Good Faith and "Relational Contracts"
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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 very 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 agreements as a matter of law.
This article considers both these recent cases and the ramifications for parties to this special category of commercial agreement (referred to as “relational contracts”), which includes joint venture agreements, distribution agreements and franchise agreements.
1. What were the cases about?
Sheikh Tahnoon Bin Saeed Bin Shakhboot Al Nehayan v Ioannis Kent (Aka John Kent) [2018] EWHC 333 (Comm), 2018 WL 01036160
Sheihk Tahnoon Bin Saeed Bin Shakhboot Al Nehayan (Sheihk Tahnoon) and Mr. Kent entered into a joint venture to develop a luxury hotel and online travel business. Mr. Kent managed the business and Sheihk Tahnoon provided funding. When the business started to fail, Sheihk Tahnoon sought to extricate himself from the relationship and, following negotiations, the parties entered into a framework agreement to demerge the business and a promissory note under which Mr, Kent agreed to repay some of Sheihk Tahnoon's losses. During the negotiations, and without Mr. Kent's knowledge, Sheihk Tahnoon’s representatives had conducted separate negotiations to sell Sheihk Tahnoon’s majority shareholding in one of the companies directly to a third party, instead of transferring it to Mr. Kent as stipulated in framework agreement.
When Mr. Kent failed to make the payments due under the framework agreement and promissory note, Sheihk Tahnoon sued for payment of the outstanding sums (approximately €15 million). In response, Mr. 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 Sheihk Tahnoon had breached his fiduciary duties and/or a contractual duty of good faith.
In determining whether a general duty of good faith could be implied in the joint venture between Sheikh Tahnoon and Mr. Kent, the court examined (amongst others) the judgment in Yam Seng Pte Ltd v International Trade Corp [2013] EWHC 111 (QB). The court in that case held that a duty of good faith could be implied into ordinary commercial contracts and, whilst it should not be implied by default, it was more likely to be implied into “relational contracts” which are long term commercial relationships which require a high degree of trust and cooperation, like franchise agreements, joint ventures and distribution agreements.
Having considered the nature of the joint venture between Sheikh Tahnoon and Mr. 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 did identify two forms of “furtive and opportunistic conduct” as incompatible with the implied duty of good faith (both of which Sheikh Tahnoon was guilty): an attempt by one party to sell part of his interest in a joint venture to a third party, without informing the other beneficial owner; and for either party to use his position as a shareholder of the companies to obtain a financial benefit for himself at the expense of the other”.
This judgment helps to further clarify the position in respect of relational contracts (particularly, joint ventures) and good faith. Whilst this ruling by no means provides that all joint ventures will contain an implied duty of good faith, parties to those 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 and Others v Post Office Limited [2019] EWHC 606 (QB), 2019 WL 01228001 ("Bates")
The Bates case involved a claim of damages brought by roughly 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. 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 characteristics that would be expected to be present for a contract to be considered to be a “relational contract” – these are:
(a) there must be no specific express terms in the contract that prevents a duty of good faith being implied into the contract;
(b) the contract will be a long-term one, with the mutual intention of the parties being that there will be a long-term relationship;
(c) the parties must intend that their respective roles be performed with integrity, and with fidelity to their bargain;
(d) the parties will be committed to collaborating with one another in the performance of the contract;
(e) the spirits and objectives of their venture may not be capable of being expressed exhaustively in a written contract;
(f) they will each repose trust and confidence in one another, but of a different kind to that involved in fiduciary relationships;
(g) the contract in question will involve a high degree of communication, co-operation and predictable performance based on mutual trust and confidence, and expectations of loyalty;
(h) there may be a significant investment by one party (or both) in the venture; and
(i) exclusivity of the relationship may also be present.
The court determined that only the first of these 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 to be 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, it will be necessary for contracting parties to consider the list of characteristics against the factual matrix of the relationship.
2. Commentary
It is clear that the majority of 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 still remains unclear exactly when this duty is owed and what it requires.
It is a now well-established principle in English law that the exercise of contractual discretion is subject to a good faith limitation not to act arbitrarily, capriciously, irrationality 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 (i.e. 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 (i.e. in the context of an employer's duty of care to ensure the well-being and safety of an employee).
To act in good faith means more than to act honestly, and 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.
We therefore recommend that these types of relational agreements should 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 but also in relation to other circumstances in which the parties deal with each other.
In the context of franchising in UK, franchisors, which are members of the British Franchise Association (BFA), are obliged under the BFA's Code of Ethics "to exercise fairness in all dealings" with franchisees. The same obligation applies to franchisees (although the franchisee is unlikely to be a member of the BFA). This concept of fair dealing is pervasive and applies to issues such as training, renewals, system updates, advertising, product ties, fees, performance targets, re-sales and termination. It is similar to the codified concept of good faith in civil jurisdictions and an increasing number of common law jurisdictions, but most franchise agreements that we see do not include an express good faith provision to mitigate the risk of interpretative ambiguity.
One such example in the context of franchising is the need for a franchisor to make a decision which may benefit the network as a whole, but will not necessarily benefit every individual franchisee equally (the decision may even have an adverse impact on a minority of franchisees). Nevertheless, it is important that the franchisor has this discretion and is not prevented from taking such a decision on the basis that is not dealing with the individual franchisee fairly, or in good faith.
A well drafted "reasonable business judgment" or "good faith" clause should deal with this precise issue, as well as including reasonable limits on a party's contractual power in specific circumstances.
Parties to relational contracts should also keep one eye on developments in other some jurisdictions to try and pre-empt where the next legal challenge on this issue lies. It is noteworthy that in jurisdictions, such as Canada, franchisees have successfully challenged franchisors on their failure to protect the brand in the face of local competition. It is therefore conceivable that statements regarding the value of goodwill and system or one-sided contractual powers could be used to create an argument for an implied ongoing obligation on a party to protect and enhance the system or proactively monitor and police the network and enforce terms against non-compliant members.
The issue of good faith is evolving in English law and parties to relational contracts therefore need to monitor these developments to ensure that foreseeable risks are mitigated effectively in their contracts and commercial practices.