Good faith and the exercise of contractual discretions

Background

Commercial contracts frequently contain provisions which give one party a power or discretