Good Faith in Commercial Contracts: A New Duty?

By Ruhi Sethi

Posted: 7th August 2015 08:56

As English law currently stands, there is no general duty of good faith in commercial contracts.  There are exceptional contracts where the law will imply a duty of good faith i.e. employment, insurance and contracts governing fiduciary relationships where a group majority can bind a minority.  Over the last few years the UK courts have had to consider whether it is possible to imply a duty of good faith and if so, the circumstances in which this can be done.  Ruhi Sethi, a barrister at 4-5 Gray’s Inn Square, examines the Courts’ findings in the cases, the relevant applicable principles of implying terms into contracts and discusses whether it is likely that a new duty of good faith will be introduced into English law.
 
The Courts’ findings
 
The question of good faith in commercial contracts was first considered by Leggatt J in the case of Yam Seng Pte Limited v International Trade Corp Ltd [2013] EWHC 111 (QB) which centred on a dispute between parties to a distribution agreement.  The agreement itself was minimal and had clearly been written by the parties themselves without the assistance of lawyers.  In paragraph 131 of his judgment, Leggatt J famously said the following:
 
‘I doubt that English law has reached the stage, however, where it is ready to recognise a requirement of good faith as a duty implied by law, even as a default rule, into all commercial contracts.  Nevertheless, there seems to me to be no difficulty, following the established methodology of English law for the implication of terms in fact, in implying such a duty in any ordinary commercial contract based on the presumed intention of the parties.’
 
In paragraph 142 of his judgment, Leggatt J also noted that a great many contracts do not fit within the exceptional category of contracts but involve a longer term relationship and ‘may require a high degree of communication, cooperation and predictable performance based on mutual trust and confidence and involve expectations of loyalty which are not legislated for in the express terms of the contract but are implicit in the parties’ understanding and necessary to give business efficacy to the arrangements.’  These contracts are often referred to as ‘relational’ contracts and he set out the following examples: certain joint venture agreements, franchise agreements and long term distributorship agreements.
 
In paragraph 148 of his judgment, Leggatt J comments that the basis of the duty of good faith is the presumed intention of the parties and meaning of their contract and the recognition of this would not restrict them in pursuit of their own interests. 
 
In the wake of this judgment it was thought that this case might pave the way for a general duty to act in good faith to be incorporated into English law.  However, the cases of Mid Essex Hospital Services NHS Trust (the Trust) v Compass Group UK and Ireland Limited (trading as Medirest) [2013] EWCA Civ 200 and Greenclose Ltd v National Westminster Bank plc [2014] EWHC 1156 (Ch) swiftly put paid to any such speculation. 
 
In the former case, Medirest and the Trust were parties to a long term facilities agreement which included express provisions allowing the Trust to award service failure points and to make financial deductions if service levels were not met.  The Judge at first instance found that the Trust had breached an implied term not to exercise its discretion in any arbitrary, capricious or irrational way.  The case went to the Court of Appeal who disagreed with the High Court Judge on the basis that the Trust’s power to make financial deductions was not a discretion conferred upon the Trust but a right to exercise an unconditional contractual right.  The Court found that implying a term of good faith in this situation was unnecessary and potentially prejudicial to the exercise of the Trust’s express contractual right.
 
The latter case builds on this approach and highlights the importance of the discretion, if any, conferred by the agreement. In paragraph 150 of her judgment, Mrs Justice Andrews states that “there is no general doctrine of good faith in English contract law and such a term is unlikely to arise by way of necessary implication in a contract between two sophisticated commercial parties negotiating at arms' length”. 
 
She went on to acknowledge that“in some situations where a contracting party is given a discretion, the Court will more readily imply an obligation that the discretion should not be exercised in bad faith or in an arbitrary or capricious manner, but the context is vital.  A discretion given to the board of directors of a company to award bonuses to its employees may be more readily susceptible to such implied restrictions on its exercise than a discretion given to a commercial party to act in its own commercial interests”.
 
