Law and faith

November 2022

Rating system:
Reading time (1-10 minutes): could be less than 5
Sophistication level (1 (idiot) – 10 (expert)): 7
Entertainment value (1 (turgid) – 10 (side-splitting)): hard to give it more than about 4

What does the expression ‘good faith’ mean when you put it in a shareholders agreement?

As most of you know, my main areas of focus as a lawyer are 1/ company sales; and 2/ shareholder investments, arrangements and ‘issues’. I am gradually converting all my vast knowledge and experience of these areas into short and pithy ‘top ten things to worry about’-type articles. I have done some on company sales, such as my recent 8 common pitfalls for business sellers. I plan shortly to publish some relating to shareholder arrangements (although this slightly non-pithy one I published some time ago is quite useful).

But for the benefit of my discerning readers I will also continue to release from time to time some more in-depth articles, usually triggered by recent Supreme Court or Court of Appeal judgments. So this latest article has been triggered by a recent Court of Appeal case, and deals with a specific issue namely the concept of ‘good faith’. It could be of interest to anyone involved in negotiating share sales or shareholder arrangements.

Background

It’s foreign

The concept of ‘good faith’ seems to be creeping more and more into UK business law. But it’s not a UK law concept. It has come from continental Europe (although Americans and others like it as well), where the exact scope of the duty of good faith varies from country to country but broadly creates obligations on people negotiating with each other:

• To inform each other, where reasonable, of all important points that the other party could not discover on its own.
• To apply reasonable diligence in the performance of pre-contractual and contractual obligations.
• To observe moral and ethical standards of behaviour where they are not already implied by local law.
• Not to break off negotiations without reasonable cause in circumstances where the other party reasonably anticipates that an agreement will be signed.

These are not concepts that naturally apply in UK law, which until relatively recently had no concept of parties to business negotiations owing each other an implied duty of good faith. The UK has not historically committed itself to any general doctrine of good faith and has instead developed over considerable time piecemeal solutions (for example, involving the imposition of implied terms, or developments in the law of equity) in response to demonstrated problems of unfairness. UK law has spent many centuries ploughing its own furrow and generally prefers contractual clarity and certainty over woolly obligations that are potentially vague and subjective. It has an ethos of individualism, so that parties are free to pursue their own self-interests.
Just by way of one example, the UK courts are likely to treat an obligation to negotiate in good faith as an unenforceable “agreement to agree”. The House of Lords came to this conclusion on the basis that good faith is ‘inherently repugnant to the adversarial position of parties in negotiations’.

A new implied duty for ‘relational’ contracts

However, in the 2013 ‘Yam Seng’ case (a High Court case which was about a long-term agreement for the distribution of Manchester United branded aftershave) a thread of law started to emerge, which has been developed in subsequent cases, which says that in the case of ‘relational’ contracts (those such as joint ventures, franchise agreements or long-term distributorships where the parties were expected to have a good collaborative relationship) an implied duty of good faith might apply in certain circumstances. Note that this doesn’t apply to non-‘relational’ contracts, such as share sales, where the good old principles of dog eat dog (or buyer beware) remain supreme. This developing law remains very unclear, both as to when a ‘relational’ contract might arise and as to what ‘good faith’ might mean in any particular case.

Express duties in contracts

On top of this, more and more UK contracts nowadays have specific clauses in them saying that one or other party needs to act ‘in good faith’ in relation to various obligations it may have. I have, for example, just been asked by the sellers to add wording to a non-circumvention clause in a share purchase agreement I have drafted saying that my client (the buyer) will act ‘in good faith’ as to how it and the target company carry on business in future so that the various earn-out targets in the purchase agreement might be met. My clients and I have agreed to this wording, even though we are not too sure what it might mean. This isn’t because we (I) don’t know the law. It’s because the law has no clear rules as to what ‘good faith’ might mean in any given context. It would probably help the sellers more if they could set out a raft of specific actions which the buyer and target company should be required to do or prevented from doing. Obvious examples for profit-related earn-out would include clear restrictions on management charges which the buyer might charge the target company.

So what does ‘good faith’ mean?

