Grounding the flight of good faith in commercial contracts?

United KingdomScotland

Introduction

On 10 July 2020, the High Court delivered its judgment in the case of Cathay Pacific Airways Limited v Lufthansa Technik AG [2020] EWHC 1789 (Ch), which concerned a dispute between two commercial entities as to the operation of certain provisions in a contract for aircraft engine maintenance, repair and overhaul (“MRO”) services (the “Agreement”). In giving judgment in favour of the claimant, the Court tackled the usual principles as to contractual interpretation, and held that the disputed provision in the contract between the parties was not qualified by way of implication, whether by way of additional wording which had not been expressly included in the clause or an implied term refraining one party from acting in an arbitrary and/or unreasonable manner and/or requiring it to act in good faith.

Background

The claimant, Cathay Pacific Airways Limited, had entered into the Agreement with the defendant, Lufthansa Technik AG, under which the defendant was obliged to provide MRO services to the claimant in relation to certain aircraft engines. Following the end of the Agreement, the defendant sought payment of around USD 36m from the claimant as ‘end of term’ charges. The claimant agreed that the defendant was entitled to this sum, but argued that the sum was not only “set-off” as a result of two sums due to be paid by the defendant to the claimant in accordance with the terms of the Agreement, but that a net balance had arisen requiring payment by the defendant to the claimant.

In relation to the first of the two sums which the claimant argued it was due, the Agreement provided that the claimant may “at its option” remove aircraft engines from the scope of a specific service provided by the defendant under the Agreement (the “Servicing Provision”) prior to the end of the Agreement, which would allow a financial reconciliation to be made regarding the fees payable under the Agreement by the claimant to the defendant (the “Option”).

The issues

The defendant argued that the first sum was not payable as:

  1. the Option, when construed properly, or otherwise by way of implication, could only be exercised if the claimant removed the aircraft engines from the scope of the Servicing Provision for operational reasons. The defendant submitted that it was common ground that the engines were not removed for such reasons, as they continued to be operated;
  1. there was an implied “rationality” term in the Option which prevented the same from being exercised in an arbitrary and/or unreasonable manner (based on the principles established in Braganza v BP Shipping [2015] UKSC 17 and Socimer International Bank v Standard Bank London [2008] 1 Lloyd’s Rep 558), which the claimant had acted contrary to; and
  1. the Option was subject to a “good faith” obligation as the Agreement was a “relational contract”, so the Option could only be exercised in a way that would be objectively regarded by reasonable and honest people as commercially acceptable.

The claimant countered that the Option was a unilateral provision which was not restricted to being exercised only for operational purposes. The claimant also denied that there was an implied good faith obligation contained in the Option, but in any event the Option had in fact been exercised for reasonable commercial reasons.

The High Court’s decision

The Court noted that when interpreting a written contract:

  1. it had to identify the intention of the parties by reference to “what a reasonable person having all the background knowledge which would have been available to the parties would have understood them to be using the language in the contract to mean”;
  1. it should focus on the meaning of the relevant words in their documentary, factual and commercial context;
  1. commercial common sense was not to be invoked retrospectively;
  1. the purpose of interpretation is to identify what the parties have agreed, not what the court thinks that they should have agreed (and the court should be slow in considering that the natural meaning of a provision was incorrect simply because it appeared to be an imprudent term for one of the parties to have agreed); and
  1. it had to undertake an iterative approach, which involved checking each of the alternative suggested interpretations against other provisions of the relevant document and investigating the commercial consequences.

The Court considered the above principles in formulating its decision, which is summarised as follows:

