Articles of good faith

Contract 2 iStock 000003466551XSmall 146x219The Court of Appeal has handed down a major ruling on the contractual issues of co-operating in good faith and exercising discretion. Colin Ricciardello identifies the lessons to be learned.

On 15 March 2013 the Court of Appeal [1] in Mid Essex Hospital Services NHS Trust (“the Trust “) v. Compass Group (“the Contractor”) unanimously overturned a High Court judgment [2] in the Contractor’s favour which held that:

  • The Trust was in breach of its duties to co-operate in good faith with the Contractor when making deductions/awarding service failure points;
  • It was also in breach of an implied term requiring it not to exercise its contractual discretion to make deductions/award service failure points in an arbitrary, capricious and irrational manner;
  • The Contractor was entitled to terminate for the Trust’s material breach by making deductions/awarding service failure points;
  • Whilst on the facts the Contractor did not terminate by reason of the Trust’s repudiatory breach, the Trust was held to be in repudiatory breach by wrongly making deductions/awarding service failure points.

A good deal of commentary followed the High Court judgment, citing the Trust’s conduct as an example of how a public authority should not handle a supplier’s failure to perform. In the light of the Court of Appeal’s judgment much of that is irrelevant but what is likely to be of enduring value is the Court of Appeal’s judgment on the co-operating in good faith issue and the scope for implying a term controlling the exercise of contractual discretion. These two features are commonly found in public sector service contracts.

Facts

On 1 April 2008 the Trust entered into a contract with the Contractor to provide catering and cleaning services for seven years.

Clause 3.5 of the Contract provided that: "The Trust and the Contractor will co-operate with each other in good faith and will take all reasonable action as is necessary for the efficient transmission of information and instructions to enable the Trust or, as the case may be, any Beneficiary to derive the full benefit of the Contract."

Further, where performance criteria and standards had not been met by the Contractor, the discretion under clause 5.8 arose so the “…Trust shall be entitled to levy payment deductions against the monthly amount of the Contract Price”. Also the Trust “…may by notice to the Contractor award Service Failure Points …”. The former allowed cash deductions and the latter was relevant to determining if a termination right had arisen if sufficient points had accrued. Despite all of the Trust’s errors in calculating deductions and awarding points, it was common ground that the termination threshold had been reached.

The Trust made significant deductions and awarded a high number of points for relatively trivial incidents such as out of date ketchup sachets and a chocolate mousse. The Trust made mistakes here [3]. The Trust sought to correct its mistakes by repaying a significant part of the deductions and said it would review the performance data it relied upon in awarding points. Nevertheless, whilst the Trust withdrew a notice that it had served in July 2009 purporting to terminate because the termination threshold had been reached, it served a further notice to terminate expiring on 23 October 2009.

The Contractor had served its own notice to terminate on the grounds of the Trust’s material breach because the Trust had failed to withdraw or produce modified performance data.

The Contractor commenced proceedings and the Trust counterclaimed – both claiming breach of contract by the other party and substantial damages. The judge held that both parties were entitled to terminate so neither could claim damages from the other.

In the Court of Appeal

Duty to co-operate in good faith

Contrary to the trial judge’s finding, the Court of Appeal interpreted clause 3.5 in a different and more restrictive way and (Lord Justice Jackson delivering the leading judgment) held that the Trust’s reading was correct, so: “The obligation to co –operate in good faith is not a general one which qualifies or reinforces all of the obligations on the parties in all situations where they interact. The obligation to co-operate in good faith is specifically focused upon the two purposes stated …”.

Those were the efficient transmission of information/instructions and enabling the full benefit of the Contract to be derived. That translated into a duty to work together honestly and endeavouring to achieve the two stated purposes. The Contractor, it was decided, had discharged its duties under these two obligations.

The Court of Appeal emphasised that there is no general doctrine of “good faith “in English contract law and the content of such a duty …“is heavily conditioned by its context”. If the parties wanted to impose such a duty then they must do so expressly.

Lord Justice Beatson held that what good faith requires is sensitive to context but it remained an objective test based on whether in a particular context and construction of the contract overall, conduct “…would be regarded as commercially acceptable by reasonable and honest people …”

Implied term controlling the exercise of contractual discretion

Lord Justice Jackson reviewed the cases restricting the exercise of contractual discretion which affects both parties’ interests. There was, he held, a line of cases which required that this discretion was to be exercised honestly and in good faith and there was an implied obligation which “…was intrinsic. The contract would not make sense without it. It would have been absurd in any of those cases to read the contract as committing the party in question to exercise its discretion in an arbitrary, irrational or capricious manner”.

Importantly, Lord Justice Jackson found that a feature of these cases was that “…the discretion did not involve a simple decision whether or not to exercise an absolute contractual right. The discretion involved making an assessment or choosing from a range of options, taking into account the interests of both parties. In any contract under which one party is permitted to exercise such discretion, there is an implied term”.

