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Re Compound Photonics Group Ltd: Shareholders' Agreements and duties of good faith


In our Dispute Resolution 2022 Yearbook, we discussed the recent trend whereby minority shareholders rely on claims for breaches of a duty of good faith as the basis for an unfair prejudice petition. In this case, in the context of such a petition, the Court of Appeal construed an express duty of good faith in a shareholders' agreement, and provided some guidance as to the approach to interpreting such clauses.

Overview of the dispute and the decision at first instance

This appeal arose in the context of an unfair prejudice petition, brought by the minority shareholders, including two prominent former directors, Dr Sachs and Mr Faulkner, against a group of majority shareholders of Compound Photonics Group Limited (the "Company"). The main thrust of the petition was that the majority shareholders' removal of these two directors from the Company's board represented a breach of a clause in a Shareholders' Agreement ("SA"), which required the shareholders to act in good faith in respect of their dealings with one another, and with the Company, and was therefore unfairly prejudicial to the minority shareholders.  The key issue that the courts had to resolve, at first instance and on appeal, was the correct interpretation of that clause, which read as follows:

"Each Shareholder undertakes to the other Shareholders and the Company that it will at all times act in good faith in all dealings with the other Shareholders and with the Company in relation to the matters contained in this Agreement.”

At first instance, Mr Justice Adam Johnson reflected on the Company's constitutional arrangements, which gave Dr Sachs and Mr Faulkner an effective veto over the appointment of new directors, and required their attendance at board meetings for such meetings to be quorate (insofar as they each remained a director of the Company). The Judge concluded that those arrangements had been "expressly designed to avoid the will of the majority prevailing in matters concerned with the commercial future of the Company", and held that the duty of good faith in the SA had to be interpreted in that commercial context.

In interpreting that duty, the Judge imported wholesale the "minimum standards" that were applied in Unwin v Bond [2020] EWHC 1768 (Comm). In Unwin v Bond, the Commercial Court held that once it is established that a prospective act of a defendant is subject to a duty of good faith, the defendant is bound to observe certain minimum, overlapping standards. Specifically, they must (i) act honestly; (ii) be faithful to the parties’ agreed common purpose as derived from their agreement; (iii) deal fairly and openly with the claimant; (iv) have regard to the claimant’s interest; and (v) not use their powers for an ulterior purpose.

In this case, the Judge held that the duty of good faith in the SA required the majority shareholders to (i) deal "fairly and openly" with Dr. Sachs and Mr. Faulkner; (ii) take into account the interests of the minority shareholders as well as their own; and (iii) act with "fidelity to the bargain" that had been agreed. As regards the substance of that "bargain", the Judge held that it included the entrenchment of Dr Sachs and Mr Faulkner as directors of the Company (notwithstanding the absence of any express provision to that effect). The corollary of this conclusion was that any (non-consensual) removal of Dr Sachs or Mr Faulkner as directors of the Company would amount to a breach of the SA even if mechanically permissible under the Company's Articles. The Judge ultimately concluded that the majority shareholders had acted in breach of the duty of good faith in the SA, such that the minority shareholders had been unfairly prejudiced.

The Court of Appeal's analysis

The central issues considered by the Court of Appeal were (i) the Judge's identification of the shareholders' agreed "bargain", and (ii) the Judge's interpretation of the duty of good faith and what this duty entailed in the circumstances.

On appeal, the majority shareholders argued that the Judge had interpreted the duty of good faith too broadly, and that they had not contractually agreed to give up, for all practical purposes, their usual right to vote and remove directors as shareholders of the Company (particularly in circumstances where they had amassed 93% of the issued share capital). The Court of Appeal agreed with the majority shareholders, and allowed the appeal. The duty of good faith in the SA could not support the weight placed on it by the Judge at first instance; it was not a sufficient basis to conclude that the parties had agreed to the perennial retention of Dr Sachs or Mr Faulkner as directors of the Company.

General approach to construing and interpreting the duty of good faith

The following general principles can be distilled from the Court of Appeal's analysis:

(i)The duty of good faith must be construed based on context, applying ordinary principles of construction: the Court of Appeal reiterated that an express duty of good faith must be construed in accordance with ordinary principles of contractual interpretation. The Court warned against the imposition of general principles, or the application by analogy of decisions reached in other cases, which will inevitably turn upon their own particular facts and may be of limited value. On this basis, the Court was dismissive of the approach taken in Unwin v Bond, where the Court purported to prescribe a rigid list of minimum standards inherent in a contractual duty to act in good faith, irrespective of the relevant factual background.

(ii)The duty of good faith imposes an obligation to act honestly: The Court of Appeal confirmed the Court of Appeal's earlier decision Re Coroin, where Arden LJ determined that the requirement to act in good faith imposes a core duty to act honestly. Honesty is assessed in a subjective sense, in light of what the defendant actually knew, albeit that the standard of honest behaviour required is an objective one (i.e., it does not vary depending on different standards of moral propriety).

(iii)Depending on the contractual context, the duty of good faith may be breached by conduct which is not necessarily dishonest: Whilst the Court of Appeal accepted that the duty of good faith is not intended to impose an obligation which is "demanding" or more than "modest", it did suggest that the duty may go beyond simply an obligation to act honestly. Depending on the contractual context, a duty of good faith may be breached by conduct which is "commercially unacceptable to reasonable and honest people", even if such conduct is not dishonest. The Court of Appeal did not elaborate on the type of conduct that might fall foul of such an obligation.

(iv)No broader requirement to act in accordance with the "spirit of the bargain": The Court of Appeal cast doubt on the notion that an obligation to act in good faith imports a broader duty of adherence to the "spirit of the bargain" reached in the underlying agreement. However, since the Court of Appeal did not accept the Judge's articulation of the bargain agreed between the shareholders, this section of the judgment may be regarded as obiter.

(v) A broader duty would conflict with the inherent flexibility in a company's Articles of Association: The Court of Appeal held that if the duty of good faith in the SA were as broad as the Judge had found, it would run contrary to the powers and rights ordinarily available to shareholders, pursuant to a company's Articles and under the Companies Act 2006. Unlike an ordinary contract, the terms of a company's Articles are not cast in stone at the point of incorporation – there is an inherent flexibility to amend the Articles. The Court concluded that a good faith clause in a shareholders' agreement should not have the effect of removing this inherent flexibility, absent express wording to that effect.

Practical Takeaways
  • Whilst this case concerned an express duty to act in good faith, we consider that the Court of Appeal's analysis of the meaning and content of that duty is likely to apply equally to an implied duty to act in good faith. It is difficult to persuade an English court to imply a duty of good faith into a contract and such arguments are most likely to succeed in cases involving contracts that can be classified as "relational" - typically long term agreements involving a substantial mutual commitment and extensive co-operation and communication between the parties. Whether a court could be persuaded to treat a shareholders' agreement as such remains to be seen.
  • As explained above, whilst the Court of Appeal confirmed that a duty of good faith imposes a "core duty" of honesty, it left open the possibility that the duty may be found to be wider in some circumstances, such that conduct which is not commercially acceptable may breach this duty, even where the conduct in question was not dishonest.
  • However, the Court gave little guidance as to what conduct would be commercially unacceptable, but nevertheless honest. This is an area where we should expect further litigation and clarification from the courts.
  • Parties should proceed with caution when considering whether to include an express duty of good faith in a shareholders' agreement: the precise scope of this duty will be context-dependent, and may continue to be the subject of litigation. Although much will depend on the precise factual scenario, one potential alternative may be to include more specific express duties such as those previously imputed in Unwin v Bond (and the line of subsequent cases).

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