The debate surrounding the concept of good faith in commercial contracts has recently been re-ignited as a result of proposed legislation in SA and WA and the recent decision in the NSW Supreme Court of AMC Commercial Cleaning (NSW) Pty Ltd v Coade [2010] NSWSC 832. The concept was also recognised in the July 2010 amendments to the Franchising Code of Conduct (Code).

This article discusses the varying approaches taken by Australian Courts, in particular New South Wales and Victorian courts, and what effect an obligation of good faith has on the parties rights and obligations under commercial contracts, in particular franchise agreements.

The duty of good faith generally encompasses two distinct duties, being the:

  • duty to negotiate in good faith (pre-contractual duty), and
  • duty to act in good faith in the performance of contracts (post contractual duty).

Pre-contractual duty of good faith

The requirement not to act fraudulently arguably establishes a positive duty of honesty in contractual negotiations in Australian law. Certain legislation in Australia expands this position and imposes positive obligations of disclosure in specific circumstances, such as the requirement for full and proper disclosure in vendor statements for the sale of property and the requirement for pre-contractual disclosure under the Code.

Historically, it was not possible to make a contract to negotiate in good faith. However, in Coal Cliff Colleries Pty Ltd v Sijehama Pty Ltd (1991) 24 NSWLR 1, the New South Wales Court of Appeal held that although an obligation to “proceed in good faith to consult together upon the formulation of a more comprehensive and detailed joint venture” was too illusary, vague and uncertain to be enforceable, it is possible to create a preliminary contract to negotiate in good faith.

There are a number of obstacles facing parties seeking to rely on pre-contractual duties of good faith. Unless the term clearly specifies the criteria that comprises the duty of good faith and what conduct may be found to be in breach of such a term, it is likely that, as demonstrated by the Coal Cliff case, the courts may find the term void for uncertainty. Parties may also face difficulties establishing what damages would flow from a breach of the term and what agreement would have been struck had the term not been breached.

While there is no general statutory provision relating to the exercise of good faith in the negotiations of a commercial contract, under section 51AC of the Trade Practices Act 1974 (Cth) (TPA) ‘good faith’ is one of the criteria that a court is directed to consider when determining if a corporation has engaged in unconscionable conduct. Section 51AC of the TPA prohibits a person or corporation from engaging in conduct that, in all the circumstances, is unconscionable in business transactions for the supply or acquisition, or possible supply or acquisition of goods and services. While it may not be common for a party to assert the existence of a term of good faith in pre-contractual negotiations, section 51AC of the TPA could be used to argue that the failure to act in good faith during negotiations amounts to a party engaging in unconscionable conduct in breach of that provision.

Post contractual duty of good faith

Contracting parties are free to include express terms requiring them to act in good faith in the performance of the contract. The content and nature of the term will be dependent on the agreement between the parties. However, the question of whether a court, in the absence of such an express term, will imply a term of good faith still remains uncertain in Australian law.

There are four basic ways in which terms can be implied into a contract, namely:

  1. implied in fact (also known as implications “ad hoc”)
  2. implied in law
  3. implied by custom or usage, and
  4. implied by a sufficiently long course of dealings between the parties.

The method by which a duty of good faith will be implied into a commercial contract will generally be as a result of implication in fact or implication in law.

Terms that are implied in fact are based on the presumed intention of the parties and must satisfy five main requirements, the term must:

  1. be reasonable and equitable
  2. be necessary to give business efficacy to the contract, so that no term will be implied if the contract is effective without it
  3. be so obvious that it goes without saying
  4. be capable of clear expression, and
  5. not contradict any express term of the contract.1

Terms that are implied in law are generic and will arise if implied by statute or if it is an established normal incident of a particular class of contract (for example, employment contracts).

While the High Court has not yet expressed a considered view on the implication of a term of good faith into commercial contracts, the State and Federal Courts have considered the issue, with differing approaches to the basis upon which such a term would be implied into a commercial contract.

