It is well established (if not as well known) that the implied duty of good faith extends beyond the scope of the employment contract to cover the way in which an employer exercises powers it holds under a pension scheme it has established for its staff. Those powers may be a power to exercise a particular function, or may simply be a power to consent to the trustee doing so. When one thinks about why the duty should extend in this way, it makes perfect sense. Pensions are part of the employment package, so they are a benefit for which the employee provides consideration either by performing its duties as an employee, or by making actual monetary contributions to the pension scheme itself. And yet pensions are invariably, and for very good reasons, provided by way of a trust. Trusts offer security, being separate from the employer’s general assets, and are necessary for an employer and employee to obtain the tax incentives associated with retirement planning. But it would be wrong if the trust meant an employee was denied a remedy against an employer’s breach where one was otherwise available under contract. To put it another way, why should an employer be free to behave contrary to the duty of good faith when dealing with the pensions part of the benefits package (just because that is provided by a trust) when it could not do likewise with regard to the part of the package provided by the contract? After all, a pension is no less “pay” than contractual remunerationii, albeit it is a type of deferred pay. So in either case, redress should be available.

That said, an employer is not obliged to provide a pension and so does so voluntarily and at its own cost. As a business it is entitled to have regard to that cost when making decisions in connection with the scheme, and generally with regard to its future operation. Arguably, statute aside, the duty of good faith is the most important protection for employees, who take the risk of their master’s commercial decisions. Moreover, the duty exists because “Employment is a personal relationship. Its dynamics differ significantly from those of business deals and of state treatment of its citizens”iii. But it must recognise the commercial reality, and hence does not operate unfairly against an employer and prevent the employer from having regard to its own commercial interests, so as to impose anything like a fiduciary duty on an employer when acting in relation to a pension scheme. That point is crucial.

The origin of the extension of the duty to pension schemes is to be found in the Imperial Tobacco case itselfv, which is considered to be “the seminal judgment”vi in the area. We should therefore start by considering the facts of that case.

The Imperial Tobacco case

Imperial Tobacco plc (later known as Imperial Tobacco Ltd) (“the Company”) had established a pension fund (“the Scheme”) for its employees and their dependants by a deed dated 4 April 1929. It was administered by two custodian trustees (“the Applicants”) and a committee of management (“the Committee”) whose members were all employees of the Company. The Committee managed the Scheme, with the Applicants having only very limited discretion. The Scheme was contributory with participating employers meeting the balance of cost, and in final salary form. When established, the Scheme contained no provision for increasing pension benefits payable to members. That said, between 1970 and 1985 a practice developed of increasing benefits at or less than the rate of the annual increase in RPI. These increases were made by using the power of amendment, which said the Committee “…may at anytime by writing…and with the consent in writing of the Company…alter or modify all or any of the trusts or provisions of the [Scheme]…”. In 1985 Hanson was due to take over the Company. At that point two amendments were madevii to the Scheme’s rules, the first saying that the Scheme would automatically be closed to new members if any person gained control of the Company, and the second introducing a new rule (“r64A”) to provide that with effect from 1 November 1986, all pensions payable should annually be increased on 1 November by at least the lesser of 5% and the increase in RPI in the preceding 1st August to 31st July. The Company was taken over on 18 April 1986 and the Scheme was closed to new members. At that point, there was a surplus of at least £130,000,000. Under the Scheme rules that surplus had on winding up to be applied for the benefit of the members and did not revert to the Company.

There followed some negotiations between the Committee and the Company as to the future of the Scheme. The Committee sought from the Company’s new management confirmation that it would continue to honour the existing practice of increasing pensions at least in line with RPI increases, but the Company would not agree to any increase over the 5% guaranteed by r64A. That meant in practice the Company would not give its consent to any amendment to the Scheme rules giving effect to an increase over 5%viii. Eventually, the Company decided that the Scheme should remain closed and set up a new pension scheme (“the New Scheme”) to provide pensions for new employees. It also indicated that it was prepared to include in the rules of the New Scheme a guarantee of annual pension increases equal to the lesser of 15% and the percentage increase in RPI. Under the New Scheme any ultimate surplus would be returned to the Company. The Scheme members were invited to transfer their benefits (and a share of surplus) to the New Scheme and the Committee recommended that the transfer was beneficial being mindful of the 15% increase. However, in response, the two Applicant trustees issued a summons seeking a determination of the court on two points. Those were (1) whether the Committee had power under r64A, without the consent of any other person, to increase pension benefits above the minimum increase stipulated, and (2) if the Company’s consent was required, whether there were any constraints on the Company in granting or withholding that consent.

