Court of Appeal clarifies the contractual duty of good faith

England and Wales

The Court of Appeal has unanimously overturned a High Court judgment, finding that minority shareholders were not unfairly prejudiced by actions of the majority shareholders and that the previous judgment had interpreted the duty of good faith too broadly. In Mark Faulkner & Ors v Vollin Holdings Limited & Ors [2022] EWCA Civ 1371, Snowden LJ clarified the English law principles surrounding contractual duties of good faith and cautioned against the practice of imposing a formulaic set of standards on contractual parties irrespective of the unique context in which a contract is formed and without due regard for the other clauses to the contract that assist in this contextual analysis. The court also explained the process that courts should adopt to decide whether an express duty has been breached, and identified where the previous judgment had been too broad in its application. As part of this exercise, the court considered the manner in which the judge at first instance had applied another recent decision to the present facts.

Background

The appellants were the majority shareholders and investors in an investment structure that was developed over some years and in which two individuals, Mr Faulkner and Mr Sachs, remained involved as minority shareholders and directors. In 2013, a shareholders’ agreement and company articles of association were agreed between the parties. Clause 4.2 of the agreement contained the following duty of good faith:

Each Shareholder undertakes to the other Shareholders and the Company that it will at all times act in good faith in all dealings with the other Shareholders and with the Company in relation to the matters contained in this Agreement”.

In pursuit of maintaining the “constitutional balance” of the company, the investors decided that Mr Sachs should no longer remain a director. Under pressure from the investors, Mr Sachs therefore resigned. After a series of antagonistic exchanges between Mr Faulkner and the board, Mr Faulkner was removed as a director of the company in 2016, via a resolution under section 168 of the Companies Act 2006 (with a 97.5% majority in favour). Mr Faulkner and Mr Sachs argued that their removal as directors breached the good faith clause contained in that agreement.

At first instance, the High Court found that both the articles and the agreement indicated that Mr Faulkner and Mr Sachs were “entrenched” as directors and that their removal from office was therefore a breach of contract.

The appeal

The Court of Appeal held that the shareholders’ agreement did not have this “entrenching” effect, and so the roles of Mr Faulkner and Mr Sachs were not a contractual right; consequently, their removal as directors was not a breach of any obligation of good faith.

The court emphasised the importance of context in interpreting an express term of good faith. An express term must take its meaning from the context in which it is used, and therefore the courts must be wary of automatically applying an interpretation developed in one case to another. The court discouraged the “formulaic” approach to interpretation by which the previous judgment had applied the minimum standards of good faith set out in the recent Unwin v. Bond [2020] EWHC 1768 (Comm). These minimum standards were summarised as:

  1. acting honestly;
  2. “fidelity to the bargain” between the parties, i.e. broadly, the original purpose for which the agreement was made;
  3. “fair and open dealing”; and
  4. “regard to the interests” of the party to whom the duty was owed – in this case, at least potentially, the minority shareholders.

Adding further emphasis to the need to avoid a formulaic approach, the court found that the judge at first instance should have considered other cases in analysing whether these standards had been breached, rather than adopting Unwin as a catch-all set of rules.

Dealing with the requirement to act honestly, the court considered multiple good faith cases that have come before the court and noted that honesty was the concept from which good faith is derived and that the other Unwin standards form part of this concept. However, Snowden LJ was careful not to describe them as “derivatives” of honesty as obiter comment in other cases had done. He also added his own obiter comment that a finding of dishonesty does not automatically mean that good faith has been breached, nor is it a pre-requisite to finding a breach.

The court referred to section 168(2) of the Companies Act 2006, whereby any resolution to remove a director under section 168 can be defended by the director in question by way of written and oral representations to the company. In applying only the standards set out in Unwin, the decision at first instance had not given due consideration to the interaction between the agreement and the statutory requirements. It had therefore imposed an undue onus on the investors.

Also, in applying the standard of having regard to other parties, the judge at first instance had been wrong to conclude that the good faith clause in the agreement amounted to a requirement to have regard to the minority shareholders.

Comment

The judgment is important for its lengthy analysis of the principles that apply when interpreting an express term of good faith. The court was careful not to provide an absolute definition of “good faith” in a contractual context to underline the lesson for future courts and parties alike that the interpretation of a good faith clause relies entirely on its context and therefore requires a bespoke approach each time.

Parties to a contract are therefore well advised to realise the degree of uncertainty that a contractual duty of good faith can present. In interpreting such clauses, the court will not simply decide based on what might be considered just or fair for the parties, nor enforce an absolute duty of honesty, but will take into account the original purpose of the contract to which the parties agreed, the surrounding context (including the legislative environment), and other relevant factors. Any contractual duty of good faith is not a standalone duty that will be analysed in a vacuum. Rather, the analysis is highly fact-sensitive.

For further information, please email the authors or your usual CMS contact.

The authors would like to acknowledge the assistance of Avita Rajoo, CMS trainee, in preparing this article.