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Royal Courts of Justice in London

November 04, 2022

Keeping the Faith: English Court of Appeal Considers Contractual Good Faith Provision in Shareholder Agreement

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KEEPING THE FAITH: ENGLISH COURT OF APPEAL CONSIDERS CONTRACTUAL GOOD FAITH PROVISION IN SHAREHOLDER AGREEMENT

The English law concerning contractual duties of good faith (express and implied) has received considerable judicial attention in recent years. It will therefore be of interest to those who use English law contracts, particularly in a corporate context, that the English Court of Appeal recently considered the effect of a good faith clause in a shareholder agreement, in the context of an unfair prejudice petition under section 994 of the Companies Act 2006 (the “Companies Act”)[1].

The appeal considered the extent to which a good faith obligation in a shareholder agreement prohibited the removal of S and F, respectively CEO and Chairman of Compound Photonics Group Limited (the “Company”), and, if such obligation was breached, whether this had unfairly prejudiced the minority shareholders of the Company (including S and F).

The decision provides helpful guidance on the proper interpretation of the nature and scope of express good faith provisions. It confirms, in particular, that the only obligation common to all such provisions is a requirement for the parties to act honestly.

What this means in practice, and the scope and content of any additional obligations which might arise out of a contractual duty of good faith must be derived from the terms and context of the agreement in each case, applying the usual principles of contractual interpretation. The exercise is fact sensitive, and it cannot be assumed that aspects of the duty found to arise in one case can be transposed to another.

Background

The Company, which was seeking to produce and market a new type of miniaturised projector, was 93% owned by three investors (the “Majority Shareholders”). The Majority Shareholders had entered into a shareholders’ agreement (the “SHA”) with the other shareholders in the Company (including S and F) (the “Minority Shareholders”).
The SHA provided that the shareholders would undertake to “act in good faith in all dealings with the other shareholders and with the Company in relation to the matters contained in [the SHA]” (the “Good Faith Provision”).

In response to growing dissatisfaction with the performance of the Company, S was forced to resign from his position as CEO and director by the Majority Shareholders in March 2016. F was allegedly then excluded from company decision-making and also removed shortly thereafter.

On the basis of the Majority Shareholders’ alleged treatment of S and F, the Minority Shareholders brought an unfair prejudice petition under section 994 of the Companies Act, in which they claimed (amongst other things) that the Majority Shareholders had breached the Good Faith Provision and that the directors appointed by the Majority Shareholders had acted in breach of their duties under the Company’s articles and the Companies Act. They claimed that this had caused them unfair prejudice, and that the Majority Shareholders should therefore be ordered to buy out their shares.

Decision

The first instance judge had found that the removal of S and F (and certain related conduct) by the Majority Shareholders constituted a breach of the Good Faith Provision and amounted to unfair prejudice under s994 of the Companies Act. In reaching this conclusion, the judge endorsed and applied the reasoning in Unwin v Bond[2], which identified five minimum standards required of parties subject to a good faith provision.

The judge also found that the SHA formed part of the Company’s constitution, and the Company’s directors were therefore also bound by the Good Faith Provision. By participating in its breach, the directors nominated by the Majority Shareholders had also breached their directors’ duties under the Companies Act, further amounting to unfair prejudice under s994.

The Court of Appeal disagreed and overturned the judge’s decision. In doing so, it made a number of helpful observations regarding the nature and scope of express good faith provisions:

