The concept of good faith has drawn much attention in recent years, following the landmark decisions of Yam Seng Pte Ltd v International Trade Corp. Ltd. [2013] EWHC 111 (QB) and Mid-Essex Hospital Services NHS Trust v Compass Group UK and Ireland Ltd [2013] EWCA Civ 200, with much of the debate focusing on whether courts will imply a duty to act in good faith into certain types of agreement.
‘Good faith’ obligations are often inserted where the parties are unable to agree to more specific obligations, either because one party lacks the leverage to extract any more specific obligations or because the future specific obligations are unknown at the time of drafting.
We begin by looking at obligations to negotiate in good faith, taking the obligation to produce an exit plan as an example where express good faith obligations may arise. This may be at the outset of a long term agreement where it is not possible to agree a detailed exit plan at that stage or at the end of a relationship as part of either a contentious or managed exit. We conclude by examining express obligations to act in good faith which have a different genesis in the case law.
Negotiating in good faith
The case law in relation to negotiating in good faith is relatively settled. In Walford v Miles [1992] 2 AC 128, Lord Ackner stated that ‘the concept of a duty to carry on negotiations in good faith is inherently repugnant to the adversarial position of the parties when involved in negotiations’. Exceptions were made in Cable & Wireless plc v IBM United Kingdom Ltd [2002] EWHC 2059, where the court enforced an obligation on the parties to, in good faith, enter into ADR to resolve disputes, and in Petromec Inc v Petroleo Brasileiro SA Petrobras (No. 3) [2005] EWCA Civ 891, where the High Court enforced an obligation to negotiate in good faith the reasonable costs of upgrading a vessel. It did this on the basis that this obligation was sufficiently narrow in scope and there were objective criteria for assessing the agreement the parties were to have reached.
Obiter comments in Petromec that it would be ‘a strong thing to declare unenforceable a clause into which the parties have deliberately and expressly entered’ hinted courts may be open to enforcing good faith negotiations. However, the Court of Appeal in Barbudev v Eurocom Cable Management Bulgaria EOOD [2012] EWCA Civ 548 followed the settled formula, and refused to enforce a wide obligation in a side-letter requiring the parties to negotiate the main agreement in good faith. Furthermore, Longmore LJ considered Petromec and Barbudev in Charles Shaker v Vistajet Group Holdings SA [2012] EWHC 1329 (Comm) and emphasised the exceptional nature of Petromec, stating that ‘where there are no objective criteria the court is unable to enforce the parties’ agreement to agree’. Caution should therefore be exercised when including obligations to negotiate in good faith in commercial contracts, and it will be only in rare situations where this will impose any binding obligations on the parties.
All is going well: drafting at the outset of the agreement
The exit plan is an important component of any outsourcing contract, as it is one of the key areas of risk for the customer. At the end of the contract, the customer will want to migrate the services from the outgoing supplier to an incoming supplier or back in-house, with all that entails for people, assets, sub-contracts, data and know-how. The exit plan will set out the parties’ detailed obligations in order to carry out the exit without disrupting the customer’s business. Yet, when negotiating an outsourcing agreement at the start of the commercial relationship, the exit plan is often the last thing on anyone’s mind. In any event, if the project involves an element of transformational activities then any exit plan drafted pre-contract will become out of date very quickly. The result is often that the exit plan is not included in the agreement at execution or is provided only in template or draft form.
Where this happens, the outsourcing agreement should include an obligation on the supplier to produce an exit plan within a certain period of time following contract signature, and to keep it updated through the life of the agreement. The exit schedule should include detailed obligations on the supplier at a high level. Among other things, the supplier will be required to: maintain a list of relevant assets, databases and contracts and to transfer, assign or procure the novation of them to the customer or replacement supplier; provide information and assistance with any re-tendering of the services; ensure appropriate knowledge transfer; return or deletion of data; and restrictions on reassigning personnel to ensure that key personnel remain throughout the exit period and that the supplier doesn’t inflate the number of staff who may transfer back to the customer or a replacement provider as part of a TUPE transfer.
