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Contracts - Illegality and Severance


Part 2

. 1079022 Ontario Inc. (Nicolini Construction) v. Market Leadership Inc.

In 1079022 Ontario Inc. (Nicolini Construction) v. Market Leadership Inc. (Div Ct, 2009) the Divisional Court upheld a fee recovery ruling against a mortgage broker that was unregistered under the Mortgage Brokers Act:
[5] I have not been persuaded that the trial judge erred in finding the appellants disentitled to collect this fee for this reason. My reading of the Act supports the proposition that it creates an elaborate regulatory scheme to protect the public from incompetent or unscrupulous mortgage brokers. Supervision by way of registration is the “raison d’être” of the legislation. I am satisfied it would be contrary to public policy to permit these appellants to enforce payment of this fee: see Still v. M.N.R. (1997) 1997 CanLII 6379 (FCA), 154 D.L.R. (4th) 229 (Fed. C.A.). This is not, in any sense, like the technical breach of the registration requirements of the Ontario New Home Warranties Plan as existed in Beer v. Townsgate I Ltd. (1998) 1997 CanLII 976 (ON CA), 36 O.R. (3d) 136 (C.A.). This ground of appeal also fails.
. Beer v. Townsgate I Ltd.

In Beer v. Townsgate I Ltd. (Ont CA, 1997) the Court of Appeal considered the issue of the illegality of contract in the context of non-registration under the Ontario New Home Warranties Plan Act:
Statutory Illegality

The trial judge held that each of the respondents should succeed as each of the agreements was void since the appellant had entered into the agreement prior to being registered under the Ontario New Home Warranty Program (the "Warranty Program"). There is no doubt that when it entered into the agreements, the appellant was not registered and that this contravened s. 6 of the ONHWPA.

Section 6 provides:

6. No person shall act as a vendor or builder unless he is registered by the Registrar under this Act.

It is clear that while the appellant was not registered at the time it entered into the agreements, it had complied with all of the requirements for registration. By February 14, 1989, the appellant had made the required application to the Registrar, paid the enrollment fees which amounted to more than $140,000, completed disclosures as to ownership and guarantees of the obligations under the ONHWPA and provided an irrevocable letter of credit in the sum of $4,500,000. The evidence of counsel for ONHWP was that, by February 23, 1989, there was no reason why the Registrar would not proceed with the registration "as a matter of course". She also said that the purchasers, the respondents, were not prejudiced by the sale before registration and were fully protected by the warranty under the Act. She testified that a claim on the warranty for return of deposit for proceeding in breach of s. 6 would, in the circumstances, have been refused.

It was only after four weeks at trial, on February 27, 1995, that the respondents raised this issue and they were allowed to amend their statement of claim to plead that the agreements were void for illegality. In lengthy reasons, after considering the history of the legislation and a number of authorities, the trial judge concluded that a breach of s. 6 by the vendor, the appellant, rendered the agreements of purchase and sale a nullity. She held that the agreements had been undertaken in the face of the "clear and unambiguous prohibition" against sale prior to registration. It was her opinion that the "prohibition in s. 6 of the Act is fundamental to the nature and purpose of the regulatory scheme". The object of the Act and general intent was to protect the public until registration was satisfied and that failure to register before sales made sales a nullity.

With respect, I think the trial judge reached the wrong conclusion and erred both with respect to her analysis of the Act and the authorities that she referred to, each of which is distinguishable from either the facts or the legislation in issue here. As stated above, the appellant had fully complied with all of the onerous registration requirements and there was no further action or documentation required of it. The agreements of purchase and sale contained reference to the ONHWPA and made clear that the appellant was providing the statutory warranty. The registration was granted shortly after the contracts were entered into and long before closing. Perhaps the most important thing is that the purchasers were fully protected; the fact that registration had not been issued was of no moment in this regard.

If the parties intended to make a contract which was legally binding and the protection of the public sought by the statute assured, then notwithstanding the breach of s. 6, the agreement could be legally performed. I think the trial judge failed to appreciate that illegality as to contractual formation must be distinguished from illegality as to the performance of the contract. From the reasons for judgment, it does not appear that this submission was made to her, nor was she referred to the judgment of this court in Maschinenfabrik Seydelmann K.-G. v. Presswood Brothers Ltd., 1965 CanLII 180 (ON CA), [1966] 1 O.R. 316 at pp. 321-22, 53 D.L.R. (2d) 224 (C.A.) where Schroeder J.A. said:

What is forbidden by the statute and the Regulations under review is not malum per se but malum prohibitum, and in every case it becomes a crucial question whether the contract is capable or incapable of lawful performance. In the latter case, e.g., if the parties should agree to commit a crime, or if they should clearly agree to commit an act prohibited by statute, such a contract is intrinsically illegal since it necessarily involves an offence or a violation of the law. With much deference to the opinion of the learned trial Judge who decided against the plaintiff with some reluctance, he has failed to take into account the well-settled presumption of law in favour of the legality of a contract; that if a contract can be reasonably susceptible of two meanings or modes of performance, one legal and the other not, that interpretation is to be put upon it which will support it and give it operation.

