Embracing the power of good faith in business relationships: don’t let your lawyer get in the way!
Many businesses rely on trusted long term supply chain partners for sustained business success. They therefore want contractual arrangements that support the intent that the relationship should be mutually beneficial, and that this generally requires investments in capability to generate continuous improvement in service delivery and value for money. A commitment by both parties to invest in the relationship and to act in good faith towards one another is therefore something that they wish to embrace.
Until their lawyers get involved…
Many lawyers caution against including an express obligation to act in good faith in Australian business contracts, citing concerns that it may “cut across” or restrict other contractual rights and discretions. These reservations, while not without foundation, are overblown.
A duty to act in good faith need not be unduly disruptive to contractual certainty. It won’t prevent a party from acting to preserve its legitimate interests. And Australian courts have been cautious in allowing the duty to fetter the exercise of a contractual right to terminate.
The benefits to be gained by embracing concepts like good faith, reciprocity, autonomy, honesty, loyalty, equity and integrity in your business dealings outweigh the legal risks.
Unpacking the concerns
The apprehension surrounding the impact of obligations to act in good faith on contractual rights and discretions largely draws from the cases of Renard Constructions (ME) Pty Ltd v Minister for Public Works and Alcatel Australia v Scarcella. Yet a closer examination reveals that their authority for the concerns is often overstated.
Renard Constructions concerned the principal’s exercise of a right to terminate following a “show cause” procedure under a standard form construction contract. One judge based a requirement for the principal to act reasonably when exercising this right on an implied obligation to act in good faith.
But another judge arrived at the same result without implying the obligation to act in good faith. This judge based the requirement to act reasonably on the wording of the show cause clause, which stated that the principal can terminate “if the Contractor fails … to show cause to the satisfaction of the Principal”. This judge said that because a trivial breach could trigger a show cause notice, the principal’s opinion that the contractor had failed to show cause needed to be objectively reasonable.
The third judge also rejected the implication of an obligation to act in good faith and instead found that the principal “was unable to be satisfied” because the principal’s opinion was “so distorted by prejudice and misinformation that he was unable to comprehend the facts in respect of which he had to pass judgement”.
As such, Renard Constructions shouldn’t be seen as authority for the proposition that an obligation to act in good faith can fetter the exercise of a contractual power in accordance with its terms.
The passage from Alcatel that is commonly cited as authority for the proposition that an obligation to act in good faith can fetter the exercise of a contractual power or discretion in accordance with its terms is as follows:
“If a contract confers power on a contracting party in terms wider than necessary for the protection of the legitimate interests of that party, the courts may interpret the power as not extending to the action proposed by the party in whom the power is vested or, alternatively, conclude that the powers are being exercised in a capricious or arbitrary manner or for an extraneous purpose, which is another way of saying the same thing. Thus, a vendor may not be allowed to exercise a contractual power where it would be unconscionable in the circumstances to do so.”
But this passage also demands scrutiny.
The second sentence of the passage is uncontroversial, but it deals with unconscionable conduct, which requires behaviour far beyond mere unreasonableness.
The first sentence of the passage is best understood by reference the current approach of Australian courts to the interpretation of contractual terms. Australian courts start by giving effect to the ordinary meaning of the words used in the contract. If they are clear and unambiguous, they will generally be applied as written. But if doing so leads to a result that is absurd or so unreasonable that it could not have been intended, the courts will opt for an interpretation that leads to a rational result.
Interpreting contractual powers appropriately
If a contract confers power on a contracting party that is wider than necessary for the protection of its legitimate business interests, and allowing that party to exercise the power as written would lead to a result that is absurd, or so commercially unreasonable that it could not have been what the parties intended, then a court will interpret the clause in a way that avoids such a result, for example, by requiring that the exercise of the power must be reasonable in the circumstances, or necessary for the protection of a party’s legitimate interests.
The case of Burger King Corporation v Hungry Jack’s Pty Ltd is a prime example of such a situation. In this case the court accepted that it was necessary to imply a requirement of reasonableness into the restaurant development agreement between Burger King and Hungry Jack’s to avoid Burger King, “for the slightest of breaches, bringing an end to the very valuable rights which [Hungry Jack’s] had under the Development Agreement.”
But if the contractual power is drafted in clear and unambiguous terms, and there is a rational reason for its inclusion in the contract (eg it’s there to protect a legitimate business interest), then the courts will give effect to it even though it leads to a commercial result that is harsh or unfair to the other contracting party.
Power to terminate for convenience
The latter proposition is well illustrated by cases concerning termination for convenience clauses. There have been several attempts by parties whose contracts have been terminated pursuant to a termination for convenience clause to get a court to rule the termination was wrongful on the basis that:
such powers cannot be exercised capriciously or arbitrarily, or for an ulterior/extraneous purpose (for example, so you can obtain the same outcome more cheaply from someone else); or
such powers must be exercised reasonably.