The customer will want to have a tightly controlled process for updating and agreeing the plan which includes a right for the customer to approve the plan and an obligation on the supplier to incorporate the customer’s reasonable comments. The supplier, on the other hand, will want to ensure that the customer cannot impose an exit plan and that the supplier has sufficient input into the process. An agreement to agree an exit plan ‘in good faith’ is likely to be unenforceable as, following Petromec, there is no objective set of criteria which the court can use to determine what the result of the negotiations would be.
No matter what goes into the agreement, it is all too common for the parties to forget about the exit plan until expiry or termination of the agreement. By this point, the relationship may have soured and the supplier knows it’s on the way out, and so this is hardly the best time to rely on the supplier producing a fully worked-through and appropriately detailed exit plan.
This can be avoided by having appropriate tools in the agreement from the outset. For example, production of an exit plan should be a key milestone in transition (or transformation, where relevant) with a payment attached, so that the supplier does not receive the payment until the customer has approved the exit plan.
Exit plans can also become out of date as a project develops. The supplier will have a number of obligations recurring annually, which may include updating the business continuity and disaster recovery plan or carrying out value for money and continuous improvement reviews, as well as updating the exit plan. In practice, these obligations are often honoured more in the breach than the observance. The customer should therefore consider including in the agreement a right to withhold a portion of the annual fees subject to the completion of these annual obligations. This will ensure that the supplier is appropriately incentivised to maintain the exit plan. In addition, customers should consider the use of contract management tools to ensure that key contractual dates are not overlooked.
Contentious exits: drafting on the way out
Not every project goes to plan and circumstances change. What happens when the agreement comes to an end but the exit plan has not been produced or, if it does exist, does not match the specific exit scenario facing the parties? The case of AstraZeneca v IBM [2011] EWHC 306 (TCC) provides a warning aboutf the ways that exit can go wrong if the exit plan hasn’t been produced or is unclear as to the parties’ obligations on exit.
The more contentious the exit, the more difficult negotiating the terms of that exit will be. Often, in circumstances where there have been allegations of material breach and arguments as to responsibility for delay or other problems, the parties will be able to agree to a ‘managed’ exit over the course of a number of months. With a backdrop of arguments as to fault and difficult relationships, a customer is likely to be wary of an obligation on the supplier to agree an exit plan in good faith. It will have concerns about the supplier co-operating on exit and so will want to set out the detail of the exit in any settlement agreement. Equally, the supplier will want to ensure that its obligations on exit are clear and that it is being paid properly for work undertaken on exit. A smooth transition is going to be of utmost importance to the customer so clear detailed obligations will be preferred. If this is simply not possible as the detail is not known or there is a tight timetable for settlement, the parties should agree as much of the commercial terms around exit as they can. If the customer is stuck with an obligation of good faith (because it’s all the parties can agree), the wording of the obligation becomes important. The courts are unlikely to enforce the obligation to negotiate in good faith, but an obligation to act in good faith (for example to provide good faith co-operation) may have more success.
In reality, the most effective way to ensure that the supplier produces and carries out an effective exit plan is to pay them properly for exit. This may be payment on a time and materials basis (subject to a reasonable cap to prevent an exorbitant final bill) or milestone payments attached to certain transition milestones, but should ensure that the supplier is sufficiently motivated to see exit through to completion. Evidently, much of this could be avoided if the parties have planned for exit at the outset and managed the exit plan during the life of the contract.
Acting in good faith
The courts have been much more willing to enforce express obligations to act in good faith. In both Mid-Essex Hospital Services NHS Trust mentioned above and Portsmouth City Council v Ensign Highways Limited [2015] EWHC 1969 (TCC), the court considered express obligations of good faith in the outsourcing context where the suppliers disputed the award of service failure points by the respective customers. In each case, the court interpreted the good faith obligations narrowly, so that they didn’t cut across other express obligations in the agreements.