. . . . .

A like presumption was applied by the Supreme Court in Paoli v. Vulcan Iron Works Ltd., 1949 CanLII 58 (SCC), [1950] 1 D.L.R. 593, [1950] S.C.R. 114, where it was held that as there was no evidence that the contract there under consideration was intended to be put into effect without the permission required by the Wartime Salaries Order, although the increase in salary, the subject-matter of the contract, was agreed upon between the parties before the official permission was sought, it must be assumed that the parties intended to comply with the law. I quote from the judgment of Rand, J., at p. 594:

It is said that because the consensus for an increase had been reached in June, 1942, and was to be retroactive to January 1st of that year, the contract was illegal. I must confess to great difficulty in appreciating the grounds for that view. It was illegal only on the assumption that it was intended to be put into effect and carried out without relation to approval. There is no evidence of this one way or another, and in its absence I assume that these parties intended to comply with the law of the country. That this is so is fully confirmed by the fact of the company's application.

. . . . .

There is at present a tendency to regulate many activities in modern life by statutes or by Regulations authorized by statutory enactments, and the distinction between a contract inherently illegal because it cannot be performed without violating the law and one which can be legally performed but is void on the ground that there was an intention to perform it in an illegal manner cannot be disregarded. Since there is a presumption against illegality in the latter case, it is necessary for the defendant alleging illegality in the contract to show that there was an intention to break the law.

The contracts in this case were not "inherently illegal" in that, by their terms, they were incapable of being legally carried out. It was the intention of each of the parties to make a legal contract and to carry it out.

While this appeal was pending, two other cases were tried, in which the effect of a breach of s. 6 was considered. In neither did the trial judge reach the same conclusion as that reached by the trial judge in this case. In Skyrise Developments Ltd. v. Abrahams, a decision of the Ontario Court (General Division), released July 16, 1996 [now reported 1996 CanLII 8011 (ON SC), 29 O.R. (3d) 451, 3 R.P.R. (3d) 125], on similar facts, Davidson J., applying the principles as stated by Schroeder J.A., held that the agreements of purchase and sale were enforceable. He expressly disagreed with the conclusions of the trial judge in the case at bar and referred to the decision of Gotlib J. in Puri v. Sharynton Homes Ltd. (1994), 48 R.P.R. (2d) 8 at p. 16 (Ont. Gen. Div.). She said:

I do not think it matters to this lawsuit, and it is not a satisfactory ground on which to proceed. . . . At least registration was complete prior to the proposed date of closing, and it makes no difference to the purchaser at all whether or not registration was complete at the time of the agreement of purchase and sale.

In my view, Davidson and Gotlib JJ. were right. See also the annotation by Howard D. Gerson and Theodore B. Rotenberg at 48 R.P.R. (2d) 9.

I think it is significant that while the Act provides for a financial penalty for a breach of s. 6 it does not expressly provide that the contract so made is unenforceable. If a statute does not expressly deprive a party of his or her rights under the contract, the question is whether, having regard to the purpose of the Act, and the circumstances under which the contract was made, and to be performed, it would be contrary to public policy to enforce it because of illegality: see the judgment of Devlin L.J. in St. John Shipping Corp. v. Joseph Rank Ltd., [1956] 3 All E.R. 683 at p. 690, [1957] 1 Q.B. 267 (Q.B.).

The purpose of the ONHWPA was described when it was introduced in the Ontario legislature as follows: "to provide major protection for purchasers against the added cost and inconvenience caused by poor workmanship in home construction":
Legislature of Ontario Debates (31 May 1976) at p. 2736. I think, contrary to the trial judge's finding, that the registration requirements, per se, are not fundamental to the regulatory scheme. The protection which the Act sought for purchasers was not affected. The purchasers were not alleging an evil at which the Act is aimed. Indeed, as the trial judge noted, "the builder was clearly not unscrupulous, financially irresponsible or technically incompetent, much to the contrary".

