The Court of Appeal has recently provided guidance on the interpretation of a “good faith” provision in a shareholders’ agreement, in the context of an unfair prejudice petition (Re Compound Photonics Group Ltd; Faulkner v. Vollin Holdings Ltd [2022] EWCA Civ 1371; the judgment was handed down on 21 October 2022). The court held that other than a core duty of honesty and (depending on the context) a duty not to engage in conduct that could be characterised as bad faith (conduct which reasonable and honest people would regard as commercially unacceptable, but not necessarily dishonest), any further obligations of good faith had to be derived as a matter of interpretation or implication from the terms of the contract and the commercial context – in the same way as any other term in a contract.

Given that the good faith provision was in a shareholders’ agreement, the structure of a limited company and the relationship between its members and their interests (including their ability to vote on certain decisions on an ongoing basis) had to be taken into account when determining the meaning and scope of the good faith provision. That formed a very different backdrop to that of an ordinary commercial contract. If the statutory rights of shareholders are to be restricted or removed, or if additional obligations are to be imposed, clear wording is needed. A good faith provision is not an “open invitation to the court” to impose “additional substantive obligations (or restrictions on action) outside the other terms of the contract”. The judgment is considered in more detail below.

Background

Compound Photonics Group Limited (the “Company”) was a vehicle for the intended development and commercialisation of academic research by Dr Sachs into Gallium Arsenide and liquid crystal technology. The focus of the business plan was to develop, manufacture and sell a ‘pico’ projector, which is essentially a very small (often palm-sized), portable, battery-operated projector which is designed to project media content such as films or photographs from a phone or laptop.

Mr Faulkner joined the Company as Chairman, with Dr Sachs occupying the position of CEO. As the business progressed, outside funding was obtained from Vollin Holdings Limited, Minden Worldwide Limited and Aldon Investments Limited (together the “Investors”). By 2013, the Investors had invested in excess of US$135 million in the Company and eventually held a 93% shareholding.

After a series of requests for more investment by Dr Sachs and Mr Faulkner, along with delays and missed deadlines, the Investors decided it was in the best interest of the Company for Dr Sachs and Mr Faulkner to be removed from their roles and for the Company to change direction. Both the High Court Judge and the Court of Appeal found that those were genuinely and rationally held views for good commercial reasons.

Dr Sachs was forced to resign, and Mr Faulkner was removed by the shareholders pursuant to s168 of the Companies Act 2006 (the “2006 Act”). The relevant agreements in force at the time were the 2013 shareholders’ agreement (the “SHA”) and the 2013 Articles (the “Articles”). Clause 4.2 of the SHA states (emphasis added):

“4.2 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.”

Dr Sachs, Mr Faulkner and 68 other shareholders (the “Petitioners”) brought a claim against the Investors for unfair prejudice under s994 of the 2006 Act. The claim was brought primarily on the basis that the actions of the Investors (i.e. by forcing the departures of Dr Sachs and Mr Faulkner) were in breach of the “good faith” provision in the SHA. The Petitioners also claimed that the directors nominated by the Investors had acted in breach of their duties.

High Court judgment

The High Court held that the Petitioners had been unfairly prejudiced as result of Dr Sachs and Mr Faulkner being forced out of the Company, on the following basis:

• Although the general power of the shareholders to remove a director under s168 of the 2006 Act is an “inalienable right”, exercising this right could infringe some other right (such as a contractual right to remain a director).
• Although there was no express provision in the SHA which prevented Dr Sachs or Mr Faulkner from being removed from office, the Judge considered that the SHA generally indicated that the parties had reached a “bargain” which “entrenched” Dr Sachs and Mr Faulkner in their roles at the Company. For example, the SHA stated that Dr Sachs and Mr Faulkner would need to be present for board meetings to be quorate, and both had to vote in favour of a decision for it to be passed at board level.
• A party subject to a duty of good faith is bound to observe the following “minimum standards” imported from Unwin v Bond [2020] EWHC 1768 (Comm):
  • They must act honestly;
  • They must be faithful to the parties’ agreed common purpose as derived from their agreement (“fidelity to the bargain”);
  • They must not use their power for an ulterior purpose;
  • They must deal fairly and openly with the claimant; and
  • They must have regard to the claimant’s interest (although they can consider and take into account their own interests).
• As the good faith provision applied to “all dealings”, this broad language covered the manner in which voting rights were exercised.

The Judge held that, as the good faith provision required “fidelity to the bargain” and the parties had reached a “bargain” which “entrenched” Dr Sachs and Mr Faulkner in their roles at the Company, it would amount to a breach of contract if the Investors removed Dr Sachs or Mr Faulkner from the board or interfered in any way with the management of the company; and the removal of Dr Sachs and Mr Faulkner was unfairly prejudicial to the Petitioners.

The Judge also held that these actions amounted to a breach of directors’ duties: (1) s171(a) of the 2006 Act, the obligation to act in accordance with the company’s constitution (on the basis the SHA formed part of the constitution, given the wording of s17 and s29 of the 2006 Act); and (2) s172(1)(f), the requirement for a director to act fairly as between members of the company.

Court of Appeal judgment

The decision was overturned on appeal. The Court of Appeal held that there had been: (1) no breach of the duty of good faith by the Investors; (2) no unfair prejudice; and (3) no breach of directors’ duties for the reasons set out below.

