Place your faith carefully - the court re-examines an express duty of good faith in the context of a shareholders’ agreement

03 November 2022

The Court of Appeal has held that an obligation in a shareholders’ agreement to act in good faith did not prevent the majority shareholders of a company from removing its directors.

Three key take-aways
  • The precise scope of an express duty of good faith is a matter of contractual interpretation and depends on the individual circumstances of each case.
  • Apart from acting honestly, there are no automatic elements of a duty of good faith, such as “open and fair dealing”, “procedural fairness” and taking another party’s interests into account.
  • Parties that wish to include a duty of good faith should spell out clearly what it entails. In particular, if they wish to exclude or restrict their existing legal rights, the contract should specifically say this.

What happened?

Re Compound Photonics Group Ltd [2022] EWCA Civ 1371 was an appeal from an earlier decision of the High Court, in which the court found that two founders suffered unfair prejudice when they were excluded from the business of a company, and one of them also suffered unfair prejudice when he was removed as a director.

You can read more about the High Court’s decision in our previous summary. For ease, we have set the key facts out again below.

The case concerned a company established in 2004 by a Dr Sachs and two colleagues to develop a compact projector that could be attached to a mobile phone. That vision arose out of years of academic research by Dr Sachs into gallium arsenide and liquid crystal technology.

In 2005, Dr Sachs met a Mr Faulkner through a tech start-up fund. Mr Faulkner introduced dozens of individual investors (the minority), who, along with Mr Faulkner, invested and subscribed for shares in a new vehicle, which later became a subsidiary of the company in question.

In due course, the business required more capital. In 2010, a new investor – Vollin Holdings Limited – agreed to inject a substantial amount into the company. Dr Sachs, an associate of his and Mr Faulkner were appointed as directors. Vollin was entitled to nominate two further directors (and did so).

In 2013, Vollin increased its investment, resulting in it holding around 80% of the company’s shares. The company adopted new articles of association and the parties entered into a new shareholders’ agreement (SHA). Those documents contained (among others) the following provisions:

  • The SHA stated that the shareholders would “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 the [SHA]”.
  • It also required them to “co-operate with the [board] in the running and operation of the company”.
  • The articles listed certain circumstances in which the directors would automatically leave office. These included where the board resolved to remove the director from office, or where the director became bankrupt or made an arrangement with their creditors.
  • However, the articles specifically prevented the board from removing Dr Sachs and Mr Faulkner as directors. They also said that neither Dr Sachs nor Mr Faulkner would cease to be a director if they became bankrupt or made an arrangement with their creditors.
  • The company’s directors would take decisions by majority vote, but a decision would be effective only if both Dr Sachs and Mr Faulkner voted in favour of it.

In 2014, another company – Minden Worldwide Limited – invested in the business and nominated a director. So, by 2014, the board comprised three “founder directors” and three investor nominee directors. The investors held around 80% of the company’s shares. The remaining 20% were held by Dr Sachs, Mr Faulkner and the other minority shareholders.

The business struggles

The business failed to develop as anticipated. The company was unable to manufacture the product that had generated so much interest. The investors began to lose faith in management, specifically in Dr Sachs and Mr Faulkner, and started to form their own vision for the future of the company.

In 2016, the investors told Dr Sachs that they were not prepared to make any further investment in the company while he remained a director. This ultimately led to Dr Sachs resigning from the board.

Over time, the investor nominee directors began to restrict the flow of information to Mr Faulkner and started to hold discussions on the company’s future without involving him.

Mr Faulkner made various requests for detailed information on the company, attempted to involve himself in meetings organised by the nominee directors, and ultimately began to communicate directly with the company’s shareholders in relation to further funding.

The investors became concerned with Mr Faulkner’s actions. They used their powers under the Companies Act 2006 to call a general meeting, at which they removed Mr Faulkner as a director.

The claim and the initial decision

Dr Sachs and Mr Faulkner claimed that their exclusion from the business, Dr Sachs’ “forced resignation” and Mr Faulkner’s removal had unfairly prejudiced them and the other minority investors.

In particular, they alleged that, by forcing Dr Sachs to resign and removing Mr Faulkner, the investors had breached their obligation of good faith in the SHA.