In Portsmouth v Ensign, Ensign claimed that Portsmouth CC had breached an express obligation of good faith by changing how it exercised its discretion to award service failure points. The contract gave the council discretion to award service failure points and included a tariff of maximum ‘awards’ for any service failure by Ensign. As circumstances changed, the council came under increasing budget pressure and began awarding the maximum service failure points possible for each service failure. The court considered clause 44 (Best Value) and in particular clause 44.4.1 which stated that ‘PCC and [Ensign] shall deal fairly, in good faith and in mutual co-operation with one another and with Interested Parties.’ The court held that as the award of service failure points was discretionary and did not involve any co-operation, it was not covered by clause 44.4.1, which appeared in its context to be primarily concerned with the best value provisions. These cases emphasise that care must be taken when drafting good faith obligations, particularly in relation to the scope of the obligation, as the courts are likely to construe it narrowly.
Despite rejecting a wide obligation to act in good faith, the court in Mid-Essex Hospital Services NHS Trust and Portsmouth v Ensign found, in each case by applying the standard contractual rules of interpretation, that the customers in exercising their discretion were under an implied duty to act honestly and on proper grounds and not in a manner that is arbitrary, irrational or capricious. Unfortunately, the court didn’t specify how this standard was different from good faith!
There has been no clear dicta on the precise meaning of good faith in the commercial context, with each conclusion being based on the particular facts of the case in question. However, some key strands emerge. Honesty is a core element of good faith (as in Mid-Essex Hospital Services NHS Trust and Portsmouth v Ensign), and the court held in Horn v Commercial Acceptances [2011] EWHC 1757 (Ch) that good faith required the disclosure of all material facts.
In Yam Seng, the court asked the question whether ‘in the particular context the conduct would be regarded as commercially acceptable by reasonable and honest people’. Again, the court emphasised the role of honesty and also the second element of good faith, being some level of ‘commercial acceptability’. In Bristol Groundschool Ltd v Intelligent Data Capture Ltd [2014] EWHC 2145 (Ch), bad faith was interpreted to mean ‘commercially unacceptable’, and the court found that IDC had acted in bad faith by improperly accessing Bristol Groundschool’s computer systems.
In a similar vein, the court in CPC Group Limited v Qatari Diar Real Estate Investment Company [2010] EWHC 1535 (Ch) held that good faith required the parties to ‘adhere to the spirit of the contract, to observe reasonable commercial standards of fair dealing, to be faithful to the agreed common purpose, and to act consistently with the justified expectations of [the other party]’. In Berkeley Community Villages Ltd v Pullen [2007] EWHC 1330 (Ch), good faith prevented action that frustrates the purpose of the agreement.
Recently, at a hearing to decide whether to grant injunctive relief preventing termination of the agreement (BT Cornwall Ltd v Cornwall Council [2015] EWHC 3755 (Comm)), Cornwall Council was found not to have breached a duty to act in good faith in relation to ‘a continuing Partnership dialogue’ by exercising its right to terminate for material breach for failure to meet the agreed KPIs. The narrowly interpreted clause was held to have no bearing on the exercise of contractual rights. In addition, despite evidence that the Council may itself have caused a large number of faults, the court found that there was good faith and an absence of capriciousness.
It is not clear from these standards of honesty and commercial acceptability what may be expected in any given situation from a party under an express obligation to act in good faith. When drafting an agreement, it is preferable to bolster any obligation to act in good faith with a reasonableness obligation (whether best, all reasonable or simply reasonable endeavours). In order to reduce the burden placed on the good faith obligation, the parties should, where possible, spell out in greater detail what they are hoping to achieve, perhaps with more specific obligations (provided the scope of the good faith obligation remains clear) or by including a stated common purpose.
Conclusion
Express obligations to negotiate in good faith will nearly always be unenforceable and should not be relied upon when drafting a commercial agreement. Having said that, in situations where other commercial tools are not available, the parties’ respective commercial teams may derive some comfort from the words ‘good faith’ to reflect the goodwill between the parties. Duties to act in good faith are more likely to be enforceable, and require behaviour which is honest and not commercially unacceptable, although there remains no clear definition of good faith and each case involving good faith has so far been considered in the context of specific facts. Where it is included, in each case, the scope of the good faith obligation should be explicit, as the courts have tended to interpret any such obligations narrowly.
Michael Butterworth is a Commercial Technology associate at Kemp Little LLP.
Rachel Kane is a trainee at Herbert Smith Freehills LLP.