The first question was answered very firmly in the negativeix, but it is the second question which especially interests us. It was accepted that there was no ground for suggesting that the Company’s right to give or withhold consent was a fiduciary powerx, and hence that the Company would have to decide whether or not to consent by reference only to the interests of the Scheme members, disregarding its own interests. That was clearly not the intention behind r64Axi. Equally, there was no express limitation in the rule on the Company’s right to give or withhold consent.

There were, however, two submissions made to the effect that there were implied limitations. The first such limitation was that the Company’s right to give or withhold consent must not be unreasonably withheld. That implied that the Company was effectively under a duty to behave reasonably. The court saw no grounds for implying a limitation of reasonableness on the Company’s right to refuse consent. In fact, it said there were very good reasons why such a limitation should not be implied. As was pointed out by the Company’s counsel, “…in all pension schemes, including this one, the company has a direct personal interest in how the scheme is to operate for the future. Any change in benefits may well be reflected in the company having to make increased contributions. What is “reasonable” from the point of view of the company may be unreasonable viewed in the eyes of the pensioners. Which viewpoint would the court have to adopt in testing reasonableness? Would the Court have to seek to balance the reasonableness of both viewpoints? In the context of a pension scheme, a test of unreasonable withholding of consent would be unworkable”.xii

The alternative submission was that because pension schemes were quite different in nature to traditional trusts, and because the employees were not volunteers, in the sense they gave consideration for the benefits they received, it made sense to see the Scheme as established against the background of the employment relationship and to be interpreted against that background. The employer was not conferring a bounty, and in many cases membership of the Scheme was a requirement of employment.xiii

Having so decided, the judge (Browne Wilkinson V-C) went on to say this:
“In every contract of employment there is an implied term-
'that the employers will not, without reasonable and proper cause, conduct themselves in a manner calculated or likely to destroy or seriously damage the relationship of confidence and trust between employer and employee’
(See Woods v WM Car Services (Peterborough) Ltd., [1981] ICR 666 at 670, approved by the Court of Appeal in Lewis v Motorworld Garages Ltd., [1986] ICR 157.) I will call this implied term 'the implied obligation of good faith'. In my judgment, that obligation of an employer applies as much to the exercise of his rights and powers under a pension scheme as they do to the other rights and powers of an employer. Say, in purported exercise of its right to give or withhold consent, the company were to say, capriciously, that it could consent to an increase in the pension benefits of members of union A but not of the members of union B. In my judgment, the members of union B would have a good claim in contract for breach of the implied obligation of good faith: see Mihlenstedt's case, [1989] IRLR 522 at 525, 531-532(paras 12, 64, 70).

In my judgment, it is not necessary to found such a claim in contract alone. Construed against the background of the contract of employment, in my judgment the pension trust deed and rules themselves are to be taken as being impliedly subject to the limitation that the rights and powers of the company can only be exercised in accordance with the implied obligation of good faith. In Mihlenstedt's case it was not necessary to decide whether the employee's rights rested in contract alone or could be enforced under the trust deed, since the case could be decided in contract alone. However, Nourse LJ expressed the view that as a matter of trust law the employee had no remedy under the pension trust deed (see [1989] IRLR 522 at 525 (paras 11-12)). Nicholls LJ left the matter open (see [1989] IRLR 522 at 531 (para 64)). May LJ dissented. Thus that case does not provide any authority binding on me which drives me to the conclusion that there can be no implied limitation under the trust deed. Although, in certain circumstances, it may be necessary for the members of the scheme to sue in contract (eg to obtain a mandatory order that the company do exercise its powers in a particular way), I can see no valid reason why the members of the scheme should be forced to sue in contract in all cases: contractual and trust rights can exist in parallel.”xiv

