Legal Briefing

Keep the faith

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Corporate and commercial | 01 July 2012

Contractual parties are increasingly agreeing to commit themselves to a mutual duty of ‘good faith’, despite the apparent lack of certainty as to the meaning of such a duty. The High Court recently demonstrated the significance of such clauses and showed that a duty of good faith is a meaningful obligation with the potential for a considerably wider application than either party might have envisaged. In Compass Group and Ireland Ltd (t/a Medirest) v Mid Essex Hospital Services NHS Trust [2012], Mr Justice Cranford indicated that a duty of good faith was a material obligation, and breaching that obligation could give rise to a repudiatory breach of the contract. The effect of this decision may be to make parties think more carefully about whether they intend to owe one another a duty of good faith for the contractual term.

CONTRACTUAL DUTY OF GOOD FAITH

The law does not recognise any general implied duty on contracting parties to act in good faith. While the courts will recognise the validity of an express contractual duty of good faith, case law has previously failed to provide any significant degree of certainty as to the extent of the obligation imposed on the parties by such a clause.

In Manifest Shipping Co v Uni-Polaris Shipping Co [2001] it was held that a duty of good faith could only be breached where a party had acted in bad faith, which necessarily required a degree of dishonesty. More recently, it was held in CPC Group Ltd v Qatari Diar Real Estate Investment Co [2010] that behaviour conducted in bad faith would amount to a breach, but it was also suggested that conduct that did not specifically entail bad faith could also amount to a breach, dependant on the relevant commercial circumstances.

In Berkeley Community Villages Ltd v F Pullen [2007], it was held that a duty of good faith required a party:
‘… to observe reasonable commercial standards of fair dealing in accordance with their actions which related to the agreement and also requiring faithfulness to the agreed common purpose and consistency with the justified expectations of [the other party].’

The extent of the duty set out in Berkeley was qualified by Gold Group Properties Ltd v BDW Trading Ltd [2010], in which it was held that the duty did not require a party to give up contractual rights that were freely negotiated between commercial parties. High Court Judge Mr Stephen Furst QC stated that:
‘… good faith, whilst requiring the parties to act in a way that will allow both parties to enjoy the anticipated benefits of the contract, does not require either party to give up a freely negotiated financial advantage clearly embedded in the contract’.

COMPASS GROUP AND IRELAND LTD (T/A MEDIREST) V MID ESSEX HOSPITAL SERVICES NHS TRUST

The facts

Mid Essex Hospital Services NHS trust (the trust) and Medirest entered into a contract on 1 April 2008 for the provision by Medirest of hospital catering services to the trust.The contract was to last for seven years, with the trust having an exclusive option to extend the term by an additional three years.

Clause 3.5 of the contract required both parties to:
‘… co-operate with each other in good faith and to take all reasonable action as is necessary for the efficient transmission of information and instructions and to enable the trust or… any beneficiary to derive the full benefit of the contract’.

Under clause 5.8 of the contract, the trust was entitled to apply ‘service failure points’ in the event that the services provided by Medirest were not to the standard required under the contract. Where the trust applied ‘service failure points’, it was entitled to deduct corresponding amounts from the fee payable to Medirest under the contract. In the event that a certain number of service failure points were generated, it would trigger mechanisms in the contract that provided the trust with additional rights: to issue a warning notice; to require remedial steps to be taken; and where 1,400 points are accrued, to terminate the contract.

During 2008, the trust identified a number of service failures and accordingly applied a number of service failure points. Subsequently, in January 2009, the trust made deductions of over 50% of the amount it owed to Medirest for the services it had provided in the previous six month period. Medirest disputed the trust’s calculations and deductions on the basis that multiple service failure points had been applied to each performance failure. Medirest calculated that 18,822 service failure points were due, amounting to deductions of £37,000, which contrasted with the 52,908 service failure points applied by the trust, amounting to deductions of £587,000.

Both parties sought to terminate the contract. The trust claimed it was entitled to terminate under clause 5.8 on the basis of Medirest accruing over 1,400 service failure points. While Medirest did not dispute that at least 1,400 service failure points had been correctly applied, and had thus triggered termination rights to arise, it argued that the trust’s excessive deductions amounted to a material breach of the contractual duty of good faith. The trust contended that the calculations and deductions had not been made in bad faith and that Medirest was therefore not entitled to terminate on these grounds.

Medirest contended that the trust’s breach of its duty of good faith amounted to a repudiatory breach of contract, which, if established, would mean that the trust was only entitled to nominal damages for post-termination losses.

The arguments

The issue in dispute between the parties was the extent of the mutual duty of good faith that arose by virtue of clause 3.5.

The trust argued that both the duty of good faith, and the obligation to take all reasonable action contained in clause 3.5, were restricted in their application to that which was necessary to achieve the two purposes set out in the clause: the effective transmission of information and instructions, and to enable the trust and any beneficiary to derive the full benefit of the contract.

