UK: The Implied Duty Of Good Faith In Commercial Contracts And Its Impact On Deferred Consideration Clauses In Corporate Sale And Purchase Agreements

Last Updated: 15 February 2017
Article by Janice Wall and Omar Amin

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 ITC1 – 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 Anstalt2 whilst the concept of relational contracts was rejected in Globe Motors3. 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.

Footnotes

1. The High Court decision in Yam Seng PTE Ltd v International Trade Corporation Ltd [2013] EWHC 111 (QB) is available at http://www.bailii.org/ew/cases/EWHC/QB/2013/111.html.

2. MSC Mediterranean Shipping Company S.A. v Cottonex Anstalt [2016] EWCA Civ 789.

3. Globe Motors Inc v TRW LucasVarity Electric Steering Ltd [2016] EWCA Civ 396.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement

Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of www.mondaq.com

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

Disclaimer

Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

Registration

Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

Cookies

A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

Links

This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

Mail-A-Friend

If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

Security

This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.