That’s the problem. No one really knows. Where parties put express duties of good faith into contracts the courts have to try to work out what the parties meant (that’s their job) but they struggle to do so, as there is no clear UK law around it. In every case the court has to try to decide what was intended based on the context and facts of that particular case. The answer could involve a combination of various different possible rules or standards. But it’s next to impossible to say in advance what might apply to a particular situation. You can look for guidance at any number of court judgments about other contracts or from other areas of law, but these will have turned on their own particular facts and so can only be of limited value. You don’t end up taking away a list of clear principles and when they might apply.

In a 2020 case (Unwin v Bond) the Court of Appeal did mention five ‘minimum’ standards. These five standards are that a party should:

• act honestly
• be faithful to the parties’ agreed common purpose
• deal fairly and openly
• consider its own interests while having regard for the other party’s interests and
• not use powers for an ulterior purpose.

There are also many possible others, such as a duty to disclose relevant information. However, even in this 2020 case the Court of Appeal then said that these five ‘minimum standards’ should not be applied to the shareholders agreement at issue. Instead, it concluded that an express duty of good faith consists of 1/ a core duty to act honestly and 2/depending on the contractual context, a duty not to engage in conduct that could be characterised as bad faith. It said that any further obligation must be capable of being derived by interpretation or implication from the contract.

So, not a lot of help really!

This all means that there is a lot of uncertainty around what generally worded ‘good faith’ obligations in contracts might mean, which is not what business people generally want (although sometimes this uncertainty can be an objective for one party or the other). So if you really want to impose any such obligations in any contract, you would be far better off breaking things down into more detailed obligations which are as clear and specific as possible.

Recent Court of Appeal case

What was it about?

This case involved a Dr Sachs and some colleagues who founded a company in 2004 to develop a compact projector that could be attached to a mobile phone. In 2005 they raised funds through a seed investor called Mr Faulkner who also brought in other seed investors. Eventually they needed more serious funding and in 2010 found a serious investor, Vollin Holdings Ltd. In 2013 Vollin increased its investment further, and in 2014 another investor came in. By this stage the investors held 80% of the shares and the founders and seed investors held 20%. New Articles of association and a shareholders agreement (‘SHA’) between all shareholders were put in place. These had all sorts of specific provisions, including some designed to give Dr Sachs and Mr Faulkner some protections, including veto rights on board decisions and rights not to be removed by the board as directors. The SHA also included an obligation on all shareholders to ‘act in good faith in all dealings with the other shareholders and with the Company’ in relation to the matters contained in the agreement.

Over time the business failed to develop as hoped. The investors lost faith in Dr Sachs and Mr Faulkner. They refused to invest any more money unless Dr Sachs resigned as a director, which he eventually felt compelled to do. They also started excluding Mr Faulkner from various discussions about the company’s future, and restricted the flow of information to him. Mr Faulkner tried to remain involved, by communicating directly with shareholders, and the investors eventually used their powers as controlling shareholders to call a general meeting at which they voted (as entitled under s168 Companies Act 2006) to remove Mr Faulkner as a director.

Dr Sachs and Mr Faulkner brought an unfair prejudice petition under s994 Companies Act 2006. An unfair prejudice petition is basically a claim that the majority shareholders have been unfair, and asking the court to do something about it, the most common order being for the majority to buy the minority out (see this recent article about some valuation issues to watch out for in this kind of situation).

Part of their claim revolved around the ‘good faith’ obligations in the SHA.

What did the High Court say?

The judge said he thought that the investors had acted in a way which they genuinely believed would promote the business, and that on the whole Mr Faulkner’s behaviour would normally have justified his exclusion. He also acknowledged that Dr Sachs had not been removed but had resigned under pressure.

However, he still upheld the petition, because of the good faith provision. He said he thought that when combined with the other provisions, such as about how the board should operate, the investors had effectively meant that the investors had agreed to forego any right to play a role in the company’s management and had instead decided to cede control to Dr Sachs and Mr Faulkner. He referred to the 2020 Unwin v Bond case and various other previous court decisions relating to what ‘good faith’ meant, and concluded that ‘good faith’ meant that the investors had to deal ‘fairly and openly’ with the other shareholders, had to remain faithful to the ‘bargain’ with them, and had to keep the interests of the minority in mind. He ruled that by ‘forcing’ Dr Sachs to resign and by removing Mr Faulkner and by excluding them from the business the investors had not done any of these. The judge said that as a result they had suffered unfair prejudice, so they won their case.

