Duty of good faith in long-term contracts
COMPASS GROUP (T/A MEDIREST) v MID ESSEX HOSPITAL NHS TRUST [2012]
This case shed light on how important a contractual obligation to co-operate in ‘good faith’ can be. A duty of ‘good faith’ is a concept imposed in many continental European jurisdictions but which is poorly defined in English law and has been comparatively rare in commercial contracts.
Facts:
- Mid-Essex Hospital Trust (T), entered into a long-term catering agreement with Medirest (M). Clause 3.5 imposed a duty to co-operate in good faith: “The Trust and the Contractor will co-operate with each other in good faith and will take all reasonable action as is necessary… to enable the Trust to derive the full benefit of the Contract.”
- The contract also incorporated a service failure point mechanism which enabled deductions to be made from payments in the event of service failures. Significantly, service failure points applied on an on-going basis until M either remedied the performance failure to T’s satisfaction or it had taken steps to prevent its recurrence.
- There were some initial problems with the service soon after it started in April 2008. Although improvements to the overall service were made, T issued a formal warning notice in December 2008 which triggered an obligation on M to prepare an action plan. The plan was finally agreed in January 2009. At that point T stated that M had accrued 52,908 service failure points and the deductions for the six months to December 2008 came to £590,118 - over half the normal service fee payable for the period to which it related.
- T had interpreted the service failure point regime so that multiple service failure points and huge service credit entitlements accrued from each of the original minor service failures.
- M contested this and calculated that only 18,822 service failure points had accumulated resulting in a much smaller deduction of £37,365. M's view was that service failure points stopped running once T knew that the failure had been rectified or had been informed of the steps taken to remedy. T insisted on formal email notification in respect of each and every incident.
- Despite attempts to resolve the dispute, the relationship deteriorated and T started to withhold substantial sums from payments due to M. M sent a notice to T stating that it was in material breach and demanding that T pay the sums withheld and re-issue a corrected service failure point schedule explaining the basis of the deductions claimed. If T did not, M threatened that it would exercise its right to terminate the contract.
- T paid the sums withheld but did not re-issue the relevant schedule until much later. M consequently served a termination notice. T then served its own termination notice as M had and continued to incur more than the permitted 1,400 service failure points in a rolling 6 month period, which was the threshold for termination. After further negotiations, the parties agreed the contract would terminate on 23 October 2009 without prejudice to whose termination was effective.
- The main issue for the Court to decide was whether M was entitled to terminate for T’s material breach of its obligation to co-operate in good faith.
Decision:
- The Court favoured a broad interpretation of the good faith obligation so that it imposed on both parties a general obligation to co-operate in good faith that was not limited just to the specific purposes referred to in the clause.
- The Court held that an obligation to co-operate, consistent with the wording, and take ‘all reasonable action’ was the essence of the obligation.
- Based on previous judgments, the Court decided that the ‘good faith’ obligation required the parties:
- not to take unreasonable actions which might damage their working relationship; and
- to be faithful to, and not undermine, the agreed common purpose of the contract (provision of an important service to the hospital and its patients), to observe reasonable commercial standards of fair dealing and to act consistently with justified expectations.
- On the facts, the Court had little doubt that T had breached its duty of good faith. Even though M was in breach by not having met its performance monitoring and reporting requirements for quite some time and had on any calculation accrued service failure points in a six month period which led to an express right for T to terminate, T’s calculation of the service failure points was described as ”absurd”' and ”cavalier”. The service level calculations were, by T's own admission, ”in many respects indefensible”, but T nevertheless sought to withhold payment based on these calculations and did not respond positively when M tried to resolve the dispute. The breaches of contract on M's part in 2008 were held to be no justification for T's breaches the following year and did not prevent M acting on those breaches.
- The Court also confirmed that where a party can exercise discretion in the use of a contractual provision, then not only must that discretion be exercised honestly and in good faith but it should not be exercised “arbitrarily, capriciously or in an irrational manner”. T had discretion when applying the service credit regime and it was held not to have applied the regime in an appropriate manner.
- These factors damaged and, ultimately, destroyed the parties’ working relationship. There was held to be a 'material breach' for the purposes of the contractual termination clause and M was therefore entitled to exercise its right to terminate the agreement on this basis.
- In determining whether a breach is ‘material’, the Court said the following factors should be considered:
- the actual breaches in question;
- the consequences of the breaches to the innocent party;
- any explanation for the breaches;
- the breaches in the context of the agreement; and
- the consequences of determining the agreement was terminated and of determining it was to continue.
- The Judge also regarded the conduct of T as giving rise to an independent right to terminate at law for what is called ‘repudiatory’ breach, which exists quite independently of any contractual right permitting termination. The breaches of contract in this case “constituted a serious and continuing breach of its critical obligations, which went to the very heart of a long term contract requiring cooperation”.
Points to Note:
- The meaning of the obligation on both parties to act in good faith was crucial in the outcome of this decision as the Court held that T’s behaviour was a clear breach of the express duty, giving M the right to terminate the contract. Therefore, it is evident that good faith obligations can be important and can take on significance in determining how contracting parties’ conduct is viewed. However, there is nothing wrong in managing a contract in a ‘challenging’ manner provided it is based on “fact and common sense”.
- Even if the service credit mechanism had applied automatically, there is a suggestion in the judgment that if mechanical application of a service credit regime in strict accordance with its drafting would lead to absurd results, they should not be applied if the primary purpose was to generate price reductions rather than curb performance failure. Given that service credit regimes can sometimes lead to disproportionate results, this might provide service providers who are in such a situation with another argument in addition to standard claim that ‘penalties are unenforceable’ which succeeds very rarely these days.
- It is worth remembering that here, the good faith obligation was set out expressly in the contract. It remains to be seen whether contracting parties and their lawyers increasingly look to include an express ‘good faith’ obligation which, until now, has not been common in English contracts. We suspect that they will. There is no general implied duty of ‘good faith’ in English law in contrast to a number of continental jurisdictions.
- An important factor in the decision was the fact that in this context, as in many other outsourcing arrangements, performance required continuous and detailed co-operation between the parties. It is interesting that the Judge found that T had breached the duty of good faith in failing to respond positively when M made attempts to resolve the dispute.
- It is now quite clear that standard ‘boiler plate’ drafting which purports to exclude terms being implied cannot operate so as to exclude terms which are necessary to give business efficacy to the contract and which give effect to what the parties must be taken to have meant or which are essential to the agreement.
- Even if there is a bedding in period (typically 3 months) during which no service credits will apply, make it clear whether performance reports are to be produced in respect of that period and also whether the immunity is just in respect of service credits or remedies generally.
- The Court accepted that in context it was perfectly possible for T to exercise a right of termination in accordance with a contractual provision but for the notice to provide that the contract would terminate at a stated date in the future. The very nature of the contract was supportive of T's right to give notice to terminate at a future date so that alternative arrangements could be put in place in the meantime.
- This case was appealed in 2013 - see Mid Essex Hospital NHS Trust v Compass Group (t/a Medirest) (CA).