New South Wales

The New South Wales courts have widely recognised an implied duty to act in good faith in the performance of commercial contracts. In Renard Constructions (ME) Pty Ltd v Minister for Public Works (1992) 26 NSWLR 234 Priestley JA said at 268:

People generally, including judges and other lawyers, from all strands of the community, have grown used to the courts applying standards of fairness to the contract which are wholly consistent with the existence in all contracts of a duty upon the parties of good faith and fair dealing in its performance. In my view this is in these days the expected standard, and anything less is contrary to prevailing community expectations.

In Alcatel Australia Ltd v Scarcella (1998) 44 NSWLR 349 the court clarified that this duty, in New South Wales, was implied as a matter of law. The court in Burger King Corp v Hungry Jacks Pty Ltd [2001] NSWCA 187 endorsed the position that a term of good faith is implied as a matter of law and further stated that the New South Wales case law indicates that obligations of good faith and reasonableness will be more readily implied in standard form contracts, particularly if such contracts contain a general power of termination.

However, subsequent decisions in New South Wales have blurred the basis upon which a term of good faith is said to be implied in commercial contracts. In Saxby Bridge Mortgages Pty Ltd v Saxby Bridge Pty Ltd [2000] NSWSC 187, while Simos J ultimately rejected the implication of a term of good faith, he approached the question on the basis of whether it could be implied in fact and did not address whether it could be implied in law. In Insight Oceania v Philips Electronics [2008] NSWSC 710, Bergin J re-iterated the approach previously taken in her decision in AHA v TAB Limited [2006] NSWSC that commercial contracts are not a class of contracts that, as a legal incident, have an implied obligation of good faith.

Although the basis upon which a term of good faith is to be implied into commercial contracts is not settled in New South Wales, the weight of the case law is in favour of it being implied as a matter of law. The New South Wales courts have been more willing than their other State counterparts to imply a term of good faith into commercial contracts, notwithstanding their division over the basis upon which it is implied.

Victoria

The law in Victoria in relation to implied duties of good faith has not yet progressed to the extent it has in New South Wales. Although Victorian courts recognise the doctrine, they often decide matters on alternative bases.

In Far Horizons v McDonalds Australia [2000] VSC 310, Justice Byrne did not consider himself at liberty to depart from the considerable authority in Australia following the decision in Renard and held that a duty of good faith was implied in a franchise agreement as a legal incident. However, since this decision, the Victorian Supreme Court in Esso Australia Resources Pty Ltd v Southern Pacific Petroleum NL (Receivers and Managers Appointed) (Administrator Appointed) [2005] VSCA 228 made it clear that if such a term was to be implied in Victoria, it would be implied as a matter of fact, not law.

In Esso the Court held that a duty of good faith may be implied only where the facts and circumstances warrant it, particularly where it was necessary to protect a vulnerable party from exploitative conduct which would subvert the original purpose for which the contract was made. Warren CJ added that the interests of certainty in contractual activity should not otherwise be interfered with. The Court continued on to say that, in their opinion, even if a duty of good faith was to be implied, in this case the duty was not breached as Southern Pacific did not act unreasonably, or capriciously in the pursuit of an ulterior motive and did not prevent the performance of the contract or deny Esso its benefits. However, the Court fell short of clarifying where a vulnerable party will be exploited or in what circumstances a commercial contracting party is in a ‘vulnerable position’.

The consequence of the decision in Esso is arguably at odds with the intention of the decision as depicted by Warren CJ. It is difficult to see how certainty in contractual activity can be maintained where a term of good faith is implied on an ‘ad hoc’ basis. If it is clear that commercial contracts, as a legal incident, will be subject to an implied term of good faith, then parties can ensure that the express terms of the contract negate any unintended consequences. However, if it is unclear whether commercial contracts will be subject to such an implied term, parties may find themselves subject to such a term when this was not their original intention.

Queensland and Western Australia

While the body of this article focuses on Victorian and New South Wales case law, for completeness, the position in Queensland and Western Australia is briefly considered below.

