increasing the cost of performing the Contract for CF(L)Co, nor did they diminish the value of what it receives from Hydro-Québec. On the contrary, the Court found that even though Hydro-Québec derives far greater benefits from the Contract that had been anticipated, 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 on the parties, for example by ordering the sharing of unanticipated profits that have in fact been honestly earned. For the majority, “it does not seem to make sense that, when all is said and done, CF(L)Co is seeking to use the concepts of good faith and equity in a manner that actually goes beyond the limits of the doctrine of unforeseeability even though the Québec legislature has refused to incorporate that doctrine into the province’s civil law” (para. 106).

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 (para. 113).

As a final point, I mention that the majority also concluded that CF(L)Co’s claim was time-barred, since the latest change in circumstances on which it was relying had occurred in 1997, years before the three-year limitation period applicable to such a claim.

Relevance in International Arbitration

So what can be made of this decision and of our review of various approaches to changed circumstances that has relevance to international arbitration.

In the foreword to a recent ICC Dossier entitled Hardship and Force Majeure in International Commercial Contracts, Yves Derains notes that hardship and force majeure are “at the heart of the very notion of contract, as they seek to balance two basic principles: “pacta sunt servanda” and “rebus sic stantibus”, which “have traditionally controlled the effects of the passing of time on the performance of contractual obligations”.¹²

Except for contracts calling for the instantaneous performance of the parties’ obligations, such as tanking at a gas station, most contracts involve commitments in relation to the future, which by definition is uncertain. This is well-captured by the definition that a French author gives to the very notion of contract: “une emprise sur l’avenir”; or a “hold on the future”.

Although special challenges obviously arise in the case of long-term contracts, these must be seen for what they are: instruments to allocate risks and rewards in respect of an uncertain future. The contract at issue in the Churchill Falls case has a 65-year term. To get a sense of how uncertain the future was for the parties signing that contract in 1969, consider the economic and technological changes that had taken place during the previous 65 years, between 1904 and 1969. In that time period, 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. Must these not inform the scale of changes that CF(L)Co and Hydro-Québec could have reasonably anticipated during the life of their contract?

In international commercial contracts, hardship is often addressed through hardship clauses, which are an important tool for international practitioners 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.¹³ Indeed, it seems that the alteration of the contract by an arbitrator is only admitted if: (i) the parties expressly provide for it in their contract, (ii) the applicable legal provisions governing hardship provide for it; or (iii) the arbitrators are specifically empowered to act as amiables compositeurs.¹⁴

What common principles can be derived from our review of the treatment of hardship and good faith across jurisdiction and soft law instruments?

Beginning with hardship, the following criteria are generally recognized as essential prerequisites for the exercise of a judicial or arbitral power to order a renegotiation or modify the terms of a contract in the event of changed circumstances: (1) the change must be unforeseeable and beyond the control of the parties (2) the change must fundamentally alter the equilibrium of the contract, either: (i) by rendering performance of the contract excessively onerous for one of the parties, or (ii) by diminishing the value of the consideration received by one of the contracting parties; and (3) the risk reflected by the change in circumstances must not have been allocated by the contract 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 be used to evaluate the fairness of the contract itself, or to change the parties’ substantive rights and obligations thereunder. Stated otherwise, the purpose underlying the duty of good faith is to ensure that each of the contracting parties receives the benefit to which it is entitled under the contract. In that sense, it serves to protect the negotiated contractual equilibrium, and to provide a remedy when the conduct of a party disrupts that equilibrium.

Conclusion

I conclude by submitting that, properly understood, the principle of good faith is an instrument of corrective justice that allows the court or the arbitrator to remedy breaches of the contractual equilibrium agreed upon by the parties. Corrective justice is also what is dispensed by the court or the arbitral tribunal when it is asked, pursuant to a hardship clause or by applying a law that recognizes the doctrine of unforseeability, to adapt a contract in order to restore the original equilibrium.

In contrast, asking a judge or an arbitrator to modify the allocation of risks and benefits that flow from a Contract in order to redistribute them between the parties – as CF(L)Co was asking – improperly seeks to transform the principle of good faith from a corrective justice mechanism into an instrument of distributive justice, one that falls beyond the judicial and, I would argue, the arbitral role.

So I end on that note: Courts and arbitrators have in common to dispense corrective justice. Unless they are specifically empowered to do so by the parties, they should be wary to venture into the realm of distributive justice.