In this week’s update: an implied duty of good faith in a loan agreement, environmentally-conscious contract clauses, the Government position on electronic signatures, an improperly executed deed of guarantee was effective as a contract and a few other items.

Court considers contractual duty of good faith

The High Court has said that a lender was not under an implied obligation to act in good faith when calling in a loan, requiring a valuation of a property portfolio and subsequently enforcing security.

Background

Morley v Royal Bank of Scotland plc [2020] EWHC 88 (Ch) concerned a loan facility advanced to an individual borrower operating as a sole trader. The loan was non-recourse to the borrower but was secured over a portfolio of commercial properties owned by him.

In 2009, the lender obtained a valuation of the portfolio which showed the borrower was in breach of its loan-to-value (LTV) covenant. The lender began to charge default interest. The parties then began discussions to restructure the loan. They ultimately reached an arrangement under which the borrower salvaged part of his portfolio and the remainder was transferred to a subsidiary of the lender.

The borrower later brought proceedings against the lender. He claimed (among other things) that the facility was a “relational contract” and so the lender was under an obligation to act in good faith, but that it had breached that duty in numerous ways. These included by “manufacturing" disputes, obtaining the valuation purely to “force” a breach of the LTV covenant, making threats so as to impose the restructuring on the borrower, and refusing to accept offers to salvage the entire portfolio.

Linked to this, he also alleged that, in deciding to obtain the revaluation, charge default interest and call in the loan, the lender had acted for an improper purpose. It had therefore exercised its contractual discretions under the loan facility irrationally or arbitrarily.

What did the court say?

The court disagreed. It said the loan facility was an ordinary agreement, not a “relational contract”.

A decision to call the loan in was not a discretion but an absolute right, and there was no requirement on the lender to act in good faith when making such a decision.

However, in deciding to revalue the portfolio and increase interest, the lender was required to act rationally. (This was never in dispute. The courts have previously said these kinds of powers must be exercised in good faith.) But the judge was happy that the lender had acted properly with logical commercial interests in mind.

The court also rejected the borrower’s claims that the lender had engineered the borrower’s default or put undue pressure on him to enter into the restructuring.

In some ways, this was a rather muddled case. The decision is not surprising, but the approach to considering a duty of good faith is interesting.

English law may imply two contractual duties to “act in good faith”:

  • General duty of good faith. There is no general duty to act in good faith in English law. But, in some cases, a court will imply a duty into a contract. This is more likely if the contract involves significant co-operation, communication and confidence – a so-called “relational contract”.But, as we reported a month ago, a court will not imply a duty merely because a contract is “relational”. Instead, it will ask two questions: would the term be obvious to a reasonable reader of the contract, or is it essential for the contract to work properly?However, if the court does imply a duty of good faith, that duty is overarching and applies to all behaviour by the parties in connection with the contract (although it will not cut across any express provisions of the contract).
  • Duty to exercise a discretion rationally. Separately, when exercising a “contractual discretion”, English law requires a person not to act irrationally, arbitrarily, capriciously, perversely or for an improper purpose. This is often described as a duty to exercise a contractual discretion “in good faith”, or the “Braganza duty” (after a recent case).This does not stop someone from reaching a particular decision one way or the other. But they must follow a proper procedure in reaching their decision, taking all relevant factors into account and not acting on the basis of irrelevant factors or ulterior motives.The Braganza duty applies when exercising a discretion, not an absolute right. It is not always clear whether something is an absolute right or a discretion. A termination right (including calling in a loan) is invariably an absolute right, but varying payments or terms may well be a discretion.

Although similar, the two duties are separate. The Braganza duty applies to all contracts, regardless of whether they contain an overarching implied duty of good faith, although it is more restricted than a general duty of good faith. Likewise, a contract may contain an overarching duty to act in good faith even if it reserves few or no discretions to its parties.

In this case, whilst recognising that the two duties are different, the court subjected the same alleged breaches to a relatively short analysis that almost treats the two duties interchangeably. This is understandable. All contracts are potentially subject to the Braganza duty; so, when a court considers whether a contract is “relational” and contains a general duty of good faith, it is sensible and efficient to consider the Braganza duty at the same time.

