A new era for good faith in English contract law?

In 2009 the parties entered into a distribution agreement (Agreement) in which the defendant granted the claimant the exclusive rights to distribute certain fragrances in specific territories in the Middle East, Asia, Africa and Australasia. The contract period initially ran from May 2009 until April 2010 but was later extended until 31 December 2011.

To begin with, the business relationship between the parties was described by the judge as a "warm one", despite some strain caused by delays in supplying products. In 2010, however, the relationship soured and in July 2010 it ended acrimoniously with the claimant informing the defendant that it was terminating the contract as the defendant was in breach.

The claimant claimed damages for, inter alia, alleged breaches of the Agreement, including late shipment of orders, failing or refusing to supply all the specified products, undercutting prices agreed with the claimant and providing false information.

The claimant asserted that there was an implied term of the Agreement that the parties would deal with each other in good faith. An important issue therefore, to be decided by Leggatt J, was whether a duty of good faith could be implied into the contract and it is this aspect of the case which is the subject of this case review.

English law – the current position

Leggatt J stated that in English contract law, the general view amongst commentators was that there is no overriding principle of good faith and that the English courts have always thought that parties should be entitled to negotiate freely between themselves and contract as they desire, without fear of interference from the courts. However, this view ( if indeed it does exist in the English courts) appeared, according to the judge, to be "swimming against the tide" as a general concept of good faith is recognised in many civil law countries (eg Germany, France and Italy) and either exists (eg in the U.S.) or is evolving in common law jurisdictions too (eg Australia and Canada). The principle is also recognised in Scotland.

Under English law a duty of good faith is implied by law in certain categories of contract, eg contracts of employment and contracts between partners or others whose relationship is characterised as a fiduciary one. References to good faith have also entered into English law via EU legislation, eg the Unfair Terms in Consumer Contracts Regulations 1999, which give effect to a European Directive, contain a requirement of good faith.

Implication of a duty of good faith

Leggatt J doubted that English law had reached the stage where it is ready to recognise a requirement of good faith as a duty implied by law, even as a default rule, into all commercial contracts. Nevertheless, there was no difficulty, following the established methodology of English law for the implication of terms in fact, in implying such a duty in any ordinary commercial contract based on the presumed intention of the parties. The relevant background against which a contract can be interpreted includes "shared values and norms of behaviour". These norms of behaviour are often taken for granted and so may not be spelt out in a contract.

Leggatt J analysed English case law and concluded that there are standards of honesty and fair dealing that are taken for granted between contracting parties. There was therefore "nothing new" to English law in recognising an implied duty of good faith in the performance of contracts. The concept was already reflected in several lines of authority, for example:

·  where duties of cooperation or "fidelity to the parties' bargain" in the performance of the contract have been implied (eg Rainy Sky SA v Kookmin Bank[2011] 1 WLR 2900);

· where a duty of honesty has been implied (eg HIH Casualty v Chase Manhattan Bank[2003] 2 Lloyd's Rep 61);

· where it has been held that a power conferred by a contract on one party to make decisions which affect them both must be exercised honestly and in good faith for the purpose for which it was conferred, and must not be exercised arbitrarily, capriciously or unreasonably (in the sense of irrationally) (eg Socimer International Bank Ltd v Standard Bank London Ltd [2008] 1 Lloyd's Rep 558);

· cases where the consent of one party is needed to an action of the other and a term is implied that such consent is not to be withheld unreasonably (in a similar sense) (eg Gan v Tai Ping (Nos 2 & 3) [2001] Lloyd's Rep IR 667); and

· where it has been held that an onerous or unusual contract term on which a party seeks to rely must be fairly brought to the notice of the other party if it is to be enforced (eg Interfoto Picture Library Ltd v Stiletto Visual Programmes Ltd [1989] 1 QB 433).

Long-term contracts

Leggatt J explained the importance of recognising the doctrine of good faith and fair dealing in "relational contracts" such as those involving a longer-term relationship, such as joint venture agreements, franchise agreements and long-term distributorship agreements. These contracts required a high degree of communication, cooperation and predictable performance based on mutual trust and confidence. They involve expectations of loyalty, which are not necessarily legislated for in the express terms of the contract, but are implicit in the parties' understanding, and are necessary to give business efficacy to the arrangements.

An objective test

Leggatt J stated that the test of good faith is objective, ie what would be regarded as commercially unacceptable by reasonable and honest people. The content of the duty is heavily dependent on context and is established through a process of construction of a contract.

Leggatt J concluded that the Agreement contained an enforceable implied obligation on the parties to act in good faith, and that the defendant breached that obligation by knowingly concealing from the claimant the true situation concerning the defendant's pricing arrangements with a crucial distribution channel in Singapore. That breach was held to be repudiatory. It justified the claimant's termination of the distributorship, and its subsequent damages claim.

Comment: This case suggests a shift in approach, with the court, apparently for the first time, drawing together disparate lines of authorities to find that English law is capable of recognising an implied duty of good faith in commercial dealings as a matter of fact in certain circumstances, beyond the limited categories of cases in which such a duty has been historically implied by law (eg fiduciaries, employment). Whilst context remains key, this case is clear authority that implication of such a term is possible in "relational" contracts requiring extensive cooperation, singling out joint ventures, franchise agreements and long-term distribution agreements. As Leggatt J recognised, it is possible for parties to agree to exclude such a duty in their contracts, although this might be difficult to achieve in practice (just as parties might find it hard to negotiate, for example, an exclusion of the duty to act honestly).

The European Commission's proposed Regulation for a Common European Sales Law (CESL) contains a general duty on contractual parties to act in accordance with good faith. The UK Government's response to its consultation on CESL recorded concerns from UK businesses that a general principle of good faith would bring unwanted uncertainty and unpredictability to contractual relations. For more information on this initiative see our briefing at:

Where on the web?

http://www.allenovery.com/SiteCollectionDocuments/CESL.pdf

Leggatt J believes that "the traditional English hostility towards a doctrine of good faith in the performance of contracts, to the extent that is still persists, is misplaced". It will be interesting to see if the approach taken in this case filters through into other case law. We will most certainly see other litigants try to rely on it.

Further information

This case summary is part of the Allen & Overy Litigation Review, a monthly update on interesting new cases and legislation in commercial dispute resolution.  For more information please contact Sarah Garvey sarah.garvey@allenovery.com, or tel +44 (0)20 3088 3710.​