  • At the core of all express good faith provisions is an obligation to act honestly. Any additional obligations said to arise from such provisions must be discernible from the parties’ agreement as a matter of contractual interpretation, taking account of the legal and commercial context of each case. Simply because an obligation arises in one case does not mean its proper interpretation can be applied formulaically in subsequent cases.
  • In particular, the Court expressed “considerable reservations” in respect of the judge’s suggestion that all good faith provisions required parties to act in accordance with the spirit of their contract (the “Fidelity Obligation”). To the extent a Fidelity Obligation does arise, however, it does not import additional obligations which are not otherwise discernible from the parties’ agreement. It merely supports the common purpose and aims of the parties as objectively ascertained from the express or implied terms of their agreement, applying the usual rules of contractual interpretation.
  • Where an obligation not to act in bad faith arises from a particular good faith provision, dishonesty will not necessarily be required in order to establish breach of that provision. Depending on the context, bad faith may simply include conduct which would be considered commercially unacceptable by reasonable and honest people. However, the Court also stressed that it would not be appropriate to be prescriptive in describing what conduct might fall into that category.
  • The judge in the present case and the judge in Unwin v Bond had relied, in their formulation of what a duty of good faith required, on US commentary (in relation to the US Restatement of Contracts) and a line of Australian cases (concerned with good faith requirements but not in a private company, shareholder agreement context). The Court did not find these references and authorities helpful in interpreting the Good Faith Provision since they had not been developed in the context of the interpretation of individually negotiated contracts.

On its proper interpretation, the Court held that the Good Faith Provision merely required the parties to act i) honestly, and ii) not in bad faith, towards each other and the Company. There was no additional obligation on the Majority Shareholders, contrary to the judge’s findings, to deal fairly and openly with S and F, or to have regard to the interests of the Minority Shareholders, except as otherwise required by the Companies Act.

The Court also held that the judge’s conclusion that the SHA formed part of the Company’s constitutional documents (and therefore bound the Company’s directors, under s. 171 Companies Act, to act in accordance with the Company’s constitution) was based on a misinterpretation of ss.17 and 29 of the Companies Act, which expand the definition of the constitutional documents of a company to include certain agreements and resolutions as well as the company’s articles. The SHA was not such a “constitutional agreement”–i.e., agreed to by all the shareholders which, if not so agreed, would not have been effective for its purpose unless passed by a special or other resolution. The SHA did not amend the Company’s articles or do anything else that would have required a special resolution. This provision was not intended to indirectly subject directors to a general obligation to act in accordance with any relevant shareholder agreement(s).

Applying these principles to the facts, the Court held that the Majority Shareholders and their nominated directors had not acted dishonestly, in bad faith or otherwise in breach of the Good Faith Provision or the SHA. In particular, the Court noted that they had rationally and genuinely held the view that their actions in connection with S and F were necessary, in the interests of the Company and its business. Even if there was an argument that the Majority Shareholders had acted unfairly, the Minority Shareholders had identified no financial or other prejudice which would make out a claim under section 994.

Comment

The Court’s reluctance in this case to attribute standardised, fiduciary-like obligations to contractual good faith provisions, per Unwin, is consistent with the English courts’ cautious approach to the doctrine of good faith more generally, including its limited and incremental development of the implied duty of good faith.

In the corporate context, the decision should provide some comfort to shareholders and directors (and, indeed, potentially other commercial parties) who might otherwise have been impacted by the relatively expansive and onerous interpretation of express good faith obligations adopted in the first instance decision.

What the core obligation to act honestly (and, potentially, not in bad faith) requires in each case, however, remains fact sensitive, and so the judgment can provide little (and certainly no prescriptive) guidance as to what parties must do in practice to comply with a contractual good faith provision.

Likewise, it should also not be assumed that the more limited interpretation of the provision in this case means that additional obligations, such as a duty to deal fairly and openly with other parties and/or to have regard to their interests, could not arise as a matter of contractual interpretation in the contexts of other agreements.

Perhaps most important from a practical perspective, the case demonstrates that it is preferable for any particular obligations or behaviours intended to flow from the inclusion of a good faith provision to be set out explicitly, where possible. Absent such express provision, parties may find that their good faith clauses provide less protection than they might think.

Footnotes

[1]   In Re Compound Photonics Group Ltd Faulkner v Vollin Holdings Ltd [2022] EWCA Civ 1371.
[2]  [2020] EWHC 1768 (Comm)

Authors and Contributors

Jonathan Swil

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Matthew Skinner

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Phil Cheveley

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Maegen Morrison

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Michael Scargill

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Chris Collins

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