Meaning of contractual duty of good faith

The Court of Appeal has taken a restrictive interpretation of an express duty of good faith in a decision handed down on 21 October 2022 - Re Compound Photonics Group Ltd; Faulkner v. Vollin Holdings Ltd [2022] EWCA Civ 1371.  This decision is important as (i) the Court of Appeal judgment provides a lengthy examination of the meaning of a contractual duty of good faith, and (ii) the decision casts doubt on some previous case law on this point (including overturing the High Court's decision).   

Background

The case concerned the removal from office of two directors who had been appointed by the minority shareholders.  The company's articles of association sought to entrench the position of those directors by providing that the board could not vote to remove them – however, importantly, the shareholders' agreement did not contain an obligation for the majority shareholders to not vote to remove the directors.  Subsequently, one of the directors was "forced" to resign after coming under pressure from the majority shareholders to do so, and the second director was removed from office by the majority shareholders passing an ordinary resolution under s.168 Companies Act 2006.

The High Court held that the minority shareholders had been unfairly prejudiced by the forced removal of their two appointed directors.  At the heart of the Judge's decision was a finding that the majority shareholders had breached an express duty of good faith in the shareholders' agreement by not respecting the "agreement" to entrench the position of the two directors.  

Court of Appeal decision 

The Court of Appeal unanimously agreed to overturn the High Court decision.  Giving the only judgment, Snowden LJ provided a lengthy examination of the existing case law on the meaning of the obligation of good faith.  One of the cases discussed was the relatively recent High Court decision in Unwin v. Bond [2020] EWHC 1768 (Comm) which had provided a pithy bullet point summary of the meaning of good faith, being:

• to act honestly 
• to be "faithful to the parties agreed common purpose" 
• to not use powers for an ulterior motive
• to deal fairly and openly
• to have regard to the other party's interests 

To the disappointment of blog writers everywhere (all of whom appreciate a pithy bullet point summary), Snowden LJ cast doubt on whether such a "formulaic" approach is appropriate.  

Whilst Snowden LJ is essentially saying that the meaning of good faith needs to be determined on the facts of every case, the following points can be taken from his judgment:

i) the duty of good faith definitely does include a duty to act honestly;

ii) the duty of good faith goes beyond just a duty to act honestly, and also includes a duty not to act in bad faith – meaning a prohibition on "conduct that reasonable and commercial people would regard as commercially unacceptable, but not necessarily dishonest".  Whilst this aspect of good faith might seem somewhat vague, Snowden LJ said that it would not be "appropriate to try to be prescriptive in describing what conduct might fall into this category";

iii) the court took a narrow view of good faith requiring the parties to be "faithful to the parties agreed or common purpose" (the second of the Unwin v. Bond bullet points).  The court decided that such a requirement would not apply to a shareholders' agreement in the absence of express wording to the contrary.  The court also held that even if it did, the current shareholders' agreement did not create a valid "agreement" to entrench the two directors in the absence of an obligation on the shareholders to not vote to remove the directors;

iv) the court took a narrow view of good faith requiring the parties to deal fairly and openly (the fourth of the Unwin v. Bond bullet points, and often taken to mean procedural fairness).  Applied specifically to the facts of the current case, the court decided that the majority shareholders were not under any procedural duty with respect to director removal beyond that set out in s.168 and 169 of the Companies Act 2006; and

v) the court rejected that a duty of good faith required the majority shareholders to "have regard to the interests of the [minority shareholders] in some undefined way over and above any requirements that would be imposed on shareholders to have regard to the interests of the Company".  This casts doubt on the ongoing relevance of the fifth of the Unwin v. Bond bullet points.  

Consistent with his desire to avoid a "formulaic" approach, Snowden LJ was not setting out to provide a one size fits all definition of good faith going forward.  However, he has provided a precedent for a narrower interpretation of the principles that were previously thought to apply and has, perhaps, provided a narrower definition to begin with.

Practical points

There are two obvious practical points that arise from Re Compound Photonics:

i) there remains a relatively high degree of ambiguity as to what "good faith" means in any given context (as is evident from the requirement for a 79 page Court of Appeal judgement to explain what it means when applied to the facts of this case).  Therefore, by agreeing to include a good faith obligation in a contract, parties are introducing a greater degree of uncertainty as to future interpretation of that contract.  That uncertainty is always likely to favour the "weaker" party (i.e. the one having rights enforced against it), and act as a potential restraint on the "stronger" party.

ii) in order to entrench the position of directors appointed by one set of shareholders, it is necessary for the other shareholders to agree in the shareholders' agreement (or otherwise) not to vote to remove those directors.  Any other form of purported entrenchment is likely to be susceptible to defeat by a s.168 ordinary resolution.