A move away from the formulaic approach to the contractual duty of good faith

Compound Photonics Group Ltd; Faulkner v Vollin Holdings Ltd [2022] EWCA Civ 1371

The question

Has the approach to establishing the duty of good faith in commercial agreements changed?

The key takeaway

In an apparent move away from the courts’ formulaic approach to establishing a duty of good faith, the Court of Appeal has decided that the meaning of good faith needs to be determined on the facts of the case. The court then went on to provide a precedent for a narrower definition and interpretation of the principles that were previously thought to apply.

The background

The majority shareholders of a company forced out 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 express term for the majority shareholders not to vote to remove the directors.

There was, however, a clause in the shareholders’ agreement under which the shareholders undertook to each other and to the company that they would at all times act “in good faith” to each other. 

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 CA 2006, s 168.

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 their express duty of good faith in the shareholders’ agreement by not respecting the “agreement” to entrench the position of the two directors. The majority shareholders appealed. 

The decision

The central issue for the appeal court was whether the High Court’s interpretation of the good faith clause, leading to a finding of unfair prejudice, had been correct. 

After a lengthy examination of the existing case law on the meaning of the obligation of good faith, the Court of Appeal decided to overturn the High Court’s decision. The court called into doubt the existing formulaic approach to establishing the duty of good faith, stating that it needed to be determined on the facts of each case. 

Despite a keenness to avoid a prescriptive approach, the following points, based on a narrower interpretation of the principles, can be taken from the court’s judgment as guidance for the interpretation of good faith clauses:

• the duty of good faith does include a duty to act honestly
• 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 honest people would regard as commercially unacceptable, but not necessarily dishonest”. While this aspect of good faith might seem vague, the court reasoned that it would not be “appropriate to try to be prescriptive in describing what conduct might fall into this category”
• the court took a narrow view of good faith requiring the parties to be “faithful to the parties’ agreed common purpose”. 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 not to vote to remove the directors
• the court took a narrow view of good faith requiring the parties to deal “fairly and openly”. 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 CA 2006, ss 168 and 169

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”.

Why is this important?

This case signals a step change in the court’s approach to good faith clauses with less reliance on a set formula and more emphasis on interpretation based on the commercial context and facts. 

It means that parties wishing to rely on a good faith clause need to state clearly what they are trying to achieve. In this case, for example, the parties would have likely needed to explicitly agree in the shareholders’ agreement not to vote to remove the directors. 

Any practical tips?

Ideally, include specific standalone obligations that reflect the commercial deal, as this avoids the uncertainty of good faith duties, the scope of which will depend on the particular commercial context and facts (and how these are applied by the court). 

If good faith obligations are included, think about good faith in the context of the specific agreement. Be prescriptive about what amounts to a duty of good faith, including express examples of what positive action might be required to satisfy it and in what circumstances.

“Good faith” can mean all of the following: acting with honesty and integrity, a duty to cooperate or disclose information, stopping a party from taking a particular action or requiring a party to give up its commercial interests in favour of the other party. If parties wish to introduce a requirement to deal “openly and fairly” with each other, it may be worth introducing an explicit requirement for one party to be consulted before certain decisions are taken. 

Good faith doesn’t have to be dealt with in a “good faith” section of the contract, it may be dealt with in the wording of other clauses in the contract. 

Bear in mind when negotiating a contract that, in certain circumstances, it will be advisable to expressly exclude the contractual duty of good faith. 

Winter 2022