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18 November 2019
In two recent cases, the English courts considered whether the duty of good faith should be implied into commercial contracts.
English law has traditionally resisted implying the obligation of good faith into commercial contracts, except in limited circumstances. However, in a growing line of authorities (of which the two recent cases are particularly significant), the English courts have confirmed that a duty of good faith will be implied into certain types of agreement as a matter of law.
This article considers both recent cases and the ramifications for parties to this special category of commercial agreement (so-called 'relational contracts'), which includes joint venture, distribution and franchise agreements.
Sheikh Tahnoon Bin Saeed Bin Shakhboot Al Nehayan v Ioannis Kent
Sheihk Tahnoon Bin Saeed Bin Shakhboot Al Nehayan (Tahnoon) and Ioannis Kent entered into a joint venture to develop a luxury hotel and online travel business.(1) Kent managed the business and Tahnoon provided funding. When the business started to fail, Tahnoon sought to extricate himself from the relationship and, following negotiations, the parties entered into:
During the negotiations – and without Kent's knowledge – Tahnoon's representatives conducted separate negotiations to sell his majority shareholding in one of the companies directly to a third party, instead of transferring it to Kent as stipulated in the framework agreement.
When Kent failed to make the payments due under the framework agreement and promissory note, Tahnoon sued for payment of the outstanding sums (approximately €15 million). In response, Kent claimed that his consent to the framework agreement and promissory note had been obtained by unfair means (including physical duress and other illegitimate pressures). He also counterclaimed that Tahnoon had breached his fiduciary duties and a contractual duty of good faith.
In determining whether a general duty of good faith could be implied into the joint venture between Tahnoon and Kent, the court examined (among other things) the judgment in Yam Seng Pte Ltd v International Trade Corp ( EWHC 111 (QB)). The court in that case had held that a duty of good faith can be implied into ordinary commercial contracts and, while it should not be implied by default, it is more likely to be implied into relational contracts that are long-term commercial relationships which require a high degree of trust and cooperation (eg, franchise, joint venture and distribution agreements).
Having considered the nature of the joint venture between Tahnoon and Kent, the court concluded that it was "a classic instance of a relational contract" and that "the implication of a duty of good faith in the contract" was "essential to give effect to the parties' reasonable expectations". The court also noted that the facts satisfied both the business necessity test for the implication of a contractual term and the test for the implication of a term in law, on the basis that the nature of the contract as a relational contract implicitly required (in the absence of a contrary indication) treating it as involving an obligation of good faith.
Although it asserted that an exhaustive list of what the obligation of good faith involved was "unnecessary and perhaps impossible" and accepted that "the parties to the joint venture were generally free to pursue their own interests and did not own an obligation of loyalty to the other", the court identified the following forms of "furtive and opportunistic conduct" as incompatible with the implied duty of good faith (both of which Tahnoon was guilty of):
This judgment helps to further clarify the position in respect of relational contracts (particularly joint ventures) and good faith. While this ruling by no means provides that all joint ventures will contain an implied duty of good faith, parties to joint ventures where there is a long-term relationship with a high degree of trust involved should be careful that their actions are not contrary to the principles of good faith. Such parties should be aware of, and if necessary seek to reduce, this risk through careful contractual drafting.
Alan Bates v Post Office Limited
Bates involved a claim of damages brought by approximately 500 sub-postmasters against the Post Office following alleged defects in the electronic accounting system, which had caused the Post Office to pursue the sub-postmasters for accounting shortfalls.(2) The case (a common issues trial) did not resolve the dispute but responded to a number of common contractual issues before breach, causation and loss were considered.
One key issue determined by the court was the meaning of a relational contract in which the duty of good faith would be implied. The court confirmed that the concept of a relational contract had been established in English law and provided guidance, by way of a non-exhaustive list, of the types of characteristic that would be expected to be present for a contract to be a relational contract, including as follows:
The court determined that only the first of the above characteristics would be determinative and that, in the absence of an express clause stating that there is no duty of good faith, whether the arrangement will be considered a relational contract will also depend on the facts and context of each arrangement. In the circumstances of the case, the contracts were deemed to be relational.
In light of these guidelines, contracting parties should consider the list of characteristics against the factual matrix of the relationship.
Most joint venture partners, franchisors, licensors and principals should err on the side of caution and assume that their English law contracts are relational in nature and therefore likely to carry the risk of being deemed to include an implied term of good faith.
However, it remains unclear exactly when this duty is owed and what it requires.
It is now a well-established principle in English law that the exercise of contractual discretion is subject to a good-faith limitation not to act arbitrarily, capriciously or irrationally or for an improper purpose.
The more general implied term to perform contractual duties in good faith (as proposed in Yam Seng and examined in both of these cases) operates to imply a term 'by fact' (ie, based on a finding as to the (objective) intention of the parties). This is unlike a term implied 'in law', which is based on broader grounds of social policy (ie, in the context of employers' duty of care to ensure the wellbeing and safety of employees).
To act in good faith means more than to act honestly; the judge in Bates stated that it requires the parties not to behave in a way that "would be regarded as commercially unacceptable by reasonable and honest people".
Clearly, there is a need to mitigate the risk of good faith through careful contractual drafting. One option is to exclude good faith. In the context of exercising contractual discretion, this would mean stating that a party has absolute discretion. However, this is not a satisfactory solution – and neither is remaining silent on this issue.
Thus, parties should ensure that these types of relational agreement contain a reasonable business judgment or good-faith clause which deals with the meaning of good faith head on, both in terms of exercising contractual discretion and in relation to other circumstances in which the parties deal with each other.
The issue of good faith is evolving in English law and parties to relational contracts therefore need to monitor developments to ensure that foreseeable risks are mitigated effectively in their contracts and commercial practices.
For further information on this topic please contact Gordon Drakes at Fieldfisher LLP by telephone (+44 20 7861 4000) or email (firstname.lastname@example.org). The Fieldfisher LLP website can be accessed at www.fieldfisher.com.
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