As to public policy, the court must exercise its discretion guided by principles that command general acceptance: see William E. Thomson Associates Inc. v. Carpenter (1989), 1989 CanLII 185 (ON CA), 69 O.R. (2d) 545 at p. 554, 61 D.L.R. (4th) 1 (C.A.). In this case, the purchaser's argument was highly technical. As Waddams notes in The Law of Contracts, 3rd ed. (1993), at p. 381:

If every statutory illegality, however trivial, in the course of performance of a contract, invalidated the agreement, the result would be an unjust and haphazard allocation of loss without regard to any rational principles.

I think public policy favours that contracts should not be rendered unenforceable merely because of technical deficiencies. That is this case. The appeal on this ground is therefore allowed.
. Shafron v. KRG Insurance Brokers (Western) Inc.

In Shafron v. KRG Insurance Brokers (Western) Inc. (SCC, 2009) the Supreme Court of Canada set out the basics of severance and how they relate to illegality:
C. Severance

[29] Where severance is permitted, there appears to be two types: “blue-pencil” severance and “notional” severance. Both types of severance have been applied in limited circumstances to remove illegal features of a contract so as to render the contract in conformity with the law. Blue-pencil severance was described in Attwood v. Lamont, [1920] 3 K.B. 571 (C.A.), by Lord Sterndale as “effected when the part severed can be removed by running a blue pencil through it” (p. 578). In Transport North American Express Inc. v. New Solutions Financial Corp., 2004 SCC 7, [2004] 1 S.C.R. 249, Bastarache J., in dissent, described this form of severance at para. 57:
Under the blue‑pencil test, severance is only possible if the judge can strike out, by drawing a line through, the portion of the contract they want to remove, leaving the portions that are not tainted by illegality, without affecting the meaning of the part remaining.
[30] Notional severance involves reading down an illegal provision in a contract that would be unenforceable in order to make it legal and enforceable (see Transport, at para. 2). In Transport, the contract provided that interest was to be charged at a rate exceeding 60 percent contrary to s. 347 of the Criminal Code. There was no evidence of an intention to contravene this provision, and this was not a case of loan sharking. Arbour J. applied the doctrine of notional severance to effectively read down the interest rate to the legal statutory maximum of 60 percent.

[31] In Transport, a condition for application of the doctrine of notional severance appears to have been that what was illegal was easily determined by a bright-line provision in the Criminal Code. At para. 34, Arbour J. stated:
This legislatively mandated bright line [of 60 percent] distinguishes s. 347 cases from those involving provisions, for example, in restraint of trade, where there is no bright line.
It is apparent that Arbour J. would not have applied the doctrine of notional severance where there was no bright-line test for illegality. (See also Globex Foreign Exchange Corp. v. Kelcher, 2005 ABCA 419, 262 D.L.R. (4th) 752, at para. 46.)

[32] It must be recognized, however, that the court is altering the terms of the original contract between the parties by applying the doctrine of severance, whether blue-pencil or notional. In Transport, Arbour J. observed at para. 30, that “[i]ndeed, all forms of severance alter the terms of the original agreement”. Where severance is applied, whether blue-pencil or notional, the purpose is to give effect to the intention of the parties when they entered into the contract. However, courts will be restrained in their application of severance because of the right of parties to freely contract and to choose the words that determine their obligations and rights.
. 2176693 Ontario Ltd. v. Cora Franchise Group Inc.

In 2176693 Ontario Ltd. v. Cora Franchise Group Inc. (Ont CA, 2015) the Court of Appeal engages in an extended consideration of the issue of severing portions of a contract for illegality, here in the context of the franchise-governing Arthur Wishart Act ("AWA"):
(a) General Principles of Severance

[35] Where part of a contract is unenforceable because enforcement would be contrary to statute or the common law, rather than setting aside the entire contract, courts may sever the offending provisions while leaving the remainder of the contract intact. Severance lies along a spectrum of remedies available when a provision of a contract is illegal, including voiding the contract in whole or in part. The appropriate remedy will depend on the particular context: Transport North American Express Inc. v. New Solutions Financial Corp., 2004 SCC 7 (CanLII), [2004] 1 S.C.R. 249, at para. 6. Courts are generally reluctant to sever contractual provisions because severance alters the terms of the original agreement between the parties: Shafron, at para. 32.