In Laurelmont Pty Ltd v Sotckdale & Legoo (Qld) Pty Ltd [2001] QCA 212, Dutney J (with whom McPherson and Williams JJA agreed) stated at paragraph 45:

While it seems to be recognised that a term requiring the parties to act in good faith may be implied by law as a legal incident of a particular class of contract it does not operate so as to prevent action by the party against whom it is sought to be enforced taken in that party’s own legitimate commercial interests and not otherwise in breach of an express contractual term.

It appears from this extract that, similarly to both New South Wales and Victoria, a party will not be found to be in breach of an implied duty of good faith where they are acting to protect their own legitimate interests and not in pursuit of some ulterior motive.

In Central Exchange Ltd v Anaconda Nickel Ltd [2001] WASC 128, Steytler J noted that the content of the phrase ‘good faith’ was still unsettled and brings with it a degree of flexibility because of its general nature. In this case, Steytler J found that a requirement of good faith as contended by the applicant (i.e. for the respondent to keep the applicant informed of developments that gave rise to a contractual entitlement to the applicant) would impose an unwarranted and unreasonable obligation on the respondent.

High Court

The High Court has not expressly endorsed the implication of a term of good faith into commercial contracts and it declined to consider the issue in Royal Botanic Gardens and Domain Trust v South Sydney Council (2002) 186 ALR 289. However, Kirby J expressed some concerns with the implied duty, particularly its apparent conflict with the “fundamental notions of caveat emptor (i.e. buyer beware) that are inherent (statute and equitable intervention apart) in common law conceptions of economic freedom.”

Internationally

The status of the implied duty of good faith is clearer in other jurisdictions such as the USA where the Uniform Commercial Code imports a general duty of good faith in the performance of contracts and Canada where the principles of good faith have generally been accepted.

Article 1.7 of the Unidoirt Principles of International Commercial Contracts not only implies a duty of good faith but expressly forbids parties from contracting out of or attempting to limit the duty and Article 7 of the United Nations Convention on Contracts for the International Sale of Goods, states that “in the interpretation of the Convention regard is to be had to the observance of good faith in international trade.”

Can you exclude an implied term of good faith?

The cases indicate that the implied duty of good faith will not impose an obligation on the parties that is inconsistent with the express terms of the contract. So, it is possible to contract out of the obligation to act in good faith. However, it would generally be difficult to negotiate such a term into a commercial contract. Where such a term is included in a franchise agreement it would certainly indicate that there existed a substantial disparity in bargaining power.

In Central Exchange Ltd v Anaconda Nickel Ltd (2002) 26 WAR 33, Steytler J (with whom Malcolm CJ and Wallwork J agreed on this point) stated that “One thing that is clear, however, is that principles of good faith ‘do not block use of terms that actually appear in the contract’ (Kham & Nate’s Shoes No 2 Inc v First Bank of Whiting (1990) 908 F 2d 1351, at 1357, referred to in Burger King [2001] NSWCA 187 at [173].”

In Vodafone Pacific Pty Ltd v Mobile Innovations Ltd [2004] NSWCA 15, Giles JA concluded that the relevant contractual powers were not fettered by an implied obligation of good faith and reasonableness. Firstly, he noted that the power afforded to Vodafone to determine target levels of connections of new subscribers “was emphatically described as a sole discretion”, stating that “the point of “sole” lay in the exclusion of any constraint.” This prevented the court form implying a term that Vodafone act in good faith and reasonably when exercising its power to determine target levels. That point was reinforced by other provisions of the contract including a clause which stated “To the full extent permitted by law and other than as expressly set out in this Agreement the parties exclude all implied terms…”.

What does good faith mean?

Sir Anthony Mason in his article “Contract, Good Faith and Equitable Standards in Dealing” (2000) 116 Law Quarterly Review 66 stated that good faith comprised three notions:

  • an obligation on the parties to cooperate in achieving the contractual objects
  • compliance with honest standards of conduct, and
  • compliance with standards of conduct which are reasonable, having regard to the interests of the parties.

This approach has been cited with approval in a number of cases including Burger King Corp v Hungry Jack’s Pty Ltd [2001] NSWCA 187 and Hughes Aircraft Systems International v Airservices Australia (1997) 76 FCR 151.