Having made that observation, Browne Wilkinson went on to consider whether he could give any further guidance, as the Committee had urged him to do so. He repeated that the test was not whether the Company was acting reasonably. Instead it was whether the behaviour of the Company was in breach of its obligations. Whilst it was “…open to the [Company] to look after its own interests, financially or otherwise, in the future operation of the Scheme in deciding whether or not to give its consent”xv, the duty of good faith did require that the Company should exercise its rights (with the emphasis being that of Browne Wilkinson):
“….(a) with a view to the efficient running of the scheme established by the fund and (b) not for the collateral purpose of forcing the members to give up their accrued rights in the existing fund subject to this scheme. As to (a), in my judgment it would be a breach of the obligation of good faith if the company were to say that it would never consider whether or not to consent to an amendment increasing benefits. In my judgment, the obligation of good faith resting on the company as employer requires that it should consider each proposal for amendment …… put forward by the [Committee] at the time it is put forward in the light of the circumstances that then exist. A blanket refusal by an employer to consider amendments of a kind which are beneficial to the employees and which have for the last 20 years been acceptable to the employer is plainly calculated to undermine the trust of the employees in their employer. Good faith requires the company to consider the proposals each time they are made. If (which the company does not accept) the company has purported to give such a blanket refusal, such refusal was improper and the company is bound to consider each proposal for amendment as it is put forward.

As to (b) above, the starting point must be that there is in existence a trust to provide pension benefits for a closed class of employees. In my judgment, the obligation of good faith requires that the company should not exercise its rights for the purpose of coercing that class to give up its rights under the existing trust. The duty of good faith requires the company to preserve its employees' rights and pension fund, not to destroy them. If there are financial and other considerations which require the fund to be determined, so be it. But if the sole purpose of refusing to consent to an amendment increasing benefits is the collateral purpose of putting pressure on members to abandon their existing rights (including the right to the surplus on determination) in my judgment the company would not be acting in good faith.”xvi

There was one further point which needed consideration. Counsel for the Company urged Browne Wilkinson to consider whether it was legitimate for the Company to have regard to its own financial interests, in the sense that it was an ultimate beneficiary of the New Scheme’s assets. In other words, could it withhold consent for the purpose of promoting the transfer of members’ benefits so that any surplus ultimately could become available to its usexvii. Browne Wilkinson disagreed saying “If the sole purpose of withholding consent to increased benefits out of the [Scheme] ……was to force its present and past employees to give up their accrued rights in an existing fund so as to confer on the [Company] benefits that it cannot enjoy unless the members give up such rights,…”xviii that would conflict with the duty to act fairly and in good faith. He went on to say “the [Company] could not, without breaching the duty of good faith, seek to coerce an employee in giving up say a car which was his own property; no more can the employer seek to coerce the employee to give up another species of property, i.e. his rights to the pension fund”xix.

On the facts of the case, Browne Wilkinson observed there were no obvious financial or other reasons why the Company should not provide non-contributory pensions and guaranteed inflation linking up to a maximum of 15% subject to an obligation on the members to surrender part of their initial pension: that was what was being promised under the New Scheme. The Committee was prepared to reopen the Scheme, and yet the Company was refusing to consent to increases over 5%, and seeking to induce transfer to the New Scheme. The only inference from that was that the Company wanted the surplus in the New Scheme, and if so, it was not consenting so as to use the Scheme assets other than exclusively to provide Scheme pensions, but for a collateral purpose which would be unlawful.xx

A more recent application of the doctrine – the Prudential case

All the statements made in Imperial Tobacco set out above were quoted and applied much more recently in the case of Prudential Staff Pensions Limited v Prudential Assurance Co Limited and Othersxxi. Again, this was a dispute about increases to pensions in payment. Historically, the employer had provided for discretionary pension increases in line with RPI within the defined benefit section of the Prudential Staff Pension Scheme (“the Scheme”), but in 2005, the employer, Prudential Assurance Co. Ltd (“Prudential”), decided in future to award increases in line with RPI subject to a 2.5% per annum maximum. Previously, awards had
been made on a discretionary basis, at a rate higher than that, and it was argued for the beneficiaries that the previous policy gave them a legitimate expectation of such increases. Hence when Prudential decided to cut the discretionary increase, one important question which arose was whether the decision to cut was in breach of the implied obligation of good faith.