[36] Severance takes two forms: “blue-pencil” and “notional”. Blue-pencil severance involves removing part of a contract, as if by drawing a line through it. Notional severance “involves reading down a contractual provision so as to make it legal and enforceable”: Shafron, at para. 2. Where severance is appropriate, courts choose the technique that “in light of the particular contractual context involved, would most appropriately cure the illegality while remaining otherwise as close as possible to the intentions of the parties expressed in the agreement”: Transport North American Express Inc., at para. 32.

[37] Courts will consider the context of the contract at issue and any relevant policy considerations when assessing whether and how to sever provisions: see, for example, Shafron. Severance engages policy concerns to a certain degree beyond protecting the parties’ intentions, because the court is being asked to assist one party to enforce an otherwise unenforceable provision.

[38] The context here is a business relationship carried out through the vehicle of a franchise. Franchise agreements are contracts of adhesion, frequently in standard form with the “main provisions … presented on a ‘take it or leave it basis’”: Shelanu Inc. v. Print Three Franchising Corp. (2003), 2003 CanLII 52151 (ON CA), 64 O.R. (3d) 533 (C.A.), at para. 58. These contracts often give the franchisor a significant degree of control over the franchisee’s business. In interpreting franchise agreements, courts have applied “policy goals in addition to accuracy in giving effect to the parties’ intentions” and have expressed “concern about inequality of power within the contractual relationship, and the resultant need to protect the more vulnerable contracting party from abuse at the hands of the more powerful party”: Geoff R. Hall, Canadian Contractual Interpretation Law, 2nd ed. (Markham: LexisNexis Canada, 2012), at p. 194.

[39] For the reasons outlined below, in my view, s. 22.6.4 should not be read down to permit the appellant to require a release of only non-AWA claims. The blue pencil approach does not apply in the circumstances, because there is no phrase in s. 22.6.4 that could be struck to enable the clause to require a release of only non-AWA claims. The clause should not be notionally severed given that severance would undermine the purposes of the AWA.

(b) The Clauses Should Not Be Notionally Severed

[40] In my view, notional severance is not an appropriate remedy in the circumstances, as it could undermine the purpose of s. 11 of the AWA. This court’s decision in Midas Canada Inc. is not determinative of whether clauses in a franchise agreement purporting to require a release can be severed. However, the reasoning in that decision informs the analysis and supports the view that notionally severing or reading down clauses calling for a broad release would not be in line with the purposes of the AWA. Before continuing with the severance analysis, I pause to consider the Midas decision.


(ii) Relevant Factors for Notional Severance

[48] In Transport North American Express Inc., at para. 42, a case dealing with a contract providing for an illegal rate of interest, the Supreme Court adopted several factors to assess the appropriateness of notional severance or partial enforcement as a remedy in the face of an illegal provision in a contract. When re-worded to apply to the franchise context, the factors would read as follows: (1) whether the purpose or the policy of s. 11 of the AWA would be subverted by severance, (2) whether the parties entered into the agreement for an illegal purpose, (3) the relative bargaining positions of the parties and their conduct in reaching the agreement, and (4) the potential for the franchisee to enjoy an unjustified windfall. Although not in a statutory context, the Supreme Court relied on similar considerations in Shafron to conclude that, as a general rule, notional severance should not be available in the case of restrictive covenants in employment contracts (at paras. 37-41).

[49] While the context is different, some of the factors identified are useful in this case. Indeed, in Midas, MacFarland J.A. considered the first factor – the policies of the AWA – in concluding that the clauses at issue there were unenforceable. Here, the application judge considered similar factors as well. Considering these factors is also consistent with the court’s general approach to the interpretation of franchise agreements as discussed above, which takes into account policy goals and is concerned with the inequality of bargaining power between franchisors and franchisees.

[50] In my view, the illegal purpose factor, while appropriate in the illegal interest rate context, is not helpful when considering the terms of a franchise agreement. Franchise agreements are entered into for legal and legitimate business purposes, as was the case here. Even when considering a particular problematic clause, it will be rare that parties have an illegal purpose.

[51] Similarly, the factor looking at the positions of the parties and their conduct in reaching the agreement may be of limited assistance in the franchise context. Unlike a loan on which an illegal rate of interest is charged, a franchise agreement covers a wide range of subjects and is often in standard form. As such, the parties’ conduct in reaching the agreement may not provide much insight into whether severance of a particular clause would be appropriate. However, I note that the relative bargaining positions of the parties may be relevant, especially given the concern about inequality of bargaining power in the franchise context.

[52] In the circumstances of this case, there are limited factual findings on which to assess the parties’ positions and conduct in forming the agreement, so this factor is of little assistance.

