Focus: Trusting in good faith
7 February 2011
In brief: A recent Western Australian Court of Appeal decision provides practical guidance on the ordinary meaning and scope of an express contractual term of good faith. Partner Michael Hollingdale (view CV) and Lawyer Stuart Packham report.
How does it affect you?
- Memoranda of Understanding (MOUs) can often have contractual weight, and therefore their terms can be enforceable like any other contract. Whether a MOU is contractual or not depends on what the parties' intention appears to the court to have been when it was executed.
- Parties to commercial contracts can now be satisfied that contractual terms of good faith will be ascribed content by the courts. While the precise content of the clauses may ultimately be settled by the High Court, the recent decisions of Strzelecki1 and United Group Rail2 give good faith clauses meaningful content and impose obligations on parties consistent with the commercial context in which good faith clauses operate.
- Good faith at least requires commercial parties to act honestly and cooperatively in keeping to the mutual bargain struck in their contract with one another. This can extend to various aspects of contractual performance, negotiation, and dispute resolution, depending on how good faith clauses are worded.
- The Strzelecki case confirms that good faith clauses must always be interpreted in light of the surrounding commercial circumstances. Good faith does not require parties to act in someone else's interests and at the expense of their own legitimate self-interest.
- A good faith clause may also require a party to not act unreasonably according to an objective standard, though this is not always the case. However, where a party makes an offer that would nullify the other party's expected benefit from the contract, and refuses to compromise or negotiate the terms, the party may well be found to be not negotiating in good faith. Accordingly, care is required in negotiating and drafting commercial agreements to ensure that expectations of 'reasonableness' are clear, specific, and matched closely to the contractual bargain, and not simply left at large for parties to argue over when contractual relations break down.
- These cases are indicative of a broader and recent trend of judicial reality-checking on the meaning and scope of good faith in commercial agreements.
- In light of these cases, clients should check and seek advice where necessary on how good faith obligations in their standard contracts (or under prevailing industry standards) apply to their circumstances.
The appellant, Strzelecki Holdings Pty Ltd, wished to purchase land owned by the respondent, Cable Sands Pty Ltd, at Minnup near Capel (the land). The parties did not enter into a conventional contract of sale owing to collections of radioactive tailings on the land. Instead, they executed a MOU. While the MOU remained in force, the parties were required to deal with each other in good faith.
The MOU provided that Cable Sands was to produce a report on the feasibility of dealing with the radioactive tailings. Following this, if Strzelecki wished to continue negotiations to execute a contract of sale, the parties were to negotiate in good faith for 30 days.
Strzelecki wrote to Cable Sands informing them that they wished to proceed with the purchase. Cable Sands proposed a series of special conditions to be included in the contract of sale. These conditions included that Strzelecki would be responsible for the remediation of the land and would indemnify Cable Sands against any liability under environmental law, and in relation to any injury, death, or any claims arising from the presence of contamination on the property.
Strzelecki subsequently sent a contract to Cable Sands by which Strzelecki offered to purchase the land. The contract, however, varied from Cable Sands' proposed conditions by removing its liability for the remediation and compliance with any environmental law, and also by deleting the indemnity and bank guarantee.
Strzelecki's covering letter noted that the offer as amended represented 'the contract that a court would say ... was reasonable for the parties acting in good faith to enter into taking into account the provisions of the MOU'. Cable Sands responded by saying that, while they were willing to renegotiate some of the terms, the indemnity and bank guarantee provisions were essential for them to continue. Cable Sands asked Strzelecki to reconsider its position.
Nothing further happened and the 30-day period expired without a contract for sale being finalised. Cable Sands wrote to Strzelecki's solicitors advising that the MOU had been discharged.
Strzelecki subsequently contended that the offer made was reasonable and made in good faith. Strzelecki requested Cable Sands execute the offer and return the contract within 14 days. This did not occur and Strzelecki commenced proceedings.