But the distinction is important. In this case, for example, the lender’s decision here to call for a valuation was a contractual discretion in the facility agreement. It was subject to the Braganza duty. Manufacturing disputes over covenants and making threats are not contractual discretions and so should not fall within the Braganza duty, but they may go against a general duty of good faith.

What does this mean for me?

The judgment obviously provides some comfort for lenders looking to enforce security.

More broadly, it reflects a growing willingness of the courts to entertain duties of good faith in English law. In some ways, this is nothing new, but we are now seeing more and more cases in which a party alleges a breach of an implied duty of good faith or the Braganza duty.

When proposing to take a particular decision or course of action in relation to a commercial contract, employees and directors should consider the following steps:

  • Consider the nature of the contractual relationship. Is it one where the parties have committed to collaborate on a long-term basis? Does the contract require a high degree of communication or confidence between the parties? If so, it is more likely to contain an implied duty of good faith that restricts what the parties can do.
  • Identify the decision that is being made. If it is a binary commercial choice, such as deciding whether to end or renew a contract or agree to a change in terms, there should be no duty to act in good faith. But if the decision involves evaluating a range of alternatives and is likely to affect the counterparty’s position under the contract, it is more likely to be subject to scrutiny.
  • Identify all relevant factors. When exercising a discretion, take a moment first to consider all matters that might be pertinent to the decision. In doing so, it is better to think broadly so as not to overlook anything. At the same time, it is important not to “overthink” and introduce factors that have no bearing on the decision or might suggest an improper purpose to the decision.
  • Document the decision-making process. Creating a record of how a conclusion has been reached can provide valuable evidence should the decision be challenged later down the line. At the same time, it may be best to keep any minutes pithy and to the point. The more expansive the record, the more vulnerable it may be to arguments that the decision-makers have strayed from the core question.

New environment-conscious drafting published

A set of new model clauses for commercial contracts, aimed at environmentally-conscious drafting, have been published. The Climate Contract Playbook contains sixteen template clauses for different types of commercial contract, which can be used by businesses, communities and legal advisers. Each clause bears a child’s name as a reminder of the importance of the climate to future generations.

The Playbook was developed by the Chancery Lane Project, a pro bono collaboration involving lawyers working at various UK firms (including Macfarlanes) to develop new contracts that recognise climate concerns.

It contains the following model clauses, which may be of use in commercial and corporate contracts:

  • Clauses for an investment or shareholders’ agreement designed for green investment objectives.
  • A right for a customer to end a supply contract in order to switch to a greener supplier.
  • Warranties relating to emissions data for a commercial contract or a share/business sale agreement, along with a liquidated damages clause.
  • An obligation on a supplier to align its net zero target with its customer’s.
  • A provision for a company’s constitution setting out an environmental purpose for the company.
  • Warranties for an underwriting or sponsor agreement confirming that the issuer has complied with environmental laws and assessed its carbon footprint.
  • Wording for board minutes to show that directors considered environmental factors when taking a decision.
  • A statement in heads of terms that parties intend to pursue a transaction in an environmentally-conscious way.

The model clauses are free to use. They are untailored, so businesses and legal advisers should exercise judgment when deciding how and when to use them.

Government sets out its position on electronic signing

The Lord Chancellor has given an official response by the Government to the Law Commission’s recent report on whether electronic signatures are valid under English law. In short:

  • The Government agrees that electronic signatures are effective and there is no need for new legislation. However, it endorses the Law Commission’s recommendation of a “legislative statement” confirming this.
  • In line with the Commission’s recommendations, the Government will convene an industry working group to consider practical elements of electronic signing, including security, technology and video witnessing.
  • Finally, the Government will ask the Commission to undertake a review into the law of deeds, although the statement suggests this review may not receive high priority.

Although Government responses are not authoritative statements of law, this represents yet another vote of confidence in electronic signatures. We will be following the next steps, including the work of the Industry Working Group, and report on them in due course.

