Unfair Prejudice: the meaning of contractual duty of good faith in a Shareholders’ Agreement

Shareholders’ Agreements often include an express contractual obligation that the shareholders must act in good faith towards each other and the company.  But what does that mean in practice?

In the recent case of Re Compound Photonics Group Ltd [2022] EWCA Civ 1371, the Court of Appeal has given a restrictive interpretation of a clause in a Shareholders’ Agreement that imposed an express duty of good faith on the company’s shareholders. 

In the judgment, the Court of Appeal confirmed the importance of context when defining the precise scope of express good faith obligations and rejected any formulaic application of general principles that had been decided in previous cases and in other areas of law. 

Background

A shareholder may petition to the Court for relief where the affairs of the company are being, or have been, conducted in a manner that is unfairly prejudicial to the interests of some or all of the shareholders.  A failure to comply with the company’s Articles of Association or Shareholders’ Agreement may justify the bringing of an unfair prejudice petition. 

An express duty of good faith has been considered in previous cases including in that of Unwin v Bond [2020] EWHC 1768, which held that it imposed the following “minimum standards”: (i) to act honestly; (ii) to be faithful to the parties’ agreed common purpose; (iii) to not use powers for an ulterior purpose; (iv) to deal fairly and openly; and (iv) to have regard for the other party’s interests.

Facts

In Re Compound, S and F were directors and minority shareholders.  The Company’s Articles of Association included a provision preventing the removal of S and F as directors.  The Shareholders’ Agreement did not include such a provision but did include a clause requiring that the shareholders would at all times act in good faith in all dealings with each other.  

S was forced to resign as a director when the majority shareholders refused to invest further monies in the company whilst S remained a director.  F was subsequently removed as a director by the majority shareholders.  S and F brought an unfair prejudice petition arguing that their exclusion and removal as directors was unfairly prejudicial.

High Court

The High Court granted the petition on the basis that the Articles and the Shareholders’ Agreement comprised a “constitutional settlement” between the shareholders under which S and F were effectively entrenched as directors and that the majority shareholders were in breach of contract by seeking to remove either of them.

In reaching the decision, the Court found that the shareholders undertook at all times to act in good faith and that this imposed all of the “minimum standards” from Unwin.  In particular, the good faith clause in the Shareholders’ Agreement required the majority to act with “fidelity to the bargain that had been agreed” and that the substance of that bargain was the entrenchment of S and F as directors. 

The majority shareholders appealed the decision, which included arguing that the High Court’s interpretation of the contractual duty of good faith clause was too broad and had gone too far. 

Court of Appeal

The Court of Appeal unanimously allowed the appeal.  A much narrower interpretation of the good faith obligation was applied.  The Court emphasised that it was not appropriate to define a minimum standard applicable to all good faith clauses.  Instead, as with any other contractual provision, it should be interpreted by reference to the facts of the case and the context in which it is used. 

The following general principles regarding the interpretation of an express duty of good faith clause in a Shareholders’ Agreement can be distilled from the Court of Appeal’s analysis:

• The duty of good faith includes a duty to act honestly;
• The duty of good faith also includes a duty not to act in bad faith. This would prohibit conduct that reasonable and honest people would regard as commercially unacceptable, but not necessarily dishonest;
• The requirement for parties to be faithful to the parties' agreed or common purpose should be construed narrowly. Such a requirement would not apply to a Shareholders' Agreement if no express wording were included to that effect;
• The requirement for parties to deal fairly and openly should also be construed narrowly.  The Court of Appeal decided that the majority shareholders were not under any procedural duty of fair and open dealing which went beyond what is set out in the Companies Act 2006; and
• The Court of Appeal rejected the idea that a duty of good faith required the majority shareholders to have regard to the interests of the minority shareholders in some undefined way which is over and above any requirements imposed on shareholders to have regard to the interests of the company as a matter of general company law.

Summary

The decision confirms that an express duty of good faith clause in a Shareholders’ Agreement is unlikely to impose any greater obligation than a core duty to act honestly, although the decision does leave open the possibility that commercially unacceptable conduct may also possibly breach the duty even if that conduct might not be dishonest.   

Any further obligation must be capable of being derived by interpretation or implication from the contract.  As such, if shareholders are proposing to include an express duty of good faith in a Shareholders’ Agreement, they should set out explicitly what they are expected to do beyond complying with the core duty of honesty to be able to rely on a breach of that duty in any future dispute. 

If you require any advice on Shareholders’ Agreements or on shareholder disputes (including unfair prejudice petitions), please do not hesitate to contact a member of our corporate department or commercial litigation department.