Medirest asserted that only the obligation to take all reasonable action was qualified by the two purposes. Medirest contended that clause 3.5 imposed a general obligation to co-operate in good faith in the parties’ dealings under the remit of the contract.

The decision

Cranston J favoured the argument advanced by Medirest. He referred to the finding in Rainy Sky v Kookmin Bank [2011] that, where the interpretation of a contractual clause is in dispute, the court should give the clause the meaning that it would be understood to have by a reasonable person with all the background knowledge reasonably available to the parties.

Cranston J stated that the starting point for interpretation of clause 3.5 was the duty to co-operate, there being a well-established concept requiring the parties ‘to work together, or to act in conjunction with [one another].’ The precise scope of this duty should be determined by the nature and circumstances of the specific contract. He held that, in a long-term contract, the duty to co-operate necessarily requires that the parties:

  • work together constantly, at all levels of the relationship;
  • work together to resolve problems that arise (following the judgment in Anglo Group plc v Winther Brown & Co Ltd [1997]); and
  • do not take unreasonable action that might damage their working relationship.

Cranston J then went on to consider what was added to this duty by the words ‘in good faith’. He stated that the provision would clearly be breached by conduct committed in bad faith. However, he held that clause 3.5 went further than that and applied the principle stated by Mr Justice Vos in CPC Group that the exact meaning of a duty of good faith must ‘take its colour from the commercial nature of the contract’. As the purpose of the contract was the provision of services to members of the public, the Court found that there was a clear common purpose to the contract. Cranston J appeared to follow Berkeley Community Villages in finding that ‘the objective standard of conduct’ demanded by the duty of good faith encompassed:

  • faithfulness to the common purpose;
  • fair dealing; and
  • acting consistently with justified expectations.

The Court held that the additional obligation to ‘take all reasonable action necessary’ to ensure efficient transmission of information and enable the full benefit of the contract to be derived imposed an obligation not to take unreasonable action that might damage the parties’ working relationship.

Cranston J not only held that the trust was in breach of Clause 3.5, he considered that this breach had:
‘… constituted a serious and continuing breach of its critical obligations, which went to the very heart of what was meant to be a long-term contract requiring co-operation’. 
He pointed out that as a result of the trust’s actions, Medirest would have understandably feared that the trust would start to enforce its claimed deductions or even apply further ‘irrational’ deductions. Thus, Medirest had been deprived of substantially the whole benefit the contract was intended to confer on it and was entitled to treat the trust’s breach as repudiatory. While it was accepted that the trust later abated the repudiatory breach by providing a heavily amended schedule of deductions, by this time Medirest had sought to terminate on the basis of the trust’s repudiatory breach.

As both parties had been entitled to terminate the contract, neither was able to succeed in their substantial claims for post-termination losses: the trust was able to claim for a period of four days, which represented the earlier point in time in which it was entitled to terminate; Medirest was entitled to other sums to which it had been entitled under the contract.

COMMENT

Had Cranston J taken a restrictive approach with regard to the duty of good faith owed by each party under the contract, it is possible that the trust’s actions would not have given rise to a repudiatory breach, and Medirest may have been liable to the trust for significant damages. As it was, the duty to carry out the contractual obligations in good faith was itself considered a material requirement, which gave rise to positive obligations.

Although Compass Group was decided upon its own specific facts, Cranston J’s findings have wider application, particularly with regard to long-term outsourcing contracts where there is a distinct common purpose. It is evident from the judgment that a duty of good faith requires the parties to do more than look out for their own interests in performing a contract; they must also take steps to ensure a healthy working relationship is maintained with the other parties to the deal. Furthermore, the decision suggests that any rights available to one of the parties under a contract, should only be exercised in a reasonable manner where it will be detrimental to the interests of the counter-party. It appears that parties will have a defensible position so long as they deploy ‘fact and common sense’. The trust’s breach would possibly not have been repudiatory had it treated each performance failure with a reasonable degree of common sense, rather than attempting to attribute the maximum points (and thus maximum deductions) for each performance failure by Medirest.

While the law relating to contractual good faith obligations cannot be rigid in the sense of setting out clear requirements and thresholds, the decision in Compass Group provides some assistance in illustrating the modern approach of the courts in applying such clauses. Much will depend on the nature of the contract as a whole and the specific facts in each case, but it appears a good faith clause will usually entail the following:

  • a positive obligation on the parties that goes further than simply not acting in bad faith;
  • an approach that seeks to ensure a healthy long-term relationship between the parties and deliverance of the common purpose behind the contract;
  • that in exercising right s under the contract, particularly those that could have detrimental consequences on the counter-party, a party is reasonable and takes a common-sense approach.

In light of the above, parties should give careful consideration when inserting clauses into contracts that will impose an obligation of good faith on the parties. While these clauses may often be viewed as boilerplate clauses, they have been shown to have far-reaching consequences, which can impact on the way other contractual rights are exercised.

By Christopher Pease, associate, and Crystal Randles-Mills, trainee,