Court of Appeal considers implied variation and good faith in relation to contractual rights of termination

The Court of Appeal has upheld a decision granting summary judgment to a defendant in relation to an allegation that it had wrongfully terminated a distribution agreement. The court rejected arguments based on contractual construction, implied variation and implied duties of good faith : Ilkerler Otomotiv Sanayai ve Ticaret Anonim v Perkins Engines Co Ltd [2017] EWCA Civ 183.

The decision provides useful guidance on when an express variation of a contract may result in the implied variation of other terms, a point on which there appears to have been no direct authority. The test is whether the express variation is consistent only with the existence of the alleged implied term. When agreeing variations to a contract, parties should be careful to consider whether the proposed changes have any knock-on effects on the rest of the contractual framework, which may need to be addressed by way of additional express amendments. It seems the courts are likely to assist a party in implying a variation only in relatively clear-cut cases.

The decision is also of interest in adding to a growing body of authorities rejecting a role for good faith in relation to contractual termination. 

Gregg Rowan and Andrew Hillam, a partner and an associate in our dispute resolute team, consider the decision further below.

Background

The claimant (Ilkerler) had entered into a distribution agreement with the defendant (Perkins) on 1 May 2000.  Perkins was an English company involved in the design, manufacture and supply of diesel and gas engines.  Ilkerler was a Turkish company and, under the terms of the distribution agreement, a distributor of Perkins' engines in Turkey.

The distribution agreement contained two terms relating to termination:

• Article 2.3 stated that the agreement would remain in force for an initial period of three years, following which either party could terminate by giving six months' written notice. 
• Article 19.3 provided that, at any time during the term of the agreement, if Perkins was dissatisfied with Ilkerler's performance, it could request that remedial action be taken within three months.  If Perkins remained dissatisfied at the end of that period, it could terminate the agreement upon a further three months' written notice.

In September 2012, Perkins gave notice of termination under Article 2.3 to take effect at the end of March 2013.  Ilkerler disputed the effectiveness of this notice for three reasons:

1. Perkins should have given notice under Article 19.3 rather than Article 2.3, thereby giving Ilkerler the opportunity to remedy its performance. 
2. The distribution agreement had been impliedly varied by the parties' conduct to the effect that Perkins was not able to terminate before the end of 2015. 
3. In giving notice when it did, Perkins was in breach of an implied term of good faith or fair dealing.   

At first instance, Knowles J found against Ilkerler on all three grounds.  Ilkerler was granted permission to appeal.

Decision

The Court of Appeal (Longmore LJ and Briggs LJ) upheld Knowles J's decision in its entirety, finding that Perkins's termination of the distribution agreement had been effective.   

Construction – choice of method of termination

The Court found it unarguable that, in circumstances where Perkins was dissatisfied with Ilkerler's performance, it was obliged to terminate the agreement using Article 19.3 and precluded from doing so under Article 2.3.  Perkins in fact had a choice between the two methods.

Such a construction did not render Article 19.3 nugatory (as Ilkerler had contended). The two terms fit perfectly well together because, for the first three years, Perkins could not rely on Article 2.3; it was therefore necessary to provide some means of terminating the agreement if Ilkerler's services were unsatisfactory. Even after the end of the initial three-year period, Perkins may still have wished to employ Article 19.3 to encourage Ilkerler to remedy its performance, rather than invoking outright termination under Article 2.3.  Article 19.3 therefore continued to have an effective life after the initial term.   

Implied variation

Around a year before giving notice, Perkins had requested a wholly-owned subsidiary of Ilkerler to become a party to the distribution agreement and had also asked Ilkerler to agree to a "Multi Generation Project Plan".  This "MGPP" ran to the end of 2015 and required Ilkerler to make long-term investments in its business, totalling approximately €6.37 million.  Ilkerler argued that, in view of these (and other) express variations of the distribution agreement, the agreement was necessarily further varied to the effect that Perkins could not give notice to terminate if this took effect before 2015 or (if earlier) before Ilkerler had been able to recoup the substance of its investments.  

