Good faith and rationality – becoming a trend?

Introduction

As we look to emerge from the Covid-19 pandemic and deal with the resultant economic environment, parties’ behaviour vis-à-vis their counterparties is going to come under sharper focus. This will particularly be the case where there are provisions which give parties contractual discretion.In addition, an issue that is likely to gain traction is whether a party is required to act in good faith and if so, the scope of that obligation.

In this article we look at the recent decisions and growing judicial views on:

1. The obligation of good faith
2. The duty of rationality when exercising contractual discretion

Is there a general obligation of good faith?

Express provision

A contract governing the relationship between the parties can include an express provision of good faith. In those situations what the obligation means will depend on the circumstances and wording of that contract.For example, the good faith obligation may be limited to price negotiations or extend to the overall relationship between the parties. As such reviewing the wording and context of the provision will be important.In particular, where a contract includes an express obligation of good faith this is likely to be given some weight and meaning by the English court.It can no longer be ignored as a meaningless provision.

The test of good faith is, however, likely to be objective.It is not a question of whether one party perceives the others conduct to be improper but whether honest and reasonable people consider it to be so.

Implied provision

Under English law a duty of good faith can be implied by law into contracts of employment and contracts between partners or others whose relationship is characterised as a fiduciary one.However, there is no legal principle of good faith in English contract law that has general application. Arguments are often raised as to whether a duty of good faith can be implied into commercial contracts.

English courts do not easily imply terms into a contract.In a Supreme Court decision, Lord Neuberger provided the following guidance for implying terms:

1. The implication of a term was “not critically dependent on proof of an actual intention of the parties” - the court is concerned with what notional reasonable people in the position of the parties at the time of contracting would have agreed.
2. Care must be taken when using the ‘officious bystander’ test. It is vital to formulate the question posed by the bystander with the “utmost care”.
3. Business necessity and obviousness are alternative requirements rather than cumulative. Only one of them needs to be satisfied, but it is likely that if one were satisfied the other would be too.
4. Necessity for business efficacy involves a value judgment; it is not ‘absolute necessity’. Rather, “a term can only be implied if, without the term, the contract would lack commercial or practical coherence”.
5. A term should not be implied into a detailed commercial contract merely because it appears fair or is what the court considers the parties would have agreed if it had been suggested to them. (Lord Neuberger noted that the parties may have deliberately chosen not to make provision for a particular eventuality for any number of reasons; they may not have been able to agree on what should happen and so chose to leave the matter undealt with in the hope that it did not occur.)
6. The ‘reasonable and equitable’ requirement will not usually, if ever, add anything to the analysis. If a term satisfies the other implied term requirements, it will almost inevitably be reasonable and equitable.

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Relational contracts

There has been growing judicial consideration as to whether an exception to the above is the implication of good faith in ‘relational’ contracts, i.e. a long-term relationship between the parties to which they make a substantial commitment.In Yam Seng Pte Ltd v International Trade Corp Ltd [2013] 1 All ER (Comm) 1321 it was noted that such ‘relational’ contracts:

“may require a high degree of communication, co-operation and predictable performance based on mutual trust and confidence and involve expectations of loyalty which are not legislated for in the express terms of the contract but are implicit in the parties’ understanding”.

Examples of ‘relational’ contracts cited in Yam Seng were joint venture agreements, franchise agreements and long-term distributorship agreements.

In Yam Seng the English court recognised that there can be an implied duty of good faith in the performance of ‘relational’ contracts.

Yam Seng has received mixed views from commentators and judges:

1. In Globe Motors Inc v TRW Lucas Variety Electric Steering Ltd [2016] EWCA Civ 396 the English Court of Appeal was of the opinion that an implication of a duty of good faith will only be possible where the language of the contract, viewed against its context, permits it. Therefore, suggesting there was no special status for ‘relational’ contracts.
2. However, in Amey Birmingham Highways Limited v Birmingham City Council [2018] EWCA Civ 264 the English Court of Appeal recognised that a PFI contract intended to run for 25 years was a ‘relational’ contract.

More recently in Bates & Ors v Post Office [2019] EWHC 606 (QB) it was said that the following characteristics are to be considered when determining whether a contract is ‘relational’ but even that does not mean there will be an automatic implication of a duty of good faith:

1. No specific express terms that prevent a duty of good faith being implied.
2. A long-term relationship.
3. Performance with integrity and fidelity to the bargain.
4. Collaboration in performance.
5. Spirit and objective of venture not capable of being expressed exhaustively in a written contract.
6. Trust and confidence between parties but of a different kind to that involved in fiduciary relationships.
7. 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.
8. There may be a degree of significant investment by one party (or both) in the venture, e.g. a substantial financial commitment.
9. Exclusivity of the relationship.

The fact that this remains a hotly contested area is demonstrated by the decisions that have come after Bates. In one decision the court held that a loan agreement with a term of three years was not a ‘relational’ contract and in UTB LLC v Sheffield United Limited [2019] EWHC 2322 (Ch) it was held that implying a general duty of good faith just because the contract is ‘relational’ would fail to take account of the express provisions of the contract.As such the preferred approach should be whether to imply a duty of good faith in accordance with the principles of implied terms set out above without having special rules for ‘relational’ contracts.

Duty of rationality when exercising contractual discretion

Another aspect of the good faith debate is whether a party that has a contractual discretion is required to exercise that discretion in a rational way.

It is now well established that a duty of rationality can exist as an implied obligation to ensure a contractual discretion is not exercised irrationally, arbitrarily or capriciously.However, this will depend on the terms and context of the contract in question. For example, it has been held that a party is not prevented from exercising its discretion in the pursuit of its legitimate commercial aims as long as it does not do so to vex the other party maliciously.

A distinction that is often drawn is between a discretion and a decision whether to exercise an absolute contractual right.It is the discretion that is subject to the duty of rationality (e.g. a discretion to change interest rates) and not the exercise of contractual rights (e.g. termination or right to call in a loan).

Even where the contract gives a party a “sole” or “absolute” discretion it will be important for the party exercising the discretion to ensure it can demonstrate that it has exercised its discretion by, for example, having documents that demonstrate the decision making process and the calculations undertaken.

In relation to exercise of absolute contractual rights one must be careful to ensure that the principles set out about in relation to ‘relational’ contracts are considered.However, it is becoming clear that not all long-term contracts will involve an implied duty of good faith.

Conclusion

Although the debate continues as to when a duty of good faith can be implied into a contract and whether or not a party needs to behave rationally when exercising its contractual discretion, what is becoming clear is that the English courts will give careful consideration to these points.These arguments can become substantive issues in a dispute and parties should consider factoring them in as part of their risk mitigation strategy.