“Good Faith” in Shareholders’ Agreements: What Does it Mean?

The Position Under English Law: Context is Everything

A recent decision in the Court of Appeal of England and Wales (Re Compound Photonics Group Ltd; Faulkner v. Vollin Holdings Ltd [2022] EWCA Civ 1371) precisely considered this issue. In this case, the minority shareholders of the company alleged their interests had been unfairly prejudiced by the majority investors when the latter forced the resignations of the CEO and the non-executive chairman of the company, both of whom were then excluded from continuing in the management of the company.

At first instance, the judge considered that the shareholders’ agreement and company’s articles comprised a “constitutional settlement,” such that the CEO and chairman were entrenched in their positions. As such, notwithstanding the fact that the majority investors held 93% of the shares in the company, voting in favor of removing the CEO and chairman would constitute a breach of contract. In reaching this conclusion, the first judge reasoned that the good faith obligation in the shareholders’ agreement required the majority investors to stick to the bargain they had struck, and that this bargain involved an agreement on the part of the majority investors to not use their powers to remove the CEO and chairman from office as directors. Furthermore, the judge considered that the majority investors were required to deal fairly and openly with the CEO and chairman, and to take account of the minorities’ interests as well as their own.

The majority investors appealed, arguing the judge’s interpretation of the good faith obligation in the shareholders’ agreement had gone too far. In particular, the majority investors’ position was that the good faith clause did not fetter their right to vote to remove the CEO and chairman or to take control of the company. Furthermore, they did not agree with the idea that the duty of good faith required them to act with procedural fairness or to take into account the interests of the minorities when deciding how to vote.

In allowing the appeal, the Court of Appeal^[1] confirmed the principle that “an express clause in a contract requiring a party to act in “good faith” must take its meaning from the context in which it is used.” The Court of Appeal observed that the first instance judge had imported, as a whole, a list of “minimum standards” of good faith which had been identified in a previous case (Unwin v Bond^[2]). However, the Court of Appeal emphasized that, while the phrase “good faith” had a core meaning of honesty, it did not follow that it was “logical or appropriate to attempt to analyse other cases, decided on other facts, in order to deduce a number of further ‘minimum standards’ of conduct that a defendant must be taken to have agreed to comply with in every case in which a good faith clause has been used in a contract.” The Court of Appeal also viewed that a finding of dishonesty was not a necessary pre-requisite for a breach in the contractual duty of good faith. Depending on the context, a duty of good faith might be breached by conduct taken in bad faith.

Ultimately, the Court of Appeal considered that, in this case, the duty of good faith imposed a core requirement that the parties should act honestly towards one another and the company and accepted that this also required the parties to not act in bad faith towards each other in the sense of prohibiting conduct that reasonable and honest people would regard as commercially unacceptable. It was a relevant factor in the Court of Appeal’s analysis that this was not a case of a “quasi-partnership,” which would give rise to fiduciary obligations. Rather, in this case, the shareholders had drafted a specific provision in the shareholders’ agreement confirming their relationship was not one of partnership, and that there was no fiduciary relationship between them.

The Court of Appeal’s judgment also noted the reservations “about finding a duty of fidelity to the bargain to be inherent in a good faith clause used in the context of a shareholders’ agreement in the absence of any other indication to that effect in the agreement.” For example, there were no contractual restrictions on the rights of the majority shareholders to cast the votes attaching to their shares. However, in any event, the Court of Appeal did not consider that the obligation of good faith in this context required the parties to adhere to the concept of a bargain which involved a “constitutionally omnipotent board on which [the CEO and chairman] held an unalterable balance of power.” On this point, the Court of Appeal considered that the judge at first instance had reached a view on the “bargain” which, in the context of the commercial and financial position that had been reached in 2013 when the relevant shareholders agreement was entered into, was an implausible conclusion to reach. Furthermore, there was no requirement for the majority investors to go beyond what was provided for in the Companies Act concerning removal of directors and the directors’ right to protest. There was also no requirement that they should have regard to the interests of the minorities over and above any requirements that shareholders have to consider the interests of the company.

Put briefly, under English law, an obligation of “good faith” in a shareholders’ agreement is unlikely to be analyzed as requiring anything more than honesty between each shareholder and the company unless the contractual context (which includes any other provisions agreed upon between the shareholders) demands otherwise.

The Position Under US Law: “Good Faith” Does Not Alter Existing Terms & Obligations

Certain of the English case law influencing the first instance judge with respect to the issues of “fidelity to the bargain” and “consideration of interests” referenced US law concepts of good faith.^[3] As observed by the Court of Appeal in its own assessment of that case law, US courts read an implied covenant of good faith and fair dealing into all contracts. While the specific contours of the covenant vary across each US jurisdiction, it generally requires that parties not act to prevent each other from receiving the expected fruits of their bargain. A claim for breach of the implied covenant generally cannot be brought alongside a claim for breach of any express provision of a contract, or it will typically be subject to dismissal early in the litigation. And while the implied covenant of good faith and fair dealing may be used to imply contractual terms in certain cases, it typically may not be used to circumvent or subvert the existing terms or create “free-floating” duties unauthorized by the terms of the contract.

In New York, for example, courts have specifically held that this covenant is implicit in contracts governing shareholders’ agreements. Additionally, at least one New York court has held that where a contract expressly required “good faith” but did not define that term, the express “good faith” provision should be construed to have the same meaning as the implied covenant. Furthermore, where contracts require parties to “negotiate in good faith,” New York courts have repeatedly found such provisions too vague and therefore unenforceable.

It is also relevant in the United States that majority stockholders have fiduciary obligations to minority stockholders and to the corporation, including duties of care and loyalty. Delaware courts have held that the obligation to act in good faith is not an independent fiduciary duty, but a subsidiary element of the duty of loyalty. Therefore, the failure to act in good faith alone does not automatically result in fiduciary liability unless it rises to a breach of the duty of loyalty.

These fiduciary obligations also require stockholders with voting power to exercise their power to promote corporate interests. With that said, however, majority stockholders are not required to vote against their own self-interest, and Delaware courts have held that majority stockholders are entitled to pursue their own interests when voting. Further, majority stockholders are not required to sacrifice their own financial interests for the sake of other stockholders or the corporation.

Accordingly, we expect that a US court interpreting the same shareholders’ agreement would reach the same conclusion as the Court of Appeal.

Reflections on Drafting Shareholders’ Agreements

In a shareholders’ agreement under English law, parties need to be aware that a requirement for shareholders to act with good faith towards one another and the company does not necessarily carry with it a swathe of particular requirements or standards of behavior beyond a basic and core requirement to act honestly. Accordingly, and as an example, if parties wish to preserve decisions on certain matters to one group of shareholders, then it is sensible to provide for that in the shareholders’ agreement. 

The same is true under US law. While the implied covenant of good faith and fair dealing can be used as a defense against egregious actions that would undermine the purpose of the parties’ decision to enter into a contract, to the extent that specific matters are important to the parties (such as whether directors are “entrenched” in their positions or can be removed upon a majority shareholder vote), the parties’ rights and obligations as to those matters should be explicitly set out in the relevant contracts.