Approach to determining the meaning of an obligation of good faith

• In interpreting a good faith provision, the court has to take into account the contractual and commercial context in which it is used (Compass Group UK and Ireland Ltd (t/a Medirest) v Mid-Essex Hospital Services NHS Trust [2013] EWCA Civ 200 at [109]).
• Other contractual terms may well be relevant to that interpretation by giving a frame of reference or benchmark by which to assess and give meaning to the good faith clause. There may be no such frame of reference outside the terms of the agreement (paragraph 210).
• Accordingly, other cases which turn on their own particular facts may be of limited value and must be treated with “considerable caution” (paragraph 148).
• For the same reason, it is not appropriate to apply “minimum standards”, like those set out in Unwin v Bond in a “formulaic way in every case, irrespective of the context and the other terms of the agreement in issue” (paragraph 151).
• Other than a core duty of honesty and (depending on the context) a duty not to engage in conduct that could be characterised as bad faith (conduct that reasonable and honest people would regard as commercially unacceptable, but not necessarily dishonest), any further obligations of good faith had to be derived as a matter of interpretation or implication from the other terms of the contract in issue, taking into account the commercial context (see paragraph 243 and paragraphs 275 – 276).

A good faith provision in a shareholders’ agreement

• The structure of a company and the relationship between its members and their interests (including the general ability to vote on certain decisions) form a very different backdrop to that of an ordinary commercial contract. In a company, decisions are taken democratically by specified majority votes. There is no general requirement for shareholders to take into account the interests of other shareholders when deciding how to vote. The test to determine the validity of a resolution is simply whether those voting in favour honestly believed that it was for the benefit of the company. This could be altered by a shareholders’ agreement, but this would need to be expressed clearly and directly (paragraph 198 - 201).
• Any restriction on the rights of shareholders (in this case, on the statutory right of shareholders to remove a director) or any imposition of additional obligations should be expressly set out in clear wording in the shareholders’ agreement. A good faith provision is not an “open invitation to the court” to impose “additional substantive obligations (or restrictions on action) outside the terms” of a shareholders’ agreement (especially a professionally drafted one which contains an entire agreement clause) (paragraph 205).
• The Court of Appeal did not agree that the general power of the shareholders to remove a director under s168 of the 2006 Act was an “inalienable right” that could be restricted by contract. If the Petitioners were correct about the meaning of the bargain, they could have obtained an injunction to prevent the removal of Dr Sachs and Mr Faulkner; therefore the right would not be inalienable (paragraph 257). It was illogical to envisage a contractual obligation which did not prevent the removal of a director, which at the same time gave rise to a breach of contract if the director was removed.

Specific terms of the SHA

• On a literal interpretation, the terms of the SHA did not “entrench” Dr Sachs and Mr Faulkner in their roles at the Company: there was no express agreement by the Investors not to vote at any general meeting of the Company in favour of a resolution to remove Dr Sachs and Mr Faulkner as directors.
• Further provisions of the agreement also supported this analysis, for example: (1) clause 7.8 of the SHA stated that the quorum at any board meeting should be “three directors and [should] include (insofar as they each remain a director) the Founder Director [Mr Faulkner], the CEO [Dr Sachs] and, if one or more has been appointed, an Investor Director” (emphasis added); and (2) the SHA contained a provision which required Dr Sachs and Mr Faulkner to sell some or all of their B shares on being removed from office (see paragraphs 255 to 261). These provisions clearly contemplated that Dr Sachs or Mr Faulkner could be removed from their positions.
• The relevant commercial context was that, at the time the SHA was entered into in 2013, the Investors had invested in excess of $135 million in the Company and held 80% of the shares. In such circumstances, it would be “implausible” and “commercially counter-intuitive” for the Investors to have effectively surrendered their rights to exercise any control over the management and commercial future of the Company (paragraph 273).

Directors’ duties

• The Court of Appeal also held that the SHA did not form part of the Company’s constitution given s17 and s29 of the 2006 Act. Broadly summarised, those provisions state that the company’s constitution includes an agreement which, if not agreed to by all the shareholders or a class of shareholders, would not have been effective for its purpose unless passed by a special resolution.
• That includes a written agreement between all members/a class of shareholders, to be used in place of a special resolution required by the 2006 Act (for example, to amend the Articles); and therefore the SHA did not form part of the Company’s constitution. Therefore, there could be no breach of the directors’ duty to act in accordance with the company’s constitution (s171(a) of the 2006 Act).
• In any event, given the lack of express wording in the SHA, it was held that the minority shareholders did not have a right to have Dr Sachs and Mr Faulkner remain in office “come what may” regardless of the circumstances. Just as a good faith provision in an agreement has to be read in context, so “the section 172(1)(f) duty placed upon directors to have regard to the need to act “fairly” as between members of the Company must be given some legal frame of reference and cannot simply require directors to have regard to their own free-standing view of what might be “fair” between members” (see paragraphs 297). As a result, there was no breach of the requirement in s172(1)(f) for a director to act fairly as between members of the Company.

Final thoughts

The Court of Appeal’s judgment demonstrates the limitations of a good faith provision. It is not a term that can be applied broadly without reference to the terms of the contract and the commercial context. At a basic level, such a provision will lead to a “core duty of honesty” and (depending on the context) a duty not to engage in conduct which could be characterised as bad faith. However, beyond this, the interpretation of such a provision depends heavily upon the background and terms of the contract. If the parties to a shareholders’ agreement wish to limit any rights of the shareholders or impose additional obligations, clear wording is needed in the shareholders’ agreement. A party may well not be able to rely on a good faith provision to import additional rights/obligations which have not been expressly agreed.

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