Having reviewed what Browne Wilkinson had said in Imperial Tobacco, the judge (Newey J) went on to look at some of the other subsequent circumstances and cases in which the implied duty had been applied. He began with Stannard v Fisons Pensions Trust Ltdxxii where it had been said that it might “even be that for [an employer] to make a reduction [in its rate of contribution to a pension scheme] would in some circumstances be a breach of contract with its employees.”xxiii Furthermore, in National Grid Co Plc v Laws [1997] PLR 157@[88], Robert Walker J had noted that “the Imperial Tobacco duty does not prevent the employer from looking after its own financial interests, even when they conflict with those of members and pensioners”. That approach was endorsed by the House of Lords in National Grid Co plc v Mayes [2001] UKHL 20@[11]xxiv. Also, in Hillsdown Holdings plc v Pensions Ombudsmanxxv, Knox J had noted that the obligation of good faith was short hand for “the implied obligation…that powers should not be exercised so as to destroy or seriously damage the relationship of confidence and trust between the employer and its employees and former employees”xxvi. However, that formulation did not carry the implication that a failure to observe the implied obligation would necessarily amount to bad faithxxvii. In Hillsdown, Knox J had gone on to say that (in relation to a power to suspend or determine contributions):
“The other power which Hillsdown [ie the employer] had was to suspend or determine its contributions .... Clearly that power was given to it for its own benefit and there can be no question of fiduciary duty being owed in relation to its exercise. But where it does seem to me that the obligation of good faith would have applied to restrain Hillsdown's unilateral pursuit of its own interests without a proper regard to those of its employees and retired employees would have been in a combined operation of the power to adhere further employers while at the same time suspending its contributions which would otherwise have been payable in respect of them for the purpose of running down a surplus certified to have arisen ex hypothesi in relation to the service of the employees of other employers which were in the ...scheme before the date as at which the surplus was certified. I say this for two reasons. The first is that the surplus thus certified was in the disposition of the trustees alone under the express terms of r 23(a) [of the relevant trust deed] and Hillsdown had no right to interfere with its exercise and, secondly, because it would in my view constitute a breach of the implied obligation of good faith on the one hand to enlarge the class of employers and so bring in large categories of new members and at the same time to decline to make contributions in respect of such new members for the purpose of running off a surplus which had arisen in relation to other members who were members at the time as at which the surplus was certified. It is one thing for an employer to take a contributions holiday in respect of a category of existing members and quite another to introduce a large class of new members and take a contributions holiday in relation to them so as to accelerate the effect of the contributions holiday in relation to the existing members”xxviii.

Lastly, reference was made to Lord Millett’s words in the Privy Council judgment in Air Jamaica Limited v Charltonxxix where, in relation to an employer’s power of amendment, he said that the “company [i.e. the employer] was not entitled simply to disregard or override the interests of the members. Once it became likely that the plan would be wound up, the company would have to take this fact into account, and it is difficult to see how the plan could lawfully be amended in any significant respect once it had actually been discontinued. But even if it could…it could not be amended in order to confer any interest in the trust fund on the company. This was expressly prohibited by….[the rules]. The 1994 amendments included a purported amendment to the trust deed to remove this limitation, but this was plainly invalid. The trustees could not achieve by two steps what they could not achieve by one”.xxx

Having reviewed the operation of the duty in the context of pensions, Newey J turned to look at the employment context, where he found a number of key points; first, that the employer’s motives were irrelevant, so that “If conduct objectively considered is likely to cause serious damage to the relationship between employer and employee a breach of the implied obligation may arise”xxxi; second that “The test is a severe one. The conduct must be such as to destroy or seriously damage the relationship”xxxii; and third, that in dealing with staff, an employer “…should be honest….and refrain from untruthful, unfair or insensitive conduct”xxxiii. He completed his review of the House of Lords authorities with a quotation from Eastwood v Magnox Electric plc in which it was said “The trust and confidence implied term means, in short, that an employer must treat his employees fairly. In his conduct of his business, and in his treatment of his employees, an employer must act reasonably and in good faith”xxxiv. In addition, Newey mentioned two other cases, Clark v Nomura International plcxxxv and Keen v Commezbank AGxxxvi, as authority in connection with the payment to employees of discretionary bonuses, which he must have thought were relevant to the facts in hand. In Clark v Nomura, Burton J said that “Even a simple discretion whether to award a bonus must not be exercised capriciously by ………or without reasonable or sufficient grounds”xxxvii. In Keen v Commezbank, he noted that Mummery LJ had said that “Consistent with [the] duty an employer ought to supply an employee with an explanation of the reasons for the exercise of a discretion in respect of additional pay. Unless there is a good reason to the contrary, the explanation ought to be given by the person(s) reasonable for the decision affecting the additional pay”. He then went on to say “If the parties have agreed that an employer should have a discretion to decide, by reference to certain factors, whether an employee should be paid additional remuneration by way of bonus for work done under the contract of employment and, if so, how much, the employer is under an obligation to treat his employee fairly and explain the situation. This would involve making known to the employee, quite apart from any duty of disclosure in litigation, the factors which would have influenced the decision, by whom the decision was taken and the reasons for the decision taken”.xxxviii