  1. Interpretation of the Option
  • Based on a “textual analysis” of the Option, it was clear that the parties had chosen for the Option to be exercised in the context of removing aircraft engines from the scope of the Servicing Provision.
  • The Court noted that there was no mutual understanding between the parties that the Option would only be used for operational reasons or when an aircraft engine was to be removed from the fleet. The fact that the Option had led to the “highly uncommercial result” of the defendant owing the claimant money was an “unimpressive” argument as “the process of contractual interpretation cannot be used to rectify a failure to think through the financial consequences of the operation of a clause”.
  1. Implied terms as to the Option
  • The argument propagated by the defendant that there was an implied term in the Option that it could only be exercised for operational purposes was “opaque” and the Agreement worked well without such an implied term. The Court noted that for this argument to succeed, the proposed implied qualification must be something which a reasonable reader of the Agreement would consider to be so obvious as to go without saying or necessary to give business efficacy to the Agreement. That test was not satisfied.
  • The defendant’s argument that there was an implied “rationality” term to the effect that the Option could not be exercised in an arbitrary and/or unreasonable manner was rejected by the Court, as the Option was closer in nature and type to clauses which had previously been held not to be subject to such an implied term. In this case, the parties were commercial entities aided by lawyers who had agreed that one of them should have the benefit of the Option and had agreed the financial consequences of the exercise of the same. The Court noted that even if such a term was implied, the claimant was not in breach.
  1. Whether the Agreement was a “relational contract” resulting in an implication of good faith
  • The Court considered all of the principal case law in relation to the implication of good faith obligations in commercial contracts, including Bates v Post Office (No. 3) [2019] EWHC 606 (QB), Yam Seng Pte v International Trade Corp [2013] EWHC 111 (QB), Sheikh Tahnoon Bin Saeed Bin Shakhboot Al Nehayan v Ioannis Kent [2018] EWHC 333 (Comm) and UTB LLC v Sheffield United [2019] EWHC 2322 (Ch). (See our previous Law-Now regarding good faith obligations).
  • Having done so, the judge acknowledged that the law on relational contracts “had not yet reached a stage of settled clarity”, and summarised his understanding of theposition as follows:
    • A term of good faith may be implied in a relational contract as a matter of law where the nature of the contract implicitly requires treating it as involving an obligation of good faith, subject to any contrary express term.
    • The test for whether such a good faith obligation is implied as a matter of law is whether the contract is a long-term contract which requires the parties to collaborate in future ways that respects the spirit and the objectives of their relationship, but which have not been specified in detail. To be a relational contract, the contract will also involve trust and confidence that each party will act with integrity and cooperatively.
    • A good faith term may be implied in a relational contract as a matter of fact but there is no special rule for incorporation. Each term must be considered against the usual test – whether a reasonable reader would consider the term to be so obvious as to go without saying or the term is necessary for business efficacy.
    • The overall character of the contract is an important consideration. The following considerations from Bates may be helpful:
      • there must be no express terms that prevent a duty of good faith being implied;
      • the contract will be long-term, with the mutual intention there would be a long-term relationship;
      • the parties must intend their roles to be performed with integrity, and with fidelity to meet their bargain;
      • the parties will be committed to collaborating with one another;
      • the spirits and objectives of the parties may not be capable of being expressed exhaustively in a written contract;
      • the parties will have trust and confidence in each other, but of a different kind to that of a fiduciary relationship;
      • the contract will involve a high degree of communication, cooperation and predictable performance based on mutual trust and confidence and expectations of loyalty; and
      • there may be a degree of significant investment by one or both parties, which in some cases may be a substantial financial commitment.
    • The implication of a good faith term as a matter of fact is possible even in the case of long, complex and sophisticated contracts expressed in writing.
  • Turning to the specific facts of this case:
    • As to whether such an obligation was implied as a matter of law (emphasis added), the test involved considering whether “the [Agreement was] a long-term contract which require[d] the parties to collaborate in future in ways that respect[ed] the spirit and the objectives of their joint venture but which the parties [had] not specified or [had] been unable to specify in detail”. In addition, it had to be considered whether the Agreement involved the trust and confidence that each party would act cooperatively and with integrity. The Court held that the test was not met, as the only criteria which had been satisfied in this case was that the Agreement had been a long-term contract.
    • As regards whether “good faith” had been implied as a matter of fact (emphasis added), the key question was whether a reasonable reader would consider such a term to be so obvious as to go without saying or that the term was necessary for “business efficacy”. In this case, there was very little in the Agreement that pointed towards a good faith obligation on the claimant’s part – its main obligation was simply to pay the sums due. The Agreement was not dependent on good faith, the parties had expressly provided for an obligation of good faith in other provisions in the Agreement, but had not provided for the same in the Option. The parties had given careful consideration to all the terms of the Agreement as they were commercial parties assisted by law firms, and a reasonable reader would therefore not conclude that an obligation of good faith in respect of the Option was “so obvious as to go without saying”.
    • In any event, the Court found that even if a good faith obligation had been implied, the claimant would not have been in breach.

Comment

As expressly acknowledged by the Court in this case, the law on good faith terms in relational contracts has not yet reached a state of settled clarity. Judges are currently faced with the unenviable task of seeking to reconcile previous judgments, attempting to identify clear threads to apply to the facts before them.

This decision appears to be a step towards orthodoxy, applying the core “business necessity” test for the implication of a term of good faith, notwithstanding the potential existence of a long-term relational contract. However, the position is far from settled.

Faced with the challenge of formulating a claim (or defence) outside of the strict parameters of the text of any contract, parties are likely to run more creative arguments around implied terms, duties of rationality and a general obligation of good faith, given the developing status of the law in this area. Whilst this decision confirms that the relevant tests are not easily met and the Court, at least at the first instance level, may be taking a more cautious approach of late, with the right facts these arguments may well succeed.

When drafting long-term relational contracts, commercial parties should give careful consideration to whether good faith obligations should be expressly imposed generally or in respect of particular contractual provisions, or expressly excluded, to give clarity for all parties and to limit the risk of a general obligation of good faith being implied.

At the time of writing it is not known if the decision will be appealed, but it is clear that we have some way to go before the courts have their final say on good faith obligations in commercial contracts.

The assistance of Imtiyaz Chowdhury, trainee solicitor at CMS, in preparing this article is acknowledged.