[53] Accordingly, I consider only the first and fourth factors: whether the purpose or policy of s. 11 of the AWA would be subverted by the mode of severance suggested by the appellant, and whether the franchisee would receive an unjustified windfall if the clause is held to be unenforceable in its entirety.

(iii) The Purpose and Policy of Section 11 of the AWA Would Be Subverted by Severance

[54] As MacFarland J.A. held in Midas, the purpose of the AWA is to protect franchisees (at para. 30). Section 11, in particular, aims to protect franchisees against more sophisticated franchisors who might seek to have franchisees contract out of their AWA rights. As the application judge noted, enforcing in part a clause calling for a general release raises the potential for abuse by franchisors.

[55] In the context of restrictive covenants in employment contracts, the Supreme Court cited similar concerns about abuse in holding that notional severance was not available as a remedy. The Court in Shafron concluded that, permitting notional severance would “[invite] employers to draft overly broad restrictive covenants with the prospect that the courts will only sever the unreasonable parts or read down the covenant to what the courts consider reasonable” (at para. 33). Applying the doctrine of notional severance would also “[provide] no inducement to an employer to ensure the reasonableness of the covenant and inappropriately [increase] the risk that the employee will be forced to abide by an unreasonable covenant” (at para. 41).

[56] As this court said in Shelanu Inc. v. Print Three Franchising Corp., at para. 66, the franchise context is similar to the employment context. Like employees, franchisees generally do not have equal bargaining power to the franchisor and are unable to negotiate more favourable terms (because franchise agreements are contracts of adhesion). Their relationship with the franchisor continues to be affected by a power imbalance because the franchisee must submit to inspections and audits and is often required to purchase items from the franchisor (Shelanu, at para. 66).

[57] Applying notional severance to clauses otherwise unenforceable under the AWA would similarly invite franchisors “to draft overly broad [provisions] with the prospect that the courts will only sever … or read [those provisions] down”. It would provide no incentive to franchisors to ensure their franchise agreements are in compliance with the AWA. It would also increase the risk that a franchisee – having signed a waiver or release of all claims – would erroneously believe it is not entitled to pursue any claims against the franchisor, including its AWA claims. “Reading down” contractual requirements that overreach would have a chilling effect on the exercise of franchisees’ rights. Each of these possibilities suggests that notional severance would diminish the protection offered by s. 11 of the AWA against franchisors who might seek to have franchisees contract out of their AWA rights.

[58] In my view, therefore, permitting notional severance of the overbroad clause in this case could subvert the policy and purpose of s. 11 of the AWA.

(iv) The Franchisees Would Receive a Windfall to Some Degree

[59] The issue here is whether there is a potential for the respondents to receive an unjustified windfall if the clause is struck in its entirety rather than read down to require a release of non-AWA claims alone. The appellant argues in effect that the respondents would receive a windfall: they bargained to provide a release of all claims in exchange for the appellant’s consent to a transfer of their rights under the franchise agreement, and if the clauses are severed in their entirety, they will not have to provide any release at all. The appellant contends that the application judge’s decision has the effect of giving franchisees more than they are entitled to and eroding the franchisor’s contractual rights beyond what is required to give effect to the protections under the AWA.

[60] To the extent that the respondents would no longer be required to release their common law claims, the appellant is correct that the respondents receive a greater protection than what they would have been entitled to. However, the extent of the windfall is difficult to assess, since there is significant overlap between the common law and AWA claims of a franchisee alleging misrepresentation. Of course, there is no “windfall” to the respondents by not requiring them to release their AWA claims as such a release would not be enforceable.

[61] In any event, the legitimate interests of the franchisor, in the context of an assignment, are protected even without the requirement of providing a release. As the appellant notes in its factum, “the purpose of Cora’s assignment provision is to ensure that the franchise agreement is assigned to a party that will be a competent franchisee able to operate the franchise in accordance with Cora’s standards.” All of the other conditions precedent to the franchisor’s approval of an assignment remain in place. In particular, the appellant does not lose its ability to approve the assignee as a franchisee.

(v) Conclusion on Notional Severance

[62] The potential for some windfall to the respondents in this particular case does not outweigh the potential for abuse and subversion of the purposes of s. 11 of the AWA if severance were permitted. Having regard to the relevant considerations, I conclude that the clause should not be notionally severed or read down to require only a release of non-AWA claims. Allowing franchisors to include such clauses in franchise agreements, knowing courts would only find them unenforceable in part, could serve to undermine the purposes of the AWA.


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Last modified: 06-02-23
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