The High Court agreed. The judge found that the SHA and the company’s articles amounted to a “constitutional settlement” between the company’s shareholders which effectively entrenched Dr Sachs and Mr Faulkner in office as directors. Although the investors, as shareholders, retained an “inalienable right” under UK company law to remove both individuals as directors, they had agreed by way of a private contract that they would not do so.

In deciding what the contractual duty of good faith required, the judge examined previous case law. He decided that it required the investors to deal “fairly and openly” with other, to remain faithful to the “bargain” with the other shareholders and to keep the interests of the minority in mind.

By excluding the two individuals from the company’s business, forcing Dr Sachs’ resignation and removing Mr Faulkner, the investors had not dealt fairly and openly with the individuals or with “fidelity to the bargain” embodied in the constitutional settlement. As a result, they had breached their contractual duty of good faith and broken the constitutional settlement.

The investors had also failed to take the minority’s interests into account by disregarding the fact that they had invested in the business specifically because it had been founded and was being run by Dr Sachs. (In the judge’s words, Dr Sachs was the “jockey they were backing”.)

These actions, in turn, cause the minority to suffer unfair prejudice.

Importantly, the judge felt that, by forcing Dr Sachs and Mr Faulkner out, the investors had been acting in the way they genuinely believed would promote the business, and there was good reason to believe they were right. He also felt that, in the round, Mr Faulkner’s behaviour justified his expulsion, and he acknowledged that, although pressured, Dr Sachs had resigned, rather than being removed.

However, this did not change the fact that the constitutional settlement had been broken.

The investors appealed the decision, claiming that the High Court had interpreted the duty of good faith in the SHA “far too widely”.

What did the Court of Appeal say?

The court allowed the appeal and overturned the High Court’s decision.

Lord Justice Snowden delivered the court’s judgment. He noted that the High Court judge had perhaps applied principles from previous cases too rigidly. Although previous decisions on duties of good faith can be “useful analytical tools” each decision needs to reflect the specific circumstances of the case.

In particular, Snowden LJ noted that the concepts of “fidelity to the bargain” and having regard to the interests of the other party originated in US law and developed in New South Wales in the context of individually negotiated contracts. They cannot, as a matter of English law, “automatically be regarded as incorporated into” a contractual obligation of good faith.

Several of Snowden LJ’s comments also make it clear that the relationship of parties to an “ordinary commercial contract” is “very different” from that between the shareholders in a company. The elements of a duty of good faith in each case are therefore likely to be different (or, at least, will not automatically be the same).

Historically, courts have been more willing to find an extensive duty of good faith where a contract embodies a long-term relationship. But Snowden LJ noted that it is important to exercise “considerable caution” when applying this to an investment in a company, where the contract (i.e. the company’s constitution) and the company’s management can legitimately change over time.

In particular, he said that it “cannot be readily presumed that a good faith clause [will] prescribe how the parties should behave in unforeseen future circumstances” or “[eliminate] flexibility and [entrench] the original structure so that changes cannot be made at all”.

In particular, if parties intend to negate the rights of a company’s shareholders (such as, in this case, the right to vote to remove a director), the courts would expect this to be “expressed clearly and directly”, especially in a “professionally drafted agreement”.

However, neither the SHA nor the company’s articles in this case expressly prohibited the directors from exercising their rights to vote in favour of removing Dr Sachs or Mr Faulkner as a director. Indeed, other parts of the SHA explicitly contemplated Dr Sachs and Mr Faulkner ceasing to be directors.

Moreover, Snowden LJ did not share the High Court’s view that the investors had agreed to forgo any right to play a role in the company’s management and had instead decided to cede control to Dr Sachs and Mr Faulkner.

The company’s articles allowed the shareholders to give its board directions by passing a special resolution. If they had decided to give up their right to participate in management, they would have needed to expressly exclude that right.

Finally, on a more general level, Snowden LJ felt that the idea of a “constitutional settlement” under which Dr Sachs and Mr Faulkner held the balance of power was an “implausible conclusion”. The investors had committed more than $135 m to the company, representing 80% of its equity, and even more finance was required to bring the project to completion. In that context, it was commercially counterintuitive to conclude that the investors had surrendered all control to the minority.

