Contractual Duty of Good Faith: Latest Clarifications from the Court of Appeal

Contractual Duty of Good Faith: Latest Clarifications from the Court of Appeal

December 7, 2022, Covington Alert

The fact that English law does not recognise an implied duty on contracting parties to deal with one another in good faith often comes as a surprise, even to sophisticated investors. Parties frequently try to address the problem by including express contractual obligations to act “in good faith” in performing obligations under an agreement. While such provisions can be helpful, the lack of meaningful definition of the elements of “good faith” under English law has led to real ambiguity about obligations that the term imposes on contracting parties.

The Court of Appeal's judgment in Re Compound Photonics Group Ltd; Faulkner v. Vollin Holdings Ltd [2022] EWCA Civ 1371 provides some clarity; at a minimum a party that commits to act in good faith must behave honestly. The duty may extend beyond that, but any further obligations on a party must be capable of being derived as a matter of interpretation or implication from the other terms of the contract.

The reluctance of the Court of Appeal to rely on overarching general principles in interpreting good faith clauses means that parties contracting under English law will need to define clearly their expectations of what is required by an obligation to act in good faith.

The case was an appeal against the decision of Mr. Justice Adam Johnson following an unfair prejudice petition under section 994 of the Companies Act 2006, brought by the minority shareholders (the "Minorities") of Compound Photonics Group Limited ("CPGL").

CPGL was in the business of developing and commercializing a very small projector ("Pico"), that leveraged the academic research of Dr. Sachs into gallium arsenide and liquid crystal technology. Dr. Sachs was the CEO of CPGL. In 2010 M. Faulkner joined CPGL as a director and non-executive chairman. In his role as independent financial adviser, M. Faulkner introduced the Minorities to the business. M. Faulkner stated in his evidence that Dr. Sachs was "the jockey they were backing."

Over the course of the next six years, CPGL went through several substantial funding rounds, which resulted in three investors, Vollin Holdings Limited, Minden Worldwide Limited and Aldon Investments Limited (together, the "Investors") holding 93 percent of CPGL's share capital. The Investors are part of an investment structure, ultimately owned by Russian businessmen, including billionaire Roman Abramovich.

In connection with the 2013 funding round, CPGL adopted new articles of association (the "Articles") and the parties documented their relationship in a revised shareholders' agreement (the "SHA"). Notably, clause 4.2 of the SHA included the following duty of good faith:

“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.”

After a series of delays and failures to meet the Company's business plan and bring Pico to market, the Investors lost confidence in Dr. Sachs and expressed a concern as to the “constitutional balance” of CPGL. In March 2016, the Investors demanded that Dr. Sachs step down as CEO and in September 2016, the Investors removed M. Faulkner as a director by passing a resolution under section 168 of the Companies Act 2006.

The board's decision making powers provided for in the Articles and the SHA required a majority vote, which included the votes of Dr. Sachs and M. Faulkner. In addition, the quorum for board meetings consisted of three directors, including Dr. Sachs and M. Faulkner, “insofar as [Dr. Sachs and M. Faulkner] each remain a director.” The SHA and the Articles included “leaver” provisions for individuals who ceased to be directors.

Dr. Sachs and M. Faulkner claimed that their removal was in breach of the good faith provision contained in the SHA. The High Court found in their favour, on the basis that they had been “entrenched” as directors by the Articles and the SHA. Mr. Justice Adam Johnson held that clause 4.2 of the SHA imported all of the minimum standards of good faith that were previously identified in Unwin v Bond [2020] EWHC 1768 (Comm), which require a defendant to:

• act honestly;
• be faithful to the parties’ agreed common purpose as derived from their agreement;
• not use their powers for an ulterior purpose;
• deal fairly and openly; and
• have regard to the interests of the party to whom the duty is owed.

The Investors appealed the judge’s decision to the Court of Appeal.

The Court of Appeal’s Judgment

The Court of Appeal overturned the judgment, finding that Mr. Justice Adam Johnson's approach to interpreting the contractual duty of good faith in the SHA was too broad. The Court also disagreed with the judge’s interpretation that the SHA and the Articles were intended to create a “constitutionally omnipotent” board on which Dr. Sachs and M. Faulkner held the balance of power.

Snowden LJ stepped away from the “formulaic” approach established in Unwin v Bond, which in his view would detract from the Court’s ability to examine the context in which a specific good faith provision had been introduced and to interpret it accordingly. 

The Court of Appeal found that:

• the duty of good faith imposes a core requirement that the parties act honestly towards each other;
• the duty of good faith may, in certain circumstances, include a duty not to act in bad faith or in a way "that reasonable and commercial people would regard as commercially unacceptable, but not necessarily dishonest;" and
• a duty of fidelity to the bargain in the context of changes to the constitution of a company or the composition of its board is not inherent in a good faith clause, as articles and directors "are not cast in stone when the company is incorporated."

The Court of Appeal reviewed authorities on good faith from England and Wales, Australia, and the United States. Snowden LJ noted that the concepts of fidelity to the bargain and a requirement to have regard to the interests of the other contracting party were first introduced in a commentary on US contract law. The concepts were then adopted and developed in New South Wales, however this was outside the context of individually negotiated contracts.  Therefore, there was no basis to determine that the parties to an English law governed contract should automatically be presumed to have intended to incorporate such terms into their agreement. 

Referring to the use of the expression "the spirit of the contract" in the context of a good faith clause, Snowden LJ remarked that it should not be seen as an "open invitation" to the court to interpret the clause as imposing additional substantive obligations or restrictions outside the contract terms. Instead, he favoured Arden LJ's view in Re Coroin [2013] EWCA Civ 781, [2014] BCC 14, that the court should seek to identify the shared aims of the parties from the express and implied terms of the agreement.

Further, the judgment distinguished ordinary commercial contracts from the structure of a limited company and the relationship between its members. On that basis, it rejected the concept that a requirement to have regard to the interests of the other contracting party should automatically apply in the context of shareholders voting at general meetings.

The Court of Appeal cautioned that cases from other areas of law and commerce may be of “limited value” in interpreting good-faith provisions and “must be treated with considerable caution”. In doing so, the Court of Appeal is simply endorsing Auld, LJ in Street v Derbyshire Unemployed Workers' Centre [2005] I.C.R. 97.

If you have any questions concerning the material discussed in this client alert, please contact the members of our Mergers and Acquisitions practice.