The Court of Appeal has allowed an appeal against a finding that the majority shareholders of a company had engaged in unfairly prejudicial conduct by removing from office two directors with minority interests, in a case which provides important clarification around the scope and construction of contractual provisions obliging the parties to act in good faith: Re Compound Photonics Group Ltd; Faulkner v Vollin Holdings Ltd [2022] EWCA Civ 1371.

The decision emphasises that good faith clauses must be interpreted by close reference to the particular context in which they appear, and that authorities interpreting similar clauses in other legal or commercial contexts cannot be straightforwardly applied to other situations.

In particular, the Court of Appeal rejected the proposition that it was possible or appropriate to divine from the case law a set of minimum standards that would apply in every case in which a duty of good faith is inserted into a contract, beyond the “very obvious” point that the core meaning of an obligation of good faith is an obligation to act honestly – though it also rejected the argument that a good faith obligation cannot be breached other than by acting dishonestly.

On a practical level, this case serves as a reminder that parties proposing to include an express duty of good faith should define the scope of the duty as clearly as possible within the agreement, including, where feasible to do so, identifying actions that are (or are not) required to satisfy it.

Background

The claim was brought by a group of minority shareholders in Compound Photonics Group Limited (the Company), who alleged that they had been unfairly prejudiced by the conduct of the majority shareholders in forcing one director (S) to resign and removing another (F) from office. Prior to their removal, S was CEO and F was Chair of the Company. Both were among the minority shareholder claimants.

Neither the Company’s articles nor the shareholders’ agreement (SHA) contained an express term entrenching S’s and F’s positions as directors. The claimants instead relied on an express obligation of good faith in the SHA:

“Each Shareholder undertakes to the other Shareholders and the Company that it will at all times act in good faith in all dealings with the other Shareholders and with the Company in relation to the matters contained in this Agreement.”

The claimants asserted that this provision required the majority shareholders to adhere to the inherent “bargain” set out in the Company’s articles and the SHA – namely, that S and F should be entrenched as directors and that the majority shareholders should not prevail over the board in determining the commercial future of the Company. The majority shareholders argued to the contrary that they had complied with the good faith clause by acting honestly and in a commercially justifiable manner.

The High Court found that the removal of S and F as directors had breached the contractual good faith obligation and unfairly prejudiced the minority shareholders: Faulkner v Vollin Holdings Ltd [2021] EWHC 787 (Ch).

In interpreting the good faith clause, the High Court followed Unwin v Bond [2020] EWHC 1768 (Comm) in concluding that once a party is subject to a duty of good faith it is bound by the following “minimum standards”:

  • they must act honestly;
  • they must be faithful to the parties’ agreed common purpose as derived from their agreement (which the trial judge paraphrased as “fidelity to the bargain”);
  • they must not use their powers for an ulterior purpose;
  • they must deal fairly and openly with the other party; and
  • they can consider and take into account their own interests, but must also have regard to the other party’s interests.

The trial judge identified the key content of the parties’ bargain in this case as a “constitutional settlement” in which S and F were to hold the balance of power as central figures on the board of directors, free from shareholder control in the management of the Company. This conclusion was largely based on provisions within the SHA and articles which did not address the issue directly but which, the judge concluded, envisaged that S and F would continue to hold directorships. In removing S and F from their positions, the majority shareholders had therefore not shown fidelity to the bargain and had thereby breached their contractual duty of good faith. The High Court also found that the manner of S’s and F’s removal had breached the procedural element of the Unwin minimum standards, as the majority shareholders had failed to deal fairly with S and F.

The majority shareholder defendants appealed the decision to the Court of Appeal.

Decision

The Court of Appeal overturned the High Court’s decision, ruling that the defendants did not breach the good faith clause in the SHA and had not unfairly prejudiced the minority shareholders. Snowden LJ gave the lead judgment, with which Newey LJ and Carr LJ agreed.

Interpretation of contractual good faith clauses

The Court of Appeal’s decision emphasised that a contractual clause requiring a party to act in good faith can only be interpreted by reference to the context in which it appears. Construction of such clauses cannot be approached in a formulaic way and authorities considering similar clauses in other legal or commercial contexts should be treated with caution.

Snowden LJ acknowledged that a duty of good faith must, at a minimum, have the “core meaning” of an obligation to act honestly, but rejected the High Court’s finding that any good faith clause must be taken to require compliance with the minimum standards set out in Unwin.

Procedural fairness

The Court of Appeal noted that the only basis for the trial judge’s conclusion that the clause in this case was intended to impose a duty of procedural fairness was that such a duty had been found to exist in a number of previous authorities. Those authorities were distinguishable on the basis that none was sufficiently factually similar to provide guidance on how the duty should be applied to the exercise of a shareholder’s statutory right to remove a director. Much closer analysis was required as to how (if at all) the parties had envisaged a duty of procedural fairness working in the context of the statutory procedures.

Fidelity to the bargain

The court made similar observations in reversing the High Court’s finding that the good faith obligation required the defendants to act with “fidelity to the bargain”.

Snowden LJ noted that many of the authorities relied on to support the requirement of faithfulness to the parties’ bargain originated in the United States and New South Wales and related to terms implied by law (for which a single, universally understood meaning would be beneficial) rather than express terms in individually negotiated contracts (where a formulaic approach was less likely to be appropriate). The court therefore expressed doubt as to whether an English law contract relating to an English company should be presumed to include such obligations.

Additionally, the cases relied on for the proposition that the defendants should have had regard to the interests of their counterparties had largely concerned situations in which the decisions of one party could deprive another of the commercial benefit of the contract. The court was sceptical that the same analysis would apply to voting rights in shares, where there is an established principle that a shareholder has a right to vote in their own interest.

The court noted that a number of authorities had pointed out that the interpretation of a good faith clause as requiring fidelity to the bargain may reflect that a contract (particularly a long-term contract) cannot expressly provide for every future situation at the time of drafting. However, considerable caution had to be exercised in applying this concept in the present context, as the nature of a company is that its shareholders have inherent flexibility to amend its articles of association and/or change directors.

Finally, Snowden LJ commented that references to “the spirit of the contract” in the authorities on good faith clauses should not be read as an open invitation to the court to interpret such a clause as imposing substantive obligations or restrictions that were not provided for in the contract itself – especially where the contract was professionally drafted.

The court also rejected the High Court’s findings as to the content of the parties’ bargain in this case. The provisions of the SHA and articles relied on by the trial judge were not sufficient to support the contention that the parties intended S and F to be embedded as directors, and the court questioned why a professionally drafted agreement intended to entrench two directors would not include an express provision to that effect. Moreover, the court did not accept that the SHA was intended to be a constitutional document which altered the fundamental provisions of the Company’s articles by amounting to agreement by the majority shareholders not to intervene in the business affairs of the company.

Dishonesty and bad faith

On appeal, the defendant majority shareholders argued that they could only be found to have breached the duty of good faith if they were found to be dishonest. The Court of Appeal rejected this submission, concluding that (depending on the contractual context) a duty of good faith could be breached by conduct that is in bad faith but is not necessarily dishonest, such as that which would be regarded as commercially unacceptable to reasonable and honest people.