UK: Good faith and shareholders’ agreements

Introduction

For parties preparing to enter into a joint venture (whether as shareholders through the use of a corporate vehicle or by adopting a different structure) it may seem axiomatic that each would expect the other parties to act “in good faith” in their joint venture dealings. However, English law has traditionally refused to recognise any overriding principle of good faith between contracting parties including where the parties may be co-shareholders¹. In Walford v Miles² Lord Ackner stated that “the concept of a duty to carry on negotiations in good faith is inherently repugnant to the adversarial position of the parties when involved in negotiation” and is “unworkable in practice”. Instead, the principles of freedom of contract, the ability for parties to pursue their own self-interest and certainty of contract are upheld by the courts and it is thought that a general doctrine of good faith would create obligations that are potentially too vague and subjective.

However, this rejection of an overarching doctrine of good faith has been occasionally problematic to the courts which have developed “piecemeal solutions in response to demonstrated problems of unfairness”³ – and in doing so have muddied the good faith waters.

There are therefore three issues to be considered for parties entering into contractual relationships including where expressed in a joint venture or shareholders’ agreement:

• Agreeing an express duty of good faith. However, interpreting precisely what obligations arise out of this and what the parties must do in practice to make sure they fulfil such a duty may be problematic.

• Will the English courts imply a duty of good faith – despite the over-arching rejection of the concept of good faith, the courts have shown themselves willing to imply a general duty of good faith into certain contracts, particularly so-called “relational” contracts.

• The duty of rationality – also known as the Braganza duty after the case in which it was established⁴, is a now well-recognised duty under which a party must exercise a contractual discretion in good faith and not arbitrarily or capriciously. This is clearly an exception to the general rule of English law that contractual rights are enforceable regardless of whether they are exercised in a reasonable or unreasonable way⁵, and is not considered in detail in this briefing.

Should there be an express duty to act in good faith?

Particularly in the context of a joint venture, the inclusion of an express obligation on the parties to act in good faith may seem to be an uncontroversial request. Why would anyone want to enter into a contract with a counterparty who wouldn’t agree to act in this way? However, whilst the parties to an English law agreement are free to expressly agree to act in good faith, the main issue in including such wording is a pragmatic one – good faith is an imprecise concept which is impossible to pin down with any degree of certainty. This is reflected in case law where, in the absence of a general definition of good faith, the courts have been required to interpret the specific words chosen by the parties on a case by case basis to ascertain the true intention behind including such a provision. Where an express good faith clause is included in a contract, the court must try to give effect to it, but the actions which it should translate to may not be clear.

The difficulty can be seen from those cases which have attempted to establish what is meant by an express duty of good faith. For example, in CPC Group v Qatari Diar Real Estate Investment Co⁶ Vos J considered various potential definitions or interpretations of the phrase including that it:

• underwrites the spirit of the contract and supports the integrity of its character.
• is a duty to recognise and to have due regard to the legitimate interests of both parties.
• emphasises faithfulness to an agreed common purpose and consistency with the justified expectations of the other party.

Further, in EE v Phones4U¹⁹, the judge found that an express duty of good faith should not mean that a party cannot prioritise its own interests and concerns, and held that EE’s decision to notify Phones4U that their agreement would not be extended could not be regarded as a breach of the good faith provision, as it would not be considered commercially unacceptable by reasonable and honest people.

In Unwin v Bond⁷ the difficulties which may arise, if an express duty to act in good faith is added to a shareholders’ agreement, were highlighted. Often, the shareholders in a joint venture will not only be a party to the shareholders’ agreement and have rights under the company’s constitutional documents, but they may also be directors and/or employees or have rights deriving from other contractual arrangements. Therefore, any good faith obligation arising out of the shareholders’ agreement is operating in the same space as the rights and obligations arising out of these other contracts. This was the case here where the company was owned by two individual shareholders. Mr Bond was the 80 per cent shareholder and Mr Unwin was the 20 per cent shareholder. Mr Unwin was also an employee of the company. Mr Bond dismissed Mr Unwin on grounds of poor performance. Under the company’s articles of association, Mr Unwin was obliged to sell his shares for a nominal amount in these circumstances as termination of his employment (even where he had been unfairly dismissed) made him a “bad leaver” as defined in the articles. However, the court decided Mr Bond had breached the good faith obligation in the shareholders’ agreement even though he had not been dishonest and had been acting in what he considered to be the best interests of the company. The reason for this was that he was found to have failed to "deal fairly and openly" with Mr Unwin, which was one of the “minimum standards” identified by Klein HHJ in relation to the obligation of good faith. The conclusion from this decision seems to be that, where there is an express duty of good faith and either of the shareholders holds a position as director and/or employee of the joint venture, this obligation may extend beyond their relationship as shareholders.

It seemed that this point had been taken further, in Re Compound Photonics Group Ltd⁸. Here the High Court held that, in being excluded from the management of a joint venture company, the minority shareholders had been unfairly prejudiced by the conduct of two majority shareholders, in breach of their obligations under a shareholders’ agreement including an explicit obligation, written into the shareholders’ agreement, to act in good faith. At first instance, the judge concluded that the explicit requirement for the shareholders to act in good faith was intended to impose a contractual restriction, binding as between the shareholders, on the otherwise unrestricted rights of the majority shareholders to exercise their power under Companies Act section 168(1) thereby importing all of the “minimum standards” of good faith identified in Unwin v Bond.. However, the majority shareholders appealed on the basis that the judge had interpreted the good faith clause too widely, and the appeal was granted unanimously. The Court of Appeal held⁹ that the first instance judge was not correct in finding that the good faith clause in the Shareholders’ Agreement gave the minority shareholders any entrenched rights. In his leading judgment, Snowden LJ considered that the statement of principles on the meaning of a good faith obligation articulated in Unwin v Bond should not be applied in a formulaic way in every case. Rather, it must take its meaning from the context in which it is used. In addition, Snowden LJ he made it clear that care must be taken when trying to interpret the meaning of good faith in one contract by considering cases from other areas of law or commerce, as each case turns on its own facts. Snowden LJ went on to indicate that it is not helpful to analyse case law on the issue of good faith to try to deduce “minimum standards”, beyond the basic one to act honestly (and not in bad faith).