In summary, the express duty of good faith in the SHA required the parties to act honestly towards each other and the company and not to act in a “commercially unacceptable way”.

However, it did not embody the concept of a “constitutionally omnipotent board on which Dr Sachs and Mr Faulkner held an unalterable balance of power” or prohibit the investors from removing Mr Faulkner or (had they wished to) Dr Sachs. Nor did it require the investors to deal openly and fairly with the two individuals or to have regard to the minority’s interest when exercising their powers.

What does this mean for me?

The Court of Appeal’s decision both clarifies what a duty of good faith entails but, at the same time, arguably makes such a duty much harder to define.

For some time, the courts have grappled with the precise extent of the duty, drawing on principles from other jurisdictions and tackling cases on an individual basis. The decision in this case underlines the fact that there is no singular, unified meaning of “duty of good faith”, beyond simply that – a requirement to act in good faith towards each other (whatever that means).

Precisely what a duty of good faith requires will depend on heavily on the facts and circumstances in each individual case. To understand this, the court will look at the drafting of the duty itself, the rest of the contractual arrangements (including the wording of other clauses and any other obligations in the contract) and the context in which the parties entered into the contract.

The judgment leaves open whether “bad faith” is required to breach a duty of good faith. Snowden LJ clarified that a party may end up breaching a duty of good faith if they act in a way that is “commercially unacceptable to reasonable and honest people”, even if they are not acting dishonestly. However, beyond this, it will all depend on the nature of the duty in each individual case.

This can make matters difficult for parties that are considering including in their contract a duty to act in good faith towards each other. It may not be clear quite what obligations the parties are imposing on each other until much later down the line. Indeed, the parties themselves may have very different ideas of what they are committing themselves to.

For this reason, it is important, where possible, to consider and set out precisely in the contract what the parties will be expected to do and not to do. Commercial parties might consider the following.

  • If the parties are required to take each other’s interests into account, they should state this clearly in the contract. It will rarely be appropriate to impose such a duty on the parties at all times. Rather, it may be better to require the parties to consider each other’s interests when taking certain, specified decisions. This will depend on the context.

  • If the parties are to give up any existing rights they have (such as voting rights or rights to participate in decisions), the contract should state this explicitly and unambiguously. The courts will assume that parties do not intend to forgo their legal rights unless they clearly agree to.

  • If the parties are to follow particular procedures (such as giving each other advance notice of decisions or actions they intend to take), again, this should be set out clearly.

Finally, it is important to note that this case concerned an express contractual duty of good faith. Parties are free to decide whether or not to include such a duty in their contract. If they do, the court will interpret the duty in the same way it will interpret any other contractual provisions.

However, in some cases the courts may recognise an implied contractual duty to act in good faith. This might happen in two circumstances:

  1. If the contract is “relational” (i.e. it embodies a more personal relationship between the parties) or expected to be “long-term” in nature, the courts may imply a general duty to act in good faith into the contract. This is sometimes known as a “Yam Seng duty” (after the case of Yam Seng Pte Ltd v International Trade Corp. Ltd [2013] EWHC 111 (QB)).

    A Yam Seng duty may well import many of the concepts which Snowden LJ rejected in this case, such as “open and fair dealing”, a “fair procedure” and considering the other party’s interests. Rather than muddying the waters, including a carefully crafted express contractual duty of good faith in this kind of contract may in fact help the parties to define their relationship more clearly.

  2. In any contract where a party has a discretion to make decisions that affect other parties to the contract, the courts may imply a duty to act in good faith and not irrationally, unreasonably or capriciously. This is now generally referred to as the “Braganza duty” (after the Supreme Court decision in Braganza v BP Shipping Ltd [2015] UKSC 17) and is separate from a general duty to act in good faith.

    The courts will imply this duty (or decline to imply it) on a case-by-case basis, depending on the kind of contractual decision-making power a party has. It is likely to be very difficult to exclude the duty but, if parties wish to do so, they should use the most clear and unambiguous language.