In Garry Rogers Motors (Aust) Pty Ltd v Subaru (Aust) Pty Ltd (1999) ATPR, Finkelstein J held that an implied term would require a contracting party to act in good faith and fairly not only in relation to the performance of a contractual obligation but also in the exercise of a power conferred by the contract. He continued on to state that the implied term imposes an obligation upon the party not to act capriciously, however, it would not operate so as to restrict actions designed to promote the legitimate interests of the party. Provided that the party exercising the power acts reasonably in all the circumstances, the duty to act fairly and in good faith will be ordinarily satisfied.

Good faith is often equated with the concept of reasonableness. In Esso the Court agreed with the reasoning of Priestley JA in Renard where such a comparison was made. Although the Victorian and New South Wales courts diverge on the basis of an implied duty of good faith, it appears that their approach to the content of such a term is more aligned, in that while the duty of good faith may require a party to consider the interests of another, it will not require that party to act against its own interests in doing so. Bryne J in Far Horizons v McDonalds Australia (2000) VSC 310 described a breach of the obligation of good faith as where a party seeks to further an ulterior purpose or a purpose extraneous to that for which a right or power is conferred.

In ACI Operations Pty Ltd v Berri Limited [2005] VSC 201, ACI and Berri had an exclusive supply agreement. However, under the terms of this agreement, Berri could obtain products from a third party where they received a bona fide arm’s length offer from a third party and ACI did not match that offer. The court held that the supply agreement recognised Berri’s legitimate commercial interest in securing a competitive price or terms for the supply of products. The court continued on to say that an implied obligation of good faith did not confine Berri to the passive receipt of third party offers and Berri could proactively seek these offers. Interestingly in this case, the relationship between Berri and ACI had soured and Berri wanted to terminate it. However, the Court found that this fact, in isolation, was not a sufficient ground to determine that Berri had breached an implied duty of good faith. The ultimate issue was whether the offer that had been sought by Berri constituted a ‘bona fidearm’s length offer’. This case again re-iterates the point that a party will not act in breach of any implied term of good faith where its action is consistent with the promotion of its legitimate interests and within the bounds of its express contractual rights.

A good faith obligation should not be confused with a fiduciary obligation. A fiduciary relationship is where a person has an obligation to exercise rights and powers in good faith and for the benefit of the other person. For example, a trustee has a fiduciary obligation to a beneficiary as in certain circumstances do people in partnership with each other. In equity a person in a fiduciary relationship cannot make a personal profit at the expense of the person to whom he owes a fiduciary duty or put himself in a position where his duty conflicts with his own personal interests.

While the precise nature of the duty of good faith remains uncertain, it is clear that the guiding principle in most cases will be whether or not a party was acting to pursue its own legitimate interests, or whether its motivation was to frustrate or harm the other party. However, a duty of good faith falls well short of a fiduciary duty. A duty of good faith does not require a party to exercise its rights for the benefit of the other party or refrain form exercising its rights or deriving a benefit where to do so conflicts with the interests of the other party.

Franchise agreements

The relational nature of the franchise relationship means that courts will be more inclined to imply a duty of good faith into franchise agreements. A contract is said to be relational “to the extent that the parties are incapable of reducing important terms of the arrangement to well defined obligations”2 Unlike contracts for discrete transactions, relational contracts are performed over a period of time during which circumstances may change and develop. Such is the case with franchise agreements, that often require the franchisee to adhere to an operations manual as if the terms of that manual were part of the franchise agreement. Generally the franchisor will be entitled to change the terms of its operations manual in order to improve the franchise system and, in doing so, change the obligations of the franchisee under the franchise agreement.

In Far Horizons Pty Ltd v McDonalds Australia Ltd [2002] VSC 310, while McDonalds was not found to have breached the duty of good faith by not offering the plaintiff the licence to operate a new restaurant in the vicinity of the plaintiff’s restaurant, Bryne J stated that there is to be implied into every franchise agreement a term of good faith and fair dealing that obliges each party to exercise the powers conferred on it by the agreement in good faith and reasonably and not capriciously or for some extraneous purpose. Bryne J went on to say that the scope of the duty is fettered in that it cannot operate to deny to a party the right to exercise a power conferred by the contract for the promotion or protection of its legitimate commercial interests.