Snowden LJ’s judgment confirms much of the case law which suggests that when determining the effect of an express good faith clause, the courts will closely examine the wording of the specific agreement and will only hold the parties to undertake the expressly stated obligations in good faith, not the whole contractual relationship. With the result that, generic or wide ranging obligations of this nature may not be enforced by the courts due to lack of certainty or that the obligations are unenforceable because they amount to “agreements to agree”.

Further, where there is an express duty of good faith defined, it seems unlikely the courts will agree to imply a wider duty outside of this scope, potentially even for “relational contracts” ¹⁹ (discussed in further detail below).

It is also worth noting that an express duty of good faith is unlikely to be placed at odds with defined contractual rights¹⁰ or require a party to give up its commercial interests¹¹. On the other hand, the courts do not necessarily require there to be a finding of dishonesty¹².

Accordingly, parties should be aware that although an express good faith clause may be intended to fill any gaps in the contractual relationship and encourage both parties to behave in a “fair” way, it is a poorly defined right and may also encourage spurious claims, based on broad assertions of what good faith means. At worst, it may be interpreted in a way that neither party anticipated or would have written into their agreement.

Can a duty of good faith be implied into English law agreements?

The English courts have struggled to define in a cut and dried way where a duty of faith may be implied into contracts governed by English law with some hard line authority to the effect that this would only be likely to arise where the contract would lack commercial or practical coherence without it.

However, and relevant to agreements in the nature of joint venture or shareholder agreements, the 2013 High Court case of Yam Seng¹³ recognised that the concept of good faith was used to imply two terms into a distribution agreement, in part on the basis that the contract was a long-term, “relational” contract. Whilst at the time the judgement received a lukewarm reception, including by the Court of Appeal in Globe Motors¹⁴, the concept of a “relationship contract” importing special considerations has persisted with certain recent decisions in the courts supporting the concept of implying good faith into this type of contract¹⁵. In particular, in 2019, the High Court did imply a duty of good faith into the Post Office’s contract with its sub-postmasters¹⁶, as this was found to be a “relational” contract, and in doing so set out features of a contract which would indicate it was of this type:

• A long-term contract or a contract the parties intend to be long-term, even though it lacks a fixed-term and allows termination by notice.
• The parties intend their roles to be performed with integrity and with fidelity to their bargain.
• The parties will be committed to collaborating with one another.
• The spirits and objectives of the venture cannot be expressed exhaustively in a written contract.
• The parties each repose trust and confidence in one another.
• The contract involves a high degree of communication, co-operation and predictable performance based on mutual trust and confidence, and expectations of loyalty.
• One or both parties have made a significant investment.
• The relationship is exclusive.

Notwithstanding a number of cases suggesting a willingness to imply a duty of good faith into relational contracts, in 2020 the High Court in Russell v Cartwright¹⁷ held that, rather than trying to establish whether a contract is a “relational” one, which therefore includes an obligation of good faith (as was held in Bates v Post Office), the better starting point was the application of the conventional tests for the implication of contractual terms. This meant that the question to be asked was whether a reasonable reader would consider that an obligation of good faith was obviously meant, or the obligation was essential to the proper working of the contract since it would otherwise lack commercial or practical coherence.

A similar conclusion was reached in TAQA Bratani Limited & Ors v Rockrose UKCS8 LLC ¹⁸, where the court found that, despite the contracts in question arguably being “relational”, no duty of good faith should be implied as the clause relied upon provided an absolute and unqualified power.

However, more recently in the Phones 4U v EE¹⁹ case the High Court provided more detail on the factors to be considered when assessing whether a contract is relational in nature. These included considering if there was competition between the parties and if the contract specifies the ways in which the parties agree to co-operate. The judge held that both of these factors meant the contract in question was not relational (even though the judge acknowledged that some features of a relational contract did exist).

Perhaps more importantly, the judge went on to say that, even if the agreement was relational in nature, it would not affect the outcome in this case. This was because the contract included an express term of good faith, with a defined scope negotiated between two sophisticated parties, which precluded the court from implying a more general duty of good faith.

What are the implications for the parties to a joint venture or shareholders’ agreements?

It is fairly clear that, whilst the concept of good faith is creeping into English law, the “law has not yet reached a stage of settled clarity”²⁰, and this will have implications for the drafting of JVAs or SHAs.

Where express good faith duties are included, the provisions must be clearly drafted to ensure that the agreement reflects the parties’ intentions as to the scope of that duty, as it is unlikely a court will impose a general implied duty for “out of scope” issues.

Where no express duty is included, it remains unclear from the case law whether parties to “relational” contracts are able to rely on a duty of good faith implied by the law. The willingness of the court to permit this implication, and what obligations will then be imposed, is very fact specific, and that inevitably gives rise to a degree of uncertainty around the contractual interpretation. Accordingly, even if a duty of good faith is implied by a court, there may be a lack of clarity on the contractual implications which may follow. Whilst each party to a contract may be entitled to expect that the other parties will not act dishonestly, if they want other protections these should be written in to the contract clearly enough for the parties to understand what they can do, and what they cannot do. What does appear to be clear (although there is a lack of specific authority on this point) is that an express term of the contract can prevent any duty of good faith being implied, so the parties to a JVA/SHA could choose to expressly exclude any implied duty of good faith.