He also said that the SHA effectively formed part of the company’s constitution, like its Articles, and that the board of the company was constitutionally bound by what it said.

The investors appealed, saying the judge had interpreted the duty of good faith far too widely.

What did the Court of Appeal say?

The Court of Appeal agreed with the investors. It said that although decisions in other cases could be ‘useful analytical tools’ you couldn’t just take a formulaic approach and each decision needed to reflect the specific circumstances of the case.

Here, the investors might have made their investment in the hope that everything would go well under the founders’ management, but circumstances can change and it would not be fair to rule that a ‘good faith’ obligation should impose restrictions on how they should be allowed to behave in the future (to protect the company’s interests let alone their own interests) if circumstances did change. They had after all invested an awful lot of money – over $135m with the likelihood of further investment rounds still being needed!

If Dr Sachs and Mr Faulkner had wanted provisions preventing the investors from removing them by using their rights as shareholders under company law they should have insisted on having specific provisions (such as weighted voting rights) to that effect in the Articles. (or the SHA). Although I doubt any sensible investor would have agreed to this.

The Court of Appeal concluded that in this particular case the express duty of good faith in the SHA only required the parties to act honestly towards each other and the company and not to act in a ‘commercially unacceptable way’.

Case: Re Compound Photonics Group Ltd [2022] EWCA Civ 1371

Takeways

• Simply inserting very general ‘good faith’ obligations into a contract may all seem lovey dovey and nice, but in practical terms it leaves the legal effect of the contract much less clear. As well as having to interpret what the contract would have already meant without this wording, a court now has to work out what this additional ‘good faith’ obligation might mean (which involved a 79 page Court of Appeal judgment in this case). To do so it will have to look at how the obligation is actually worded, and then analyse all the rest of the wording of the contract as well as the context in which the parties entered into the contract.
• So if you’re thinking of having such an obligation, it’s worth thinking about and discussing with the other party what you might be trying to cover. And then you may as well set out a bit more clearly and specifically what you decide you are trying to cover. In particular, if you want any party to agree to take particular interests of any party into account when making any decisions, or to forego particular legal rights they might otherwise have (such as voting rights) or to follow particular procedures, then you should try to set this all out clearly.
• This particular case revolved around the express duty of good faith in the SHA. I don’t know whether without this express duty someone could have argued that there might have been an implied duty. I expect not, as the trend of recent court decisions has been to set a very high threshold before a contract can be said to be ‘relational’ such that it might contain any implied duty of good faith. Although this case involved an arrangement between shareholders, and was therefore more of a ‘relational’ agreement than many commercial contracts, it was less ‘relational’ than one between, say, original founders of a company. Investors have very different interests and are in it for the long-term return on their investment, not for the long-term relationship. For a very good article about relational contracts and implied duties of good faith I recommend you read this by Sanjay Patel of 4 Pump Court Chambers.
• NB don’t confuse a duty of ‘good faith’ with the concept of ‘fiduciary duties’. Various types of contract or relationship (eg employment contracts, agency contracts, and company directorships) can impose fiduciary duties, but this has more the meaning of trustee-like duties, such as of loyalty and of avoiding conflict and unfair profit (as well as some ‘good faith’ duties such as to act openly and honestly).

 

 

If you are thinking of entering into any shareholder arrangements with business partners or investors or are having any issues or difficulties with existing arrangements please feel free to email me at andrew.james@onhandcounsel.co.uk to arrange a complimentary ‘Shareholder arrangements’ consultation where I can help you to identify what might be involved and how I can help. This will help you to avoid some of the pitfalls you might otherwise be exposed to, and give you the peace of mind of knowing that you have an approachable competent corporate lawyer ONHAND who can provide you with experienced, effective and cost-effective advice and assistance.