In a similar vein the very recent case of Myers v Kestrel & Ors [2015] EWHC 916 (Ch), saw the Claimants arguing that Kestrel, a company operated by two venture capital financiers, must act in accordance with an implied duty to act in good faith when modifying both types of loan notes (vendor loan notes and discounted loan notes) which applied in this case for the following reasons: to protect the minority; Kestrel was exercising a discretion under this contract and to curb the possibility of fraud.
 
The Court rejected these arguments.  Firstly, that both the vendor loan notes and the discounted loan notes were not a single class or group and in any event, the party with the power to modify the notes, Kestrel, was not a member of any class or group holding the loan notes.  Accordingly, it was clear that this was not a situation of a majority decision affecting a minority where duties of good faith can be applied.  Secondly, a duty to act in good faith when exercising contractual discretion arises where an assessment must be made or one out of a number of options must be chosen.  It does not arise where the choice is whether or not to act which was the extent of Kestrel’s choice in this situation.  Finally, in relation to the fraud argument, it was held that that this risk had been adequately provided for in the documentation. 
 
Implying terms in commercial contracts
 
In deciding the above cases, the Courts have had regard to the principles of implying terms into contracts as there have been no specific words to construe and the Court needs to either infer or imply a term to give effect to the parties’ objective intention.  Implying a term into a commercial contract is an extension of the construction exercise beyond the express terms. The Court will use its discretion to do this in limited circumstances.   
 
In the case of BP Refinery (Westernport) Pty Ltd v the President, Councillors and Ratepayers of Shire of Hastings (1977) 52 ALJR 20 Lord Simon set out the conditions to be satisfied for implying a term into a commercial contract: it is reasonable and equitable; it is necessary to give business efficacy to the contract (no term will be implied if the contract is effective without it; it must be so obvious that it goes without saying; it must be capable of clear expression and it must not contradict any express term of the contract. 
 
Lord Hoffman made further observations about the process of implication in his judgment in Attorney General of Belize v Belize Telecom Ltd [2009] UKSC 10.  In summary, he stated that the court has no power to improve upon the instrument which it is asked to construe; it cannot introduce terms to make it fairer or more reasonable and that the meaning would be what the instrument conveyed to a reasonable persons in possession of all the available background knowledge. 
 
A New Duty?
 
In his judgment in Yam Seng Pte Limited v International Trade Corp Ltd [2013] EWHC 111 (QB), Leggatt J argued for English law to recognise an implied duty of good faith in commercial contracts by persuasively dispelling many of the tradition objections such as the fear of restricting parties’ freedom of contract and highlighting the needs of parties in ‘relational’ contracts. He also outlined many advantages of introducing an implied duty of good faith in such contracts.  
 
However, in the judgments which have followed, it seems that for now rather than introducing a new general duty to act in good faith in commercial contracts, the preferred judicial option is for that duty to either be expressly provided for in contractual documentation or to be construed as an implied duty in the circumstances highlighted by the above cases. This leaves the position in relation to the duty of good faith precarious and uncertain.
 
In light of Leggatt J’s comments, the fact that many other civil law jurisdictions recognise some form of duty on contracting parties to perform their contractual obligations in good faith and the fact that it has been implied in certain circumstances, there is a strong possibility that this could be a concept that it is developed in English law in the years to come. 
  
Ruhi Sethi is a Barrister at Leading Chambers 4-5 Gray's Inn Square.  Ruhi has a broad commercial dispute resolution practice which incorporates cross border litigation.
 
Ruhi's practice includes advising clients on the following: breach of contract; construction of contractual terms; breach of fiduciary duties; dishonest assistance; supply of goods and services; aviation; misfeasance; shareholder disputes; company law; intellectual property; professional negligence; bailment; defamation; reputation management; brand protection; personal and corporate insolvency; cross border asset recovery; fraud; forensic investigations; financial services litigation; preference claims; transactions at an undervalue; wrongful trading; directors' disqualification proceedings; consumer credit claims; enforceability of loans; mis-selling; injunctive relief; commercial judicial review and procurement disputes.

Ruhi Sethi
Telephone: +44 (0)202 7404 5252
Email: clerks@4-5.co.uk
Website: www.4-5.co.uk

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