Court gives limited interpretation to express ‘good faith’ clause

In Compound Photonics Group Ltd, Re [2022] EWCA Civ 1371 the Court of Appeal gave a limited interpretation to an express ‘good’ faith’ clause in a shareholders’ agreement. The clause did not prevent the majority shareholders of a company from removing a director. The Court of Appeal unanimously agreed that the High Court had interpreted the good faith clause too broadly.

Background

This was an appeal against a High Court decision in a trial of an unfair prejudice petition under section 994 of the Companies Act 2006.

The appellants were the investors in a company, who held 93% of the shares (the Investors). The founders of the company, Mr Faulkner and Mr Sachs, held the minority shares and remained involved as directors (the Respondents).

Over time, the business failed to be as lucrative as had been hoped, and the Investors began losing faith in the Respondents’ directorship. Due to pressure from the Investors, Mr Sachs ultimately resigned from the board. The Investors later used their powers under the Companies Act 2006 to call a general meeting, at which they removed Mr Faulkner as a director.

The Respondents argued that they had been unfairly prejudiced by the conduct of the Investors when they were respectively forced to resign and removed from office as directors. The conduct breached the good faith clause contained in the shareholders’ agreement pursuant to which the shareholders undertook to each other and to the company that they would at all times act “in good faith” in relation to the matters contained in the agreement. The Respondents asserted that this provision required the Investors to adhere to the inherent “bargain” set out in the shareholders’ agreement – namely, that the two directors should be entrenched as directors and that the Investors, as majority shareholders, should not control the board in determining the commercial future of the company. The Investors argued to the contrary that they had complied with the good faith clause by acting honestly and in a commercially justifiable manner.

In interpreting the good faith clause, the first-instance Judge followed Unwin v Bond [2020] EWHC 1768 (Comm) and held that a good faith obligation included a number of minimum standards, including procedural fairness and held in favour of the Respondents. The Investors appealed.

Court of Appeal’s decision

The Court of Appeal allowed the appeal. The Court of Appeal disagreed with the approach at first instance, ruling that the Investors did not breach the good faith clause in the shareholders’ agreement and had not unfairly prejudiced the Respondents.

The decision emphasised that a contractual clause requiring a party to act in good faith can only be interpreted by reference to the context in which it appears. Construction of such clauses cannot be approached in a formulaic way and authorities considering similar clauses in other legal or commercial contexts should be treated with caution. 

The decision acknowledged that the irreducible core of a good faith obligation was a duty to act honestly, but rejected the High Court’s finding that any good faith clause must be taken to require compliance with the minimum standards set out in Unwin v Bond. While they indicated that more than the minimum duty to act honestly might be implied in any particular case, depending on the type of contract, in this case, they found that there were no fiduciary obligations between the participants and no need to imply additional standards such as procedural fairness.

Giving the judgment of the Court of Appeal, Snowden LJ simultaneously took a narrow view of the minimal good faith duty but also allowed a maximal interpretation if the contract merits it:

“the authorities do not support the proposition that a contractual duty of good faith can only be breached by conduct that is dishonest according to the explanation of that concept in Royal Brunei and Ivey. Depending on the contractual context, a duty of good faith may be breached by conduct taken in bad faith. This could include conduct which would be regarded as commercially unacceptable to reasonable and honest people, albeit that they would not necessarily regard it as dishonest

…

I accept the argument that apart from the “core” duty of honesty and (depending on the context) a duty not to engage in conduct that could be characterised as bad faith, any further requirements of an express duty of good faith must be capable of being derived as a matter of interpretation or implication from the other terms of the contract in issue in the particular case. However, I do not think that it helps to describe those other requirements as “derivative” of the core duty of honesty.” (paras. 241 – 243)

Key takeaways

There is something in this case to please both those arguing for the imposition of good faith duties in English contract law and those arguing against it

The decision emphasised that good faith clauses must be interpreted by close reference to the particular context in which they appear – the Court of Appeal cautioned against the practice of imposing a formulaic set of standards on contractual parties irrespective of the unique context. However, parties should be aware that if an express good faith clause is used to fill any gaps in the contractual relationship and encourage parties to behave in a “fair” way, it is a poorly defined right which may encourage claims based on broad interpretations. 

Parties proposing to include an express duty of good faith in an agreement should consider defining the scope of the duty as clearly as possible within the agreement, including, where feasible to do so, identifying actions that are (or are not) required to satisfy it.  However, this may be easier said than done -  in reality the term “good faith” is often used as a short cut to fill gaps in the contractual relationship precisely because defining all the nuances of the behaviour that the parties expect from each other is seen as too difficult to draft or which perhaps would not have been agreed if requested by one of the parties.

With thanks to Stephanie Allen for her assistance in preparing this post.