There followed a discussion based around the parties’ differing submissions as to the scope of the duty. The question posed by counsel for the members was whether the duty of good faith was simply an obligation to act fairly, or whether it implied “fair and open dealing”xxxix in the sense that the decision reached and the substance of the decision were both subject to scrutinyxl. Prudential’s counsel argued that put the test too high, as whilst Prudential accepted a perverse or irrational decision could be attacked, there was no requirement for an employer to assume what was in effect the duty of a trustee to take account of all relevant matters when reaching the decision. Hence, if “fair dealing” was relevant at all, it did not require the employer to arrive at a “fair result” or balance its interests in a “fair” or “reasonable” way against those of the membersxli. Newey J noted that none of the post-Imperial cases, or any of the employment cases, gave rise to a general rule that decisions had to be substantively fair.xlii In his view “…a power to increase a pension…requires a genuine and rational, as opposed to an empty or irrational exercise of discretion”xliii. Furthermore, whilst an employer’s decision could not be perverse or capricious, that did not equate to an application of an objective standard of reasonablenessxliv. As to the question of how far members’ interests were relevant, Newey’s view was that “…members’ interests and expectations may be of relevance when considering whether an employer has acted irrationally or perversely. There could potentially be cases in which, say, a decision to override expectations which an employer had engendered would be irrational or perverse. On the other hand, it is important to remember that powers such as that in issue in the present case are not fiduciary. As a result, the donee of the power is ….. entitled to have regard to his own interests when making decisions….That fact must limit severely the circumstances in which a decision could be said to be irrational or perverse”xlv. There was no obligation on an employer only to make a decision “giving proper consideration to the matters which are relevant and excluding from consideration the matters which are irrelevant”, as the duty of good faith was not fiduciaryxlvi. However, the manner in which an employer arrives at a decision could be material to determine whether there had been a breach of the obligation of good faith. Newey went on “matters relating to internal decision-making may be capable, as it seems to me, of shedding light on whether an employer has acted irrationally or perversely or …. Whether there has been a “genuine and rational, as opposed to an empty or irrational exercise of discretion” but differently, a failure of process, if sufficiently insignificant, may, once known to members, be likely to undermine trust and confidence”.xlvii

What all parties did agree upon was that the matter had to be approached on an objective basisxlviii, so that an employer’s purpose was to be decided objectively, rather than by reference to what the employer subjectively intended. But Newey did not exclude the possibility of an employer’s subjective purpose being relevantxlix, and that must surely be correct.

Finally, Newey went on to consider the facts, and found that Prudential had not acted contrary to the duty of good faith. There were a number of reasons put forward by the members to suggest it had, all of which were rejected. For instance, there was a suggestion that Prudential took the decision before the results of the 2005 actuarial valuation were properly known. That suggestion was rejected. It had enough actuarial information at the time, even though the valuation technically was not finalised. And nor did it matter (as the members suggested) that the trustees had not yet finished their consideration of the proposals, as Prudential was not bound to delay its decision until the trustees had completed their review (though it would have had to revisit the decision had the trustees objected). Also, that Prudential had not engaged in any genuine negotiation with the trustees, ahead of the decision, did not matter, as they were not bound to do so, and hence their decision was not perverse as a result. Indeed, some warning of the decision had been given in papers and presentations given to the trustees between June and September 2005. Also, there were suggestions that there had been inconsistencies between presentations given to the trustee ahead of the decision and the decision itself. Now it was true that minutes of a meeting on 14 September 2005 may not have been entirely accurate, and a presentation given by Watson Wyatt, the actuary, on 9 November might conceivably have been more a summary than a full account of the proposals, but anyone wanting a full and reliable account of what was intended could have gone to Prudential itself, so that “…any misunderstanding on the part of Trustee directors (even if generated by infelicities in what they were told) would not render Prudential’s decision irrational or perverse”l. Nor did it matter that Prudential’s decision had not taken account of the fact it had taken a contribution holiday previously, or that it was its insistence to move to gilts that had produced the deficit identified in the 2005 valuation. Above all, as to a lack of consideration of members’ expectations, the employer had taken them into account but was able to have regard for its own interests as well.