No exact authority could be found on the principles to be applied in determining whether an express variation of some terms of a contract could result in implied variations of other terms.  However, the parties agreed that it was appropriate to apply the principles usually adopted in determining whether an implied contract has arisen as a result of the parties' conduct.  Citing the Court of Appeal decisions in The Aramis [1989] 1 Lloyd's Rep 213 and The Gudermes [1993] 1 Lloyd's Rep 311, the court found that it was not sufficient that the express variations relied upon were consistent with there being a variation to the existing contractual framework.  The express variations had to be consistent only with the specific implied variation being contended for.

On the facts of the case, while the court recognised that it may be arguable that the new term proposed by Ilkerler would not be inconsistent with the express variations agreed between the parties, Ilkerler fell down at the second stage of the test.  In other words, the court found it impossible to conclude that the addition of Ilkerler's subsidiary as a party and the agreement of the MGPP were consistent only with a further variation that termination could only take effect after the end of 2015 (or after Ilkerler had recouped its investment). 

Implied terms of good faith or fair dealing

The Court of Appeal found little merit in the two specific implied terms of good faith or fair dealing suggested by Ilkerler, describing them as unnecessary, excessively vague or simply inconsistent with the proper construction of the contract. 

In making its case, Ilkerler had sought to rely upon the judgment of Leggatt J in Yam Seng Pte Ltd v International Trade Corp Ltd [2013] 1 All ER (Comm) 1321 (considered here).  While Longmore LJ described the dicta relied upon as "interesting and informative", he found that they did not support the terms proposed by Ilkerler in the present case.  In particular, he noted that, in the paragraphs of the judgment cited by Ilkerler, Leggatt J had been discussing requirements for communication and co-operation specifically in relation to the performance of the contract, as opposed to its termination. 

It is worth note that, at first instance, Knowles J had been prepared to contemplate the possibility of implying a general term of good faith into the contract, but found that such a term would not have been breached in any event.  Given that Ilkerler had not sought to rely upon a general term of this nature on appeal, Longmore LJ did not find it necessary to comment on the point in detail, but noted that he saw no reason why Knowles J's decision had been wrong.

Comment

The decision provides useful guidance on when express variations of contractual terms can result in the implied variation of other terms.  There was previously no direct authority on this point and, as Longmore LJ himself stated in his judgment, this was the main reason why permission to appeal was originally granted. The decision makes it clear that it is not enough that the express variation is consistent with the alleged implied term. It must be consistent only with the implied variation being contended for. 

As Ilkerler found, this may not be an easy hurdle to meet.  In many cases, an express variation agreed between the parties will be consistent with numerous possible implied variations.  However, a party will only satisfy the above test where the express variation is consistent with only one, single implied variation – ie the one being argued for. 

The Court of Appeal did not consider Ilkerler's arguments on implied terms of good faith and fair dealing in great detail.  Nevertheless, it is of interest that the Court of Appeal effectively found Leggatt J's well-known decision in Yam Seng to be limited to considerations relating to the performance of the contract.  In Longmore LJ's own words, requirements for communication and co-operation in the context of termination (where the parties are likely to be in conflict, rather than working together) "would take one into a different realm altogether".

This adds to a growing body of authorities rejecting a role for good faith in relation to contract termination. The High Court has similarly rejected the argument that a party's contractual right to terminate an agreement should be exercised in good faith in other cases, eg Monde Petroleum SA v Westernzagros Limited [2016] EWHC 1472 (considered here) and TSG Building Services PLC v South Anglia Housing Limited [2013] EWHC 1151 (considered here).

The possibility that good faith could be relevant in the context of whether an innocent party had the right to affirm a contract was raised by Leggatt J in another case, MSC Mediterranean Shipping Co SA v Cottonex Anstalt [2015] EWHC 283, but the Court of Appeal upheld that decision without resorting to good faith and, moreover, Moore-Bick LJ said that he did not think that it was necessary or desirable to do so (see our blog post here).