Decisively, Lord Justice Jackson found that this type of discretion did not appear in clause 5.8. He held that; “The discretion which is entrusted to the Trust in relation to service failure points and deductions in the present case is very different from discretion which existed in the authorities discussed above. The Trust is a public authority delivering a vital service to vulnerable members of the public. It rightly demands high standards from all of those with whom it contracts”.

He also went on to decide that the Trust could not be criticised if it awarded the full number of points or if it made the full amount of any deduction which it was entitled to make. Accordingly, his conclusion was; “The discretion conferred by clause 5.8 simply permits the Trust to decide whether or not to exercise an absolute contractual right”.

As there were “precise rules” in the Contract for determining the level of service failure points and calculating the amount of deductions, there was no need to imply the term in clause 5.8. Accordingly, if the Trust awarded more than the correct number of service failure points, or deducted more than the correct amount from any monthly payment, then that would be a breach of the express terms of clause 5.8 and, accordingly, there was no need to imply a term to further regulate the operation of clause 5.8.

Was the contractor able to terminate for material breach?

By the time Lord Justice Jackson came to deal with this point, he had already decided that the Trust was not in breach of the good faith/ co-operation provision (clause 3.5) nor was it in breach of the implied term argued for by the Contractor .

Also, he noted that the Trust had repaid all the sums wrongfully deducted and when the Contractor served its notice of termination for the Trust’s material breach, there was only one continuing breach which the Trust had failed to correct – namely the award of excessive service failure points. The question therefore was whether that was a “material” breach.

Lord Justice Jackson construed the meaning of “material breach” in the context of the relevant clause and noted that it had the drastic effect of allowing the Contractor to cancel a long term contract on one month’s notice. Accordingly, to be material, a breach would have to be substantial and of a serious nature rather than one of little consequence.

It was unanimously held that the Trust was not in material breach. This finding was very fact specific as follows:

  • All the service failure points up to a particular point were time expired and no longer had any contractual effect;
  • For the most recent six-month period it was not disputed that the Contractor had incurred more than the required number of service failure points which in turn allowed the Trust to terminate for that reason;
  • Points in excess of the threshold would have no contractual effect;
  • The Trust had indicated that it was reviewing its previous award of service failure points.

Had the trust committed a repudiatory breach?

The Trial Judge held that the Trust had committed repudiatory breaches. Lord Justice Jackson had no hesitation in setting that finding aside given that the Trial Judge’s conclusion was largely based upon the Trust destroying the working relationship with the Contractor by reason of its breach of its duty to co-operate in good faith; the Trust’s own notice to terminate was based on “absurd calculations” of service failure points which the Trust conceded were in many ways “indefensible”.

Reversing the decision in the Court below, the Trust could now claim the financial relief under its counterclaim.

Conclusions and points for practitioners

When negotiating and drafting contracts (particularly ones for long periods) consider whether the obligation to provide a level of service needs to be reinforced by a general duty to act in good faith or that should be restricted to key areas of service.

It is necessary to be specific and clear about good faith duties as none exists at common law. Even if the parties have agreed to this type of specific provision then “… care must be taken not to construe a general and potentially open- ended obligation such as an obligation to 'co-operate' or 'to act in good faith' as covering the same ground as other, more specific, provisions, lest it cuts across those more specific provisions and any limitations in them”. (See Lord Justice Beatson at para 154).

If the service default points and deductions drafting is clear and functions, then there should be no necessity to imply terms to make it work or lay down limits of its operation.

When exercising contractual discretion be careful to determine whether that involves a simple decision whether to exercise an absolute right. If it is, then the exercise of the power only involves “do I or don’t I” and that decision is not constrained by an implied duty not to act in an arbitrary, capricious or irrational way and the interests of both parties are not relevant. If however the discretion requires an assessment or choice from a range of options, then these implied matters are likely to be applicable.

The Trust was held not to be in material breach, but if the Contract was not for a vital public service and the circumstances surrounding deductions and award of service failure points were different, then it is not hard to see how these actions could amount to a material/repudiatory breach. As such, great care should be taken when assessing default and calculating the contractual consequences of that default.

Colin Ricciardello is a partner at Sharpe Pritchard. He can be contacted on 020 7405 4600 or by This email address is being protected from spambots. You need JavaScript enabled to view it..


[3] at paragraph 86 of the High Court judgment the Judge referred to the absurdity of the Trust’s calculations and that placed in in breach of the good faith obligations at clause 3.5. Also, the Judge held that it was an arbitrary capricious and irrational exercise of the discretion to make deductions and award points under clause 5.8 and that action constituted a breach of the implied term not to act in such a manner