High Court refuses to imply duty of good faith in relation to exercise of contractual right

In a decision earlier this year, the High Court refused to imply a duty of good faith in relation to a contractual right to amend a loan note instrument: Myers and another v Kestrel Acquisitions Ltd (Kestrel) and others [2015] EWCH 916 (Ch).

The judge cited the fact that the contractual documentation was "extensive and detailed" and the parties were professionally advised and at arm's length with one another. If they had intended that there should be a duty of good faith, they would have said so expressly but, instead, they agreed other provisions that protected the claimants' interests. This suggested that no such duty was intended.

The judge also drew a distinction between (a) a discretion that involves an assessment being made or a choice from a range of options and (b) a binary choice as to whether or not to exercise an absolute contractual right. The decision suggests that a duty of good faith is unlikely to arise in the latter situation.

This is one of a number of recent cases in which the courts have been invited to imply a duty of good faith into a contract.  On some occasions, the courts have been willing to do so – see for example our posts on the decisions in Yam Seng Pte Ltd v International Trade Corporation, Bristol Groundschool Limited v Intelligent Data Capture Limited and MSC Mediterranean Shipping Company S.A. v Cottonex Anstalt.

This latest decision goes in the opposite direction and fuels the debate as to the circumstances in which a duty of good faith will be implied.  While this debate continues, litigants can be expected to test the parameters of the duty and, in light of this decision, possibly also the distinction between decisions that are binary and those involving a range of options, which in practice may not always be easy to draw.

In view of the continuing uncertainty as to the scope of implied duties of good faith, it is advisable for contracting parties wishing to include such a duty to define the nature and extent of the duty in express terms.  Conversely, if contracting parties do not wish to be subject to a duty of good faith, it may be advisable to exclude it expressly.

Gregg Rowan, a partner in our disputes team, and Corina Demeter, a trainee solicitor, consider the decision further below.

Background

The first defendant issued vendor loan notes (VLNs) to the claimants and discount loan notes (DLNs) to its investors, who were also defendants. The VLNs were created by a Vendor Loan Note Instrument (VLNI) and the DLNs by a Discount Loan Note Instrument (DLNI). These parties and various others also entered into an inter-creditor agreement (ICA) which ranked the first defendant's debts.

Clause 9.1.2 of the VLNI allowed the first defendant to "make any modification" to the instrument unilaterally, as long as this was consistent with any modification to the DLNI. Clause 2.4.2 provided that, if the DLNI or the terms of the DLNs were modified, equivalent amendments should also be made to the VLNI and the VLNs. Various modifications were subsequently made to the VLNI with the effect that their repayment dates of the VLNs were postponed and they were subordinated to newly issued loan notes.

The claimants argued that the right to amend the VLNI was subject to an implied term that the amendments had to be made in good faith and for the benefit of the VLN and DLN holders as a whole. It was common ground that there is no general duty of good faith in commercial contracts but such a duty may be implied when in accordance with the presumed intention of the parties.

The claimants' contention in favour of a duty of good faith was based partly on clause 2.3, which stated that the DLNs and VLNs should be treated "in the same manner as if they constituted a single class of securities". The claimants argued that, as the minority within a larger single class of note-holders made up of their VLNs and the DLNs, they had a reasonable expectation that their rights would not be eroded except where the majority were acting in good faith. Secondly, they argued that, without an implied duty of good faith, there would be a "gap" in the contract which would create a risk that the majority could deprive them of their rights. Lastly, they argued that, in accordance with well-established authority, as this was a contractual discretion it had to be exercised in good faith.

Decision

The court (Sir William Blackburne) held that no duty of good faith should be implied. The contractual documentation was "extensive and detailed" and the parties were at arm's length with one another. It was unlikely that they omitted to insert an important term. That the parties had evidently considered protecting the claimants but had not included a duty of good faith suggested that no such duty was intended. The judge also expressed reluctance to imply a term that would constrain the first defendant from obtaining further investment from other sources.

With those considerations in mind, the judge cited three reasons for refusing to imply a duty of good faith.

(i) The VLNs and DLNs did not constitute a single class

The VLNs and DLNs did not constitute a single class – they were created by different instruments and there was nothing in the DLNI to suggest that the DLNs formed part of a wider class. The holders of the DLNs were not parties to the VLNI.  Even if the VLNI did contain a duty of good faith, this could not operate to require the defendant investors, as holders of the DLNs and part of the majority noteholders, to have regard to the claimants' minority interests, as the holders of the VLNs.

In any event, clause 2.3 proceeded on the footing that the VLNs and DLNs were not one class, instead requiring that they should be treated "in the same manner as if they constituted a single class". This, the judge said, related specifically to the purposes set out in the clause, namely that the notes should rank equally with regard to pre-tax returns. It did not mean they were to be treated as a single class more generally.

(ii) The ICA did not contain a duty of good faith

The DLNs were freely transferable, subject to the requirements of the ICA. There was nothing in either the DLNI or the ICA to indicate to a transferee that his rights under the DLNI were constrained by any duty to have regard to the interests of the holders of the VLNs. The ICA would have been the most obvious contract in which to include a duty of good faith but there was no such term. Instead, the first defendant had an obligation under the VLNI to ensure that the VLNs were treated in the same way as the DLNs and that any amendments to the DLNs would be reflected in the VLNs.

(iii) The discretion involved a 'binary choice'

The judge referred to Mid Essex Hospital Services NHS Trust v Compass Group UK and Ireland Ltd (t/a Medirest) [2013] EWCA Civ 200 where the Court of Appeal considered a discretion as to whether or not to exercise an absolute contractual right, and said this was very different from cases where the discretion involved making an assessment or choosing from a range of options taking into account various interests. The judge concluded that the first defendant's power in clause 9.1.2 to unilaterally modify the VLNI gave the defendant discretion as to whether or not to enforce its power to amend the VLNI. This was a "binary choice" and did not involve choosing from a range of options. The fact that the defendant had this type of contractual discretion did not justify the court imposing a good faith obligation on it.

Comment

This decision adds to the growing body of authorities on the implied duty of good faith and lends further support to the view that litigants are increasingly seeking to rely on such a duty in commercial cases. It is likely to be interpreted as suggesting a narrower role for the duty, particularly in the context of detailed commercial contracts negotiated at arms' length with the involvement of legal advisers. It remains to be seen whether this restrictive approach, and the distinction between decisions that are binary and those involving a range of options, will be adopted in other cases and, if so, the implications.

It is interesting to compare MSC Mediterranean Shipping, referred to above, which was decided shortly before Sir William Blackburne gave judgment.  In that case, Leggatt J (who was also the judge in Yam Seng Pte) held that, in the absence of clear language to the contrary, a contractual discretion must be exercised in good faith and this was also true of a choice whether or not to terminate in response to a repudiatory breach. He did not distinguish between decisions that are binary and those involving a range of options. It is interesting to consider whether, if he had done so, he would still have found that there was a duty of good faith given that, on one view, the claimant was faced with a binary choice between terminating and affirming the agreement.

The distinction may also prove to be a difficult one to draw in practice.  As an illustration, the first defendant could have modified the VLNI in various difficult ways and therefore, on one view, its choice was not binary but involved a choice between a range of possible modifications. This was not the view taken by the judge, who regarded the right to modify the VLNI as giving rise to a binary choice between modifying and not modifying. The distinction may become clearer when considered in other cases.