Good faith in contracts: cautious developments

The courts have traditionally been reluctant to interfere in commercial contractual relationships. The High Court in England recently refused to imply a term of good faith. It emphasised the primacy of the parties’ right to freedom of contract. This was a step back from recent moves to recognise the concept of good faith in commercial contractual relationships. 

23rd June 2015

Background

Mr and Mrs Myers sold their sub-prime mortgage business to Kestrel Acquisitions Limited (“Kestrel”). Kestrel was a vehicle for the purchase ultimately owned by two venture capital financiers. The sale transaction created two types of loan notes – one type held by the Myers and the other type held by the financiers. The loan notes could be modified by Kestrel by extending the repayment date, and further loan notes could be issued to raise capital, provided existing investors were given the first opportunity to invest.

Kestrel did extend the repayment date of the loan notes and issued further loan notes. The Myers contended that this diminished and subordinated the value of their loan notes. Their primary contention founded on concepts of unfairness and the need for Kestrel to use good faith in their dealings with the loan notes.

Myers’ good faith arguments

The Myers argued that Kestrel must act in good faith when modifying the loan notes because good faith is implied:

1. To protect the minority, when a majority acts in a single class or group;

2. When one party is exercising a discretion in a contract; and

3. As a curb on the possibility of fraud.

The court rejected these arguments.

Firstly, the two types of loan notes were not a single class or group; and in any case Kestrel, being the party who could modify the loan notes, was not a member of any class or group holding loan notes. This was not a case of a majority decision affecting a minority where a duty of good faith might be implied.

Secondly, a duty to act in good faith when exercising a contractual discretion applies where an assessment is being made, or a choice of options is being made which affects all parties to a contract. It does not apply to a choice as to whether or not to act, as here. Kestrel could either modify the loan note or not; there was no range of choices within that.

Thirdly, the sale provisions and protections it contained were extensive and the court concluded that all risks, including the risk of fraud, had been reasonably considered and provided for in the documentation.

General developments as to good faith

Implied terms of good faith are recognised for particular contractual relationships such as insurance contracts, employment contracts or group situations. For example, where a group majority can bind a minority, there is an obligation on the majority to act in good faith for the benefit of a class as a whole. This was set out by Sir Nathaniel Lindley MR in Allen v Gold Reefs of West Africa [1900] in relation to majority shareholders:

“the power conferred must, like all other powers, be exercised subject to those general principles of law and equity which are applicable to all powers conferred on majorities and enabling them to bind minorities. It must be exercised, not only in a manner required by law, but also bona fide for the benefit of the company as a whole.”

However, the courts in the UK have been reluctant to extend the concept of good faith to commercial contracts more generally. This contrasts with civil law jurisdictions on the Continent.

In Attorney General of Belize v Belize Telecom Ltd [2009] Lord Hoffman summed up the general attitude of the UK courts to implying terms into commercial contracts.

“The court has no power to improve upon the instrument which it is called upon to construe… It cannot introduce terms to make it fairer or more reasonable.”

In Yam Seng Pte Ltd v International Trade Corporation Ltd [2013] the court adopted a flexible approach in recognising the concept of good faith more widely:

“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 [of good faith] in any ordinary commercial contract based on the presumed intention of the parties."

However, this approach was rejected in Greenclose Ltd v National Westminster Bank Plc [2014]:

“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.”

Nevertheless, in Greenclose the court did accept a discrete area where a duty of faith would be implied. This is where a contract provides one party with discretion to act, where that act will impact all parties to the contract:

“Thus in some situations where a contracting party is given discretion, the Court will more readily imply and obligation that the discretion should not be exercised in bad faith or in an arbitrary or capricious manner.”

But this principle has clear limitations, as set out in the earlier case of Mid Essex Hospital Service NHS Trust v Compass Group UK and Ireland Ltd [2013]. Here, the court refused to imply a duty of good faith where the discretion involved simply a decision as to whether or not to exercise a contractual right.

Conclusion

Good faith in commercial contracts is not clearly established as a concept in UK jurisdictions; but it is increasingly being argued before the UK courts. The merits of good faith in contractual dealings can hardly be disputed as a principle. However, the courts are reluctant to embrace it, for doing so will undermine the traditional primacy given to parties’ freedom of contract. Nevertheless, recent developments have shown an increasing recognition of the principle and it has been applied albeit in restricted circumstances. The scope of its application is likely to be further examined and developed by the courts over the next few years.