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Case law: Court changes test for deciding if a contract is ‘relational’ so an implied duty to act in good faith applies

Parties negotiating a proposed agreement need to be aware that a different test will apply when deciding whether it is a ‘relational contract’, so that a duty to act in good faith will be implied, following a recent ruling.

November 2019

This update was published in Legal Alert - November 2019

Legal Alert is a monthly checklist from Atom Content Marketing highlighting new and pending laws, regulations, codes of practice and rulings that could have an impact on your business.

Traditionally, the courts have only implied a term into a contract if the term satisfies the strict test that it is either:

  • necessary to give business efficacy to the contract (so, if the agreement works without that term in it, the term will not be implied); or
  • so obvious it goes without saying.

Further, a term should only be implied if it is reasonable and equitable; if it is capable of clear expression; and if it does not contradict any express term of the agreement. Importantly, the implied term must not be inconsistent with an express term of the contract.

However, in several recent cases the courts have also ruled that a term saying the parties must act in good faith will automatically be implied into a ‘relational’ contract. The rationale is that such a term is essential to give effect to the reasonable expectations of the parties to such a contract, and so it satisfies the business necessity/efficacy test.

If it applies, the implied duty means ‘that the parties must refrain from conduct which in the relevant context would be regarded as commercially unacceptable by reasonable and honest people’. Each party can ‘trust that the other party will act with integrity and in a spirit of cooperation’.

In those cases, a contract has generally been held to be relational if the parties’ relationship is more than purely commercial – if there is a strong personal and collaborative element to it. In one recent ruling the High Court went further and set out a (non-exhaustive) list of specific characteristics to be applied when determining whether a contract was relational.

However, the court has recently taken a different approach in a case involving an investment and shareholders’ agreement (ISA). The facts were complex but the court said that, rather than identifying and weighing specific factors indicative of a relational contract, the better approach was to consider ‘whether a reasonable reader of the contract would consider that an obligation of good faith was obviously meant or whether the obligation is necessary to the proper working of the contract’.

It said the question was therefore ‘… whether a reasonable person reading the ISA at the time that it was made, with knowledge of the circumstances in which it is entered into (though not the negotiations of the parties or their drafts and preparatory documents) and the other agreements made as part of the same transaction, would consider that it was obvious that [the first party] had to act in good faith in all its dealings with [the second party], and vice versa, or whether such an obligation is necessary to give coherent business effect to the ISA’

However, it also said: ‘The overall character of the contract in issue will of course be highly material in answering that question but so will its particular terms, as recognised by the principle that … no term may be implied into a contract if it would be inconsistent with an express term.’

Using this new approach, the court took the view that the contract was not relational, for reasons including:

  • The ISA (and associated documents) were extremely detailed and professionally and skillfully drafted. This made it more difficult to imply terms because it raised a strong inference that the parties had given careful consideration to all the terms by which they agreed to be bound, and had chosen not to include an express duty of good faith. The exception would be if the subject matter of the contract was such that, by its nature, it was difficult to set out and agree in advance all the terms that would govern the relationship –that did not apply in this case.
  • The ISA contained express obligations of good faith in some circumstances but not a general obligation to do so. The draftsperson could have expressly provided for an overall duty to act in good faith if that is what the parties had really intended, but had chosen not to.
  • There were instances where the parties, in the exercise of their rights under the contract, were likely to have adverse interests. In those circumstances it was very unlikely the parties intended to be subject to an implied duty to act in good faith – it would be ‘inapt’. There was a ‘sophisticated and complex mix of unequal rights and obligations for two parties who have, in some respects, conflicting interests, which can work well enough even if the parties are entitled to look after their own interests to a degree that the implied term would prevent’.

In the circumstances, the court found it was impossible to say that the ISA did not function effectively in the way that the parties envisaged, unless there was an obligation on both parties to act at all times in good faith.

Operative date

  • Now

Recommendation

  • Parties negotiating a proposed contract need to be aware that a different test will apply when deciding whether it is a ‘relational contract’, so that a duty to act in good faith will automatically be implied.

Case ref: UTB LLC v Sheffield United Ltd & Ors [2019] EWHC 2322

Disclaimer: This article from Atom Content Marketing is for general guidance only, for businesses in the United Kingdom governed by the laws of England. Atom Content Marketing, expert contributors and ICAEW (as distributor) disclaim all liability for any errors or omissions.

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