(Such attempts include Thiess Contractors Pty Ltd v Placer (Granny Smith) Pty Ltd; Apple Communications Ltd v Optus Mobile Pty Ltd; Solution 1 Pty Ltd v Optus Networks Pty Ltd; Starlink International Group Pty Ltd v Coles Supermarkets Australia Pty Ltd, Trans Petroleum (Australia) Pty Ltd v White Gum Petroleum Pty Ltd and AHG WA (2015) Pty Ltd v Mercedes-Benz Australia/Pacific Pty Ltd.)
But all such attempts have been unsuccessful. In each case, the flexibility that such a clause provides to the beneficiary of it has been considered a legitimate business interest, and the drafting of the clause (which typically allows termination “without cause” or “for convenience”) has been sufficiently clear to withstand such attacks. As such, ongoing concerns that an express duty to act in good faith will undermine a properly drafted termination for convenience clause are without foundation.
Good faith and other contractual powers
The situation doesn’t significantly differ for other contractual powers and discretions. If a contract explicitly allows such powers and discretions to be exercised in a manner that disregards the interests of the other party or that materially undermines the other party’s bargained for contract benefits, then an obligation to act in good faith won’t cut across such powers.
But aside from an express power to terminate a contract for convenience (which is usually tied to an obligation to compensate the other party for its loss of bargain), it is rare to see contractual powers expressed in such terms.
Long term contracts routinely give one of the parties the power to vary the rights and obligations of the other party under the contract in particular respects. Examples of such powers in the context of construction contracts include:
the power to assess and certify the contractor’s claims for progress payments;
the power to determine claims for extensions of time;
the power to determine the cost and time impact of variations directed by the principal; and
the power to suspend the work without compensation.
The exercise of these powers could completely undermine the commercial bargain between the parties, if exercised unreasonably.
Most standard form construction contracts address this by requiring such powers to be exercised by an independent third party (variously named the superintendent, the contract administrator, the project manager or the engineer), who is expected to act reasonably. And those construction contracts that allow the principal to exercise such powers, or that require the third party to exercise the power as the principal’s agent (ie as directed by the principal), routinely require that the principal or its agent must act reasonably when doing so (or they allow the contractor to refer the matter to an independent third party who must re-determine it, acting reasonably).
Generally, courts will presume that the parties’ intention was that such broad powers would only be exercised in a reasonable manner and for the purposes for which they were granted.
Scope of the obligation
The scope of an obligation to act in good faith remains an open question, but perhaps not as open as some suggest.
The proposition that an obligation to act in good faith requires a party to cooperate is largely uncontested. This is because an implied term to cooperate (also referred to as loyalty to the promise itself) has long been an accepted feature of Australian contract law. Authority for this proposition is generally traced back the following statement in Mackay v Dick:
“as a general rule, … where in a written contract it appears that both parties have agreed that something shall be done, which cannot effectually be done unless both concur in doing it, the construction of the contract is that each agrees to do all that is necessary to be done on his part of the carrying out of that thing, though there may be no express words to that effect.”
It is also largely uncontested that it requires the parties to act honestly. But again, an obligation to act honestly has other legal sources.
The contentious aspect of an obligation to act in good faith is therefore limited to the suggestion that it requires “compliance with standards of conduct that are reasonable having regard to the interests of the parties” (as a former Chief Justice of Australia’s High Court put it in a public lecture).
But it seems to be accepted that this contentious aspect of the obligation does not require a party to subjugate its interests, unless the pursuit of those interests unreasonably interferes with other party’s ability to enjoy the bargained for benefits of its contract. If legitimate business reasons underpin the exercise of the power, its exercise will not be deemed unreasonable even if those reasons have nothing to do with any fault by other party.
Key takeaways
In conclusion, businesses shouldn’t allow lawyers to disuade them from committing to act in good faith in contracts aimed at supporting mutually beneficial, long term business relationships. Such commitments shouldn’t materially hinder the exercise of other contractual rights in accordance with their terms.
But if you are seeking a business relationship where the contract counterparty invests in its capability to continually improve the goods and services, and therefore the value for money, that it provides to you, you should think carefully about whether an express right to terminate for convenience (without cause) will undermine the desired outcome.
Indeed, it is a contractual right to end the relationship without cause, rather than a contractual commitment to act in good faith, that carries a more significant risk of undermining a successful, enduring business partnership.
Embracing, rather than excluding, good faith obligations and relational concepts like reciprocity, autonomy, honesty, loyalty, equity and integrity can provide the foundations needed to foster the mutual trust, co-operation and continuous improvement needed to sustain successful business relationships.