At Macfarlanes we support electronic signing and are able to provide electronic signature solutions to our clients in a transactional context.

Court confirms improperly executed deed took effect as a contract

The High Court has held that a deed of guarantee that was not executed properly as a deed had instead taken effect as a simple, binding contract.

What happened?

In Signature Living Hotel Ltd v Sulyok [2020] EWHC 257 (Ch), a company (Signature) agreed to guarantee the repayment obligations of another company under two loans. To this end, Signature signed a guarantee document that was framed as a deed.

Under English law, a UK company usually executes a deed in one of two ways, which are set out in section 44(2) of the Companies Act 2006:

  • Two of the company’s directors, or one of its directors and its secretary, can sign it
  • One of the company’s directors can sign it in the presence of a witness, who counter-signs

In this case, a single director of Signature signed the deed of guarantee without a witness. There was therefore no question that the guarantee had not been executed properly as a deed.

Signature claimed that, because of this, the guarantee was not enforceable.

However, the creditors argued that, although the guarantee was not effective as a deed, it could take effect as a simple contract. This is because, under English law, a guarantee does not need to be a deed to be effective. It merely needs to be set out in writing and signed by or on behalf of the person giving the guarantee. In this case, a director of Signature had signed the guarantee on its behalf.

What did the court say?

The court agreed that, even though the guarantee had not been executed as a deed, it took effect as a binding contract.

The judged noted that the guarantee had been signed by a director on behalf of Signature, that it had been given as “part and parcel” of the loan transaction and that there was contractual “consideration” flowing to Signature.

What does this mean for me?

In some ways, the decision is not surprising. It has long been assumed that a deed that has not been executed properly can, in certain circumstances, still be effective as a contract (Windsor Refrigerator Co Ltd v Branch Nominees Ltd [1961] Ch 375).

The position was thrown into some doubt by the now well-known case, Mercury Tax Group Ltd [2008] EWHC 2721 (Admin), in which the judge commented that, if parties frame a contract as a deed, the court must treat it as one, and if it is not validly executed it cannot be effective.

However, legal experts have treated this comment with caution, suggesting that it arose out of a very particular set of facts. The decision in Signature Living now shows this approach to have been correct.

This judgment is certainly useful when looking to rely on an improperly executed deed, but it is not a carte blanche. It is also important to remember the following:

  • In order for an invalid deed nonetheless to take effect as a contract, certain other formalities must be satisfied. In particular, each party must be giving something and getting something in return (“consideration”). This is not impossible but arguably more difficult where a third party is giving a guarantee and is one reason why guarantees are often framed as deeds.
  • Even if the document is effective as a simple contract, there may be differences. For example, the time limit for bringing claims under the contract will be the usual six years, and not 12 years (as it would have been if the document had been executed as a deed).
  • In some cases, the law of contract cannot “save” an improperly executed deed. For example, a power of attorney (which must be executed as a deed to be effective) which is not properly executed as a deed can, in certain circumstances, take effect as a simple agency (Katara Hospitality v Guez [2018] EWHC 3063 (Comm)), but it will not confer the full range of matters that a properly executed power of attorney would.Likewise, a transfer of land or the appointment of a new trustee will simply not be effective unless it is properly executed as a deed.

Signing documents can often be one of the most tedious parts of a transaction. The combination of weariness from negotiations and euphoria of reaching the end of a deal can easily lead parties to overlook formalities. But it is critical to have dotted the I’s and crossed the T’s.

Other items

  • FCA issues statement on coronavirus. The Financial Conduct Authority has set out its expectations of regulated firms in dealing with COVID-19, the disease caused by novel coronavirus (2019-nCoV, or SARS-CoV-2). It says it expects all firms to have contingency plans in place covering operational risks, the ability to continue to operate effectively and the steps to serve and support customers. The FCA is actively reviewing of a wide range of firms’ plans.
  • PRA writes to firms on diversity. The Prudential Regulation Authority (PRA) has written to regulated firms emphasising the importance it places on board diversity. It says that diversity improves decision-making and provides effective challenge. The letter is not directed at unregulated firms but may nonetheless provide some useful guidance.