The 2010 case of AMC Commercial Cleaning (NSW) Pty Ltd v Coade [2010] NSWSC 832 serves as a recent re-enforcement of the existence of an implied duty of good faith in franchise agreements. In this case at paragraph 7 Rein J stated that there was no dispute as to the legal principles relevant to franchises and referred to his comments in J F Keir Pty Ltd v Priority Management Systems Pty Ltd (administrators appointed) 2007 NSWSC 789, that “a franchisor is required to act reasonably and honestly (to an objective standard), not to act for an ulterior motive, to recognise and have regard to the legitimate interest of both parties in the enjoyment of the fruits of the contract, and to avoid rendering the franchisee’s interest under the agreement nugatory or worthless or seriously undermining it”.

The Court in this case found that the franchisor had breached this duty on numerous occasions, including (among other things) by serving a ‘default notice’ that was baseless, endeavouring to find ways to impose financial burdens on the master franchisee, failing to supply leads in accordance with the terms of the master franchise agreement, failing to render invoices within a reasonable time and failure to use reasonable endeavours to collect debts.

As previously discussed, in Esso it was held that a duty of good faith may be implied only where the facts and circumstances of a particular case warrant it. Specifically, such a duty would arise where it was necessary to protect a vulnerable party from exploitative conduct, which would subvert the original purpose for which the contract was made. The implication of Esso in relation to franchise agreements was considered by Meridian Retail Pty Ltd v Australian Unity Retail Network Pty Ltd Unreported BC200605745 where the court stated that although it had not been established in that case that the franchisees were vulnerable or substantially disadvantaged, authorities have indicated that the franchise relationship may frequently attract an obligation of good faith because often there is inequality in bargaining power.

Despite these decisions, it is foreseeable that there will be circumstances where a franchisee cannot be considered a ‘vulnerable’ party, for example master franchisees or multi unit franchisees may often be in a position of commercial strength and unlikely to be at risk of exploitative conduct by a franchisor.

What seems clear from the decisions is that although a duty of good faith is likely to be implied into most franchise agreements, such a duty falls well short of any obligation in the nature of a fiduciary duty or even to act fairly. This is a distinction that is sometimes confused and it is a very significant one. Franchisors do not have an obligation to subordinate their own interests to that of their franchisees or to abstain from commercial opportunities where there may be a conflict with the interests of a franchisee.

Conclusion

The concept of good faith in commercial contracts is becoming increasingly prominent in both case law and legislation. Although there is not universal acceptance of the concept and its basis is not completely clear in Australian law, parties to commercial contracts should consider this implied duty when taking action under their contracts, particularly franchise agreements.

There are some basic guidelines that franchisors should adhere to in order to minimise the risk of being found to be in breach of an implied duty of good faith. For example, when exercising rights under agreements, franchisors and commercial parties generally should ensure that the decisions and action taken have legitimate business objectives that can be demonstrated. In order to assist parties in this respect, they should maintain detailed records that set out the business objective which can be later referred to if questioned. In drafting notices of breach and termination, franchisors should ensure that they identify the nature and basis of the allegations and what action must be taken to remedy it. It is also strongly recommended that a franchisor instigate and participate in mediation prior to ultimately terminating the franchise agreement.

In relation to commercial contracting parties more generally, if parties to a contract wish to bind themselves to act in good faith they should make express provision for this. As noted above, the concept of good faith is uncertain and open to interpretation, therefore parties should define what this term means in the context of the contract. Equally, if parties do not wish to be bound by an obligation of good faith they should expressly note this in the contract. However, while parties can take action to help minimise the application (or non-application) of the term of good faith, Courts may still deem the obligation of good faith, or its removal, to be inconsistent with the more general terms and purpose of the contract.