In a judgment with potentially far-reaching implications, the Court of Appeal has given a restrictive reading of the scope of an express duty of good faith in a shareholders' agreement. In doing so, it reiterated that such clauses must be read in their context, and discouraged attempts to define a set of minimum standards applicable to all good faith clauses. We look at what this means for good faith under English law.
Good faith under English law
Unlike in many civil law systems, there is no general doctrine of good faith in English contract law. A duty of good faith will be implied into certain categories of contracts, such as insurance, employment and partnership contracts. The courts have also implied a duty of good faith in so-called 'relational' commercial contracts – typically those where the parties enter into a long-term relationship, such as joint venture, distribution or franchise agreements. However, the Court of Appeal has previously discouraged judges from looking for "some 'general organising principle' [of good faith] drawn from cases of different kinds", preferring instead to continue developing "piecemeal solutions in response to demonstrated problems of unfairness". While the court will not imply a duty of good faith into a commercial contract lightly, parties are free to include express obligations of good faith in their contracts – but in the event of dispute, it is likely to fall to the courts to determine the scope of that clause, as happened in Compound Photonics Group Ltd, Re  EWCA Civ 1371.
The clause in dispute
In this case, minority shareholders brought a petition under s.994 Companies Act 2006. The minority claimed that they had been unfairly prejudiced by the majority investors' actions, which led to the removal and resignation of two key directors - the company's CEO and chairman. The minority claimed that the intent of the company's constitution was that these personnel should have been effectively entrenched as permanent directors, that the majority investors had signed up to that bargain and that the removal of the directors constituted a breach of the good faith obligation in the shareholders' agreement. That clause provided: "Each Shareholder undertakes to the other Shareholders and the Company that it will at all times act in good faith in all dealings with the other Shareholders and with the Company in relation to the matters contained in this Agreement".
At trial, the judge agreed with the minority shareholders. He found that, while shareholders had an inalienable statutory right to remove directors using the process under s.168 Companies Act 2006, doing so could still potentially constitute a breach of the terms of the private shareholders' agreement. He found that the language of the good faith clause "could not be broader", and that it imported certain minimum standards – in particular it required the investors to act with "fidelity to the bargain" they had struck. He also found that "the bargain" they had struck was that the CEO and chairman would remain in post. The majority investors appealed on the basis that the judge's interpretation of the good faith obligation was overly wide.
Court of Appeal decision
Giving the leading judgment in the Court of Appeal, Lord Justice Snowden (with whom Lord Justice Newey and Lady Justice Carr agreed) found:
- A number of the authorities the judge had been referred to imported good faith concepts from other legal systems, notably Australia and North America, and different contexts. In particular, some authorities from other jurisdictions were geared towards defining the scope of a general duty of good faith to be implied by law. He did not think it appropriate to seek to apply those general principles when (a) English courts have resisted creating a general duty of good faith as a matter of law; and (b) the task at hand was to determine the scope of an express clause drafted by the parties.
- Good faith clauses must (like any other contract clause) be interpreted in the context in which they are used. Seeking to draw general principles from cases decided on other facts was not appropriate, nor was applying principles in a formulaic way in every case, irrespective of context and the other terms of the agreement. It is however worth noting that the Court of Appeal judgment in this case includes a detailed overview of much of the recent case law on the interpretation of good faith clauses which may prove useful in the event of disputes arising in this area.
- On the facts of the case, the judge had also erred in his assessment of the bargain the parties had struck – it was not correct to say that the parties had agreed that the two directors should be entrenched in their positions. A company's articles and directors are not cast in stone, but can be changed by democratic shareholder processes. The articles and shareholders' agreement were professionally drafted and so, if it had been the parties' intention to entrench the directors, that could have been made express. It would have required very clear wording to preclude the majority (who had invested $135 million in the company) from exercising control. In the absence of such express indication, a good faith clause cannot be presumed to prescribe how the parties should behave or prevent them from changing the original structure.
Where does this leave good faith clauses?
- A good faith clause imports a "core" duty of honesty, but parties should not fall into the trap of thinking that any other requirements imposed by a good faith provision are necessarily a "derivative" of that duty.
- It may also, depending on the context, prohibit bad faith conduct which falls short of dishonesty (such that a good faith obligation can be breached by conduct short of dishonesty but which is taken in bad faith). This may include conduct which would be "regarded as commercially unacceptable to reasonable and honest people, albeit that they would not necessarily regard it as dishonest".
- Beyond that though, it is not appropriate for the court to define some minimum standard applicable to all good faith clauses - the requirements of an express good faith clause must be derived as a matter of interpretation or implication from the other terms of the agreement in question. As with many other cases passing through the courts in recent years in different contexts, the court will apply tools of contractual construction and apply those in the relevant context to determine how a clause should be interpreted.
While this may not provide certainty on the precise scope of a duty of good faith, commercial parties should at least take comfort that it means any obligation of good faith they include in their agreement will be interpreted in the context of that agreement, rather than by reference to a prescriptive checklist. The downside for commercial parties agreeing good faith provisions in their contracts is therefore that an ongoing uncertainty remains regarding the precise scope and ambit of those obligations, which could lead to disputes at the stage where parties fall into disagreement.
It is expected that the law in this area will continue to develop over the next few years as a greater number of contracts incorporate good faith clauses which are then tested in court.
If you have any questions or would like to know more, contact a Sean Adams or Emma Carr in our Dispute Resolution team.