Strzelecki's key assertion on appeal was that Cable Sands acted unreasonably in proffering the special conditions and thereby failed to act in good faith. The Court of Appeal held that Cable Sands did not breach the express term of good faith in the MOU.
The court found that the term 'good faith' must always be understood in light of the surrounding factual matrix. Justice Pullin made the observation at  -  that:
The interpretation of the meaning of these words is not determined by the parties' subjective understanding but by the objective meaning of the words which a reasonable person would have understood them to mean.... In ascertaining the objective meaning, the court has to consider the contract as a whole.... The construction of the contract and interpretation of words is determined by taking into account the objective background of the transaction or factual matrix of the contract... but not the subjective intention of the parties.... When the issue is about the meaning of words, the natural and ordinary meaning is given to the words.
Justice Pullin also observed that the term probably embraces at least three related notions as expounded by Sir Anthony Mason (writing extra-judicially),3 namely:
- an obligation on the parties to cooperate in achieving the contractual objects (loyalty to the promise);
- compliance with honest standards of conduct; and
- compliance with standards of conduct that are reasonable having regard to the interests of the parties.
These conditions and other authorities concerning 'good faith' were considered by President Allsop in United Group Rail Services Ltd v Rail Corporation of New South Wales (2009) 74 NSWLR 618 as requiring no more than that a party act honestly within the framework of fidelity to the bargain. (See our previous Focus: Negotiating in good faith, July 2009.) The reference to 'fidelity' is a reference to the requirement that a party do all things necessary to enable the other party to have the benefit of the contract. That does not, however, require a party to give in to the other party's demands. Rather, as the court confirmed (citing United Rail with approval), parties to a transaction are only under a duty to deal with each other honestly. They do not owe each other a fiduciary obligation nor are they required to subordinate their own interests to uphold the obligation of good faith. This is because the term 'good faith' must always be understood in the light of the self-interested commercial context in which negotiations often take place.
The good faith obligation may also impose a negative obligation to avoid negotiating in an arbitrary or capricious manner. In effect, that amounts to acting in bad faith and accordingly would be a breach of a term of good faith. In most cases, bad faith occurs where one party, without justification, acts so as to nullify the expected benefit under the contract. This is not, however, to suggest that the content of an offer made in negotiations where parties must deal with each other in good faith must pass some objective test of reasonableness. In this respect, the special conditions requested by Cable Sands were not unreasonable, nor did Cable Sands take an uncompromising view on their inclusion; they were prepared to negotiate the terms. As a result, Cable Sands did not fail to act in good faith.
The Strzelecki decision confirms that a duty of good faith will not be breached merely because one party does not subordinate its own legitimate self-interest to another's. Strzelecki provides helpful judicial guidance on the meaning of good faith in the context of commercial negotiations. It affirms the widely understood expectation that business people must act honestly and genuinely with each other in performing a contract containing a term of good faith. Parties should take particular care to avoid acting capriciously or in bad faith when bound by an express 'good faith' clause.
It remains to be seen whether the way in which judge-made law has sought to define 'good faith' will be enshrined in both state and Commonwealth legislation, or how it will affect the courts' interpretation of statutory prohibitions on unconscionable business conduct, for which a breach of good faith is a relevant indicator.
- Strzelecki Holdings Pty Ltd v Cable Sands Pty Ltd  WASCA 222 (22 November 2010).
- United Group Rail Services Ltd v Rail Corporation of New South Wales (2009) 74 NSWLR 618.
- Strzelecki Holdings Pty Ltd v Cable Sands Pty Ltd  WASCA 222 (22 November 2010) at  (Justice Pullin), quoting Sir Anthony Mason, 'Contract, Good Faith and Equitable Standards in Fair Dealing' (2000) 116 LQR 66.
- Michael HollingdalePartner,
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- Stephen McComishPartner,
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- Anthony ArrowPartner,
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- Ren NiemannPartner,
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