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The implied duty of good faith in commercial contracts and its impact on deferred consideration clau

From our Global Law Section

Jurisdictions around the world (including in the United States, France, Germany and Holland) generally recognise, to some extent, the principle that contracting parties owe each other a duty of good faith in the performance of their contractual obligations. This piece will look at the differing approaches taken in several jurisdictions and how English law has developed in this regard.

US doctrine In the United States, the principle of good faith is enshrined in the Uniform Commercial Code Section 1-304 which provides that “every contract or duty within this Act imposes an obligation of good faith in its performance or enforcement”.

The case of American Capital Acquisition Partners v LPL shows the relationship of earn out mechanisms and good faith obligations in US law:

  • Under the agreement for ACA’s sale of its subsidiary (CC) to LPL, CC could receive additional earn-out consideration if it met certain gross revenue or margin targets post-completion. When CC failed to meet the performance metrics, ACA and CC officers brought suits claiming, amongst other things, that LPL diverted revenue opportunities and resources to another subsidiary so CC would not meet the earn-out targets.

  • The court allowed the seller’s claim for breach of the implied good faith obligation not to divert revenue and resources away from CC.

  • It is important to note however that the court dismissed the seller’s claim that the implied covenant of good faith also imposed on the buyer an obligation to enhance its own technology to allow CC to meet earn out targets – practically speaking, if seller anticipates buyer will need to take additional measures for seller to realise earn-out targets, the transaction agreement should expressly impose that obligation on buyer.

France and Germany The duty of good faith is adopted in various continental jurisdictions, including through the Civil Codes of France and Germany:

  • In France a general obligation to negotiate in good faith (négociations de bonne foi) applies, meaning that parties to negotiations have a general duty to act loyally and honestly towards each other.

  • Section 242 of the German Civil Code (BGB) establishes the general obligation to execute contracts in good faith.

The Dutch approach to good faith The concept of ‘good faith’ in the Dutch legal system follows the approach of its European neighbours, and perhaps goes even further:

  • The Dutch Civil Code (DCC) provides that “the relationship between parties to an agreement is governed as well by the principles of reasonableness and fairness” (Article 6:248 DCC).

  • Dutch law equates the words ‘reasonableness and fairness’ to the principle of good faith; that is, taking into account the reasonable interests of the other(s) during negotiations.

  • The principle of good faith also extends to govern the pre-contractual negotiations between, say, buyer and seller. A party who decides, at an advanced stage of negotiations, to walk away can be held liable for the terms of such contract for not acting in good faith. This is in direct conflict with English law which recognises the self-interests of each negotiating party.

  • The Dutch law doctrine of good faith in the pre-contractual relationship stage is considered to be one of the most progressive amongst civil law countries.

  • Interestingly, this good faith principle also affects the mechanics of the due diligence process. English DD transactions are predicated on the ‘caveat emptor’ principle so that the buyer is responsible himself for investigating the target. In Dutch law however, this principle is not applied as strictly. The failure of the buyer to carry out an inspection cannot be held against the buyer if the seller has withheld information which he should have disclosed. In some cases the seller will have a duty to disclose information, to act in good faith, where, for example, the buyer has a distorted view of in respect of the sale.

English law England stands out as one of the few jurisdictions that does not recognise a universal implied duty of good faith between contracting parties:

“…in keeping with the principles of freedom of contract and the binding force of contract, in English contract law there is no legal principle of good faith of general application…” – Chitty on contracts, 31st Ed.

Note that this is separate from duties of good faith which are owed because of:

  1. a fiduciary relationship between contracting parties;

  2. an expressly agreed contractual term; or

  3. specific contractual relationships e.g. partnership, agency, employment contracts.

There is concern that implying good faith would create too much uncertainty by creating obligations that are potentially vague/subjective. English law also recognises that parties are free to pursue their own self-interests.

English case-law on the matter For a long time, commentators have suggested that a general duty of good faith would be introduced into English law as a result of efforts to standardise contract law within the European Union. Such a duty is already recognised in most EU Member States’ systems of law (see above) and, following Yam Seng v ITC, it seemed inevitable that the principle would be extended further to the English jurisdiction. However, for now, it seems that the reluctance to recognise a duty of good faith in commercial contracts stands.

  • Yam Seng v ITC[1] – Leggatt J found that a duty of good faith could be implied into contracts as a matter of English law with ITC being in breach of an “implied duty of honesty”. The judge placed emphasis on ‘relational contracts’ where a high degree of communication is required for the agreement to operate effectively – thus raising the question whether this could be applied to earn out provisions in share purchase agreements where the seller may maintain a significant interest in the target company and in many cases a day-to-day involvement in the target business post-completion.

  • Note however that the Court of Appeal rejected the use of good faith as a “general organising principle” in MSC v Cottonex Anstalt [2] whilst the concept of relational contracts was rejected in Globe Motors[3]. Accordingly, Yam Seng may now have limited application.

Recent developments in English law and the current position

  • As noted above, there seems to be a general unwillingness in English law to recognise an implied covenant of good faith. This trend has arguably been reinforced by the recent Court of Appeal decision in MSC v Cottonex Anstalt.

  • The comments of the Court do not constitute binding guidance. However it is clear from the analysis that the Court was unconvinced by the enthusiasm for the development of good faith which was shown at first instance in the case. The Court remained unconvinced by the underlying principle and espoused concerns that recognising such a doctrine would provide parties with as much scope to challenge the terms of commercial contracts as to support them.

In English law, without the application of good faith principles, when drafting an earn-out clause, every attempt must be made to address conceivable future scenarios relating to the post-closing operation of the target business in order to minimise the scope for future disputes

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