Q&A on "In good faith" in contracts and letters

In our contracts and letters of intent should we oblige both parties to act “in good faith”?

It mainly depends on the type of contract, the relationship between the parties, and what exactly you want the good faith obligation to achieve. Often it may be better not to include a good faith obligation.

But doesn’t “in good faith” have an accepted legal meaning?

There are lots of cases about what acting in good faith means in the context of peculiar types of relationship – such as where two people are in partnership, one is providing insurance, or one is acting as an agent or fiduciary for the other. But in ‘ordinary’ commercial relationships - such as between parties to a shareholders’ or joint venture agreement, or a customer/supplier contract - it is uncertain whether, or how, a court will enforce an obligation to act in good faith.

Why is that?

Largely because “good faith” is a subjective matter, and because generally parties in an arm’s length relationship are entitled to act selfishly in their own interests. Also, unless the contract actually sets it out, it is difficult to decide exactly what such an obligation entails. As a result, it is often hard to assess the amount of damages that would flow from a breach. By contrast, courts are happy to enforce an agreement to act “reasonably”, as this imports an objective test of what the reasonable man in that situation could be expected to do.

So is a good faith obligation effectively unenforceable?

Not necessarily. In the recent Petromec case, the Court of Appeal was willing to enforce an obligation to negotiate in good faith over the extra costs of upgrading an oil platform according to an agreed specification. In this, the court was influenced by the facts that the obligation formed part of a wider, complex agreement that had been drafted by City solicitors, and that the matter left for negotiation was something that could if necessary be decided by the court, using evidence of what the upgrade would reasonably have cost.

What if the matter left for negotiation is less specific?

An obligation to negotiate in good faith over the terms of a proposed contract is much less likely to be enforceable, because it would involve the court deciding what terms the parties would have agreed. The more complex the contract, the more difficult this will be.

What about a clause obliging parties to deal with each other in good faith?

Although rejecting such a clause may prompt accusations of bad faith, for legal purposes it is usually better not to include one, because it’s meaning is uncertain. It could also colour a court’s interpretation of more specific clauses in the agreement, thus ‘muddying the waters’. If you are concerned about the other party acting in bad faith, it is better to include specific protection - such as a right to claim damages for breach of warranty or behaviour undertakings, or to rescind the agreement for misrepresentation.

Don’t some other countries take a different approach?

Yes. Under New York law, for example, and in some continental jurisdictions like France and Germany, courts are more willing to award damages for breach of a good faith obligation – reflecting either the costs incurred in reliance on the promise, or sometimes even loss of profits. In some jurisdictions, a good faith obligation may even be implied in some types of contracts. An overseas party may therefore have different expectations about what a contract will say, and what an express or implied good faith obligation actually entails. Equally, though, some parties may prefer their contracts to be governed by English law because the absence of any implied good faith obligation is perceived to offer greater certainty.

This article first appeared in our Directors' Digest: Small bites on the big issues April 2006. To view this publication, please click here to open it as a pdf in a new window