Some conclusions

Whilst the duty of good faith clearly extends to the pensions context, there are some significant differences between the way it applies there, from the way it applies in the purely contractual context. For instance, it is clear that the duty is owed not only to existing (active) employees/members, but also to those who have left service (i.e. deferred pensioners, and pensioners). Also, it seems from the National Bus caseli that the duty is owed to the trustees as well as the members, although this may simply be a reflection of the fact that it could be enforced against the employer by an action brought by the trustees in a representative capacity. There seems also to be a difference in whether the duty can be excluded. The case of Reda v Flag seems to suggest that an express term of the employment contract can oust the duty of good faith. By contrast, in the pensions context, the Pensions Ombudsman decision in Cyteclii suggests otherwise, largely because the members are not party to the trust deed, and hence would not be bound by a provision ousting the duty which is contained in that deed. Whether that is correct or not is debatable, as quite clearly as a matter of general trust law, beneficiaries are similarly not party to the trust deed, but are still bound by trustee exoneration clauses contained therein. If, on the other hand, the employment contract contained a term ousting the duty in connection with the exercise of functions under the pension scheme, that clause surely would be upheld. Lastly, there is the effect of a successful claim. In the purely contractual context, the appropriate remedy is damages. Where, however, a claim brought against the employer under the trust succeeded, the result would be that the relevant decision of the employer was set aside. I cannot think of any case where damages have been awarded, although that is not to say they never would be. So were the claim to succeed, the parties are in effect put back to the position they would have been in had the decision never been made, which means that a breach of the duty (if proven) has considerable nuisance value.
There are other situations where the duty has been recognised. In National Grid, for instance, the following was said:
““Mr Ham gave some examples, suggested by decided cases, of breaches of this duty of good faith:

(a) withholding consent to increased benefits for members of one trade union while granting it for members of another (see Imperial Tobacco case at p597);

(b) withholding consent to an amendment increasing benefits for the collateral purpose of putting pressure on members to abandon some of their existing rights (see Imperial Tobacco at p599);

(c) introducing new participating employers, and so introducing large numbers of new members of a scheme, while the principal employer itself takes a contribution holiday (see the Hillsdown case [1997] 1 ALL ER 862 at p890); and

(d) threatening to use a power to suspend contributions in order to put pressure on trustees to surrender existing powers (see the decision of the Ombudsman in the National Bus Company case [1997] PLR 1, 18 (paragraphs 78-80))”

This does not mean, however, that the test is whether the situation in which a breach is alleged falls into an accepted list of circumstances where the duty will be upheld. Rather, the test is simply whether a duty has been breached. The duty of good faith is proscriptive rather than prescriptive (in the sense that it limits what the employer can do rather than informs what the employer should do). For that reason, it is capable of applying to any power that is exercised under a pension scheme, and the question then is simply whether the employers conduct is such as to create a breach.

In conclusion, the following is a (by no means exhaustive) list of pointers that employers should observe to try and avoid a breach:

  • take decisions based upon proper considerations, and record the basis for any decision taken or not taken;
  • deal with trustees in a open and transparent manner;
  • avoid threatening or coercive correspondence and conduct;
  • listen seriously to any contrary proposals or objection;
  • adopt realistic but not over generous time scales to deal with trustees or member representatives;
  • avoid blanket refusals;
  • avoid hollow exercises of discretion;
  • involve trade unions and follow any set procedures for change set down in collective bargaining agreements etc;
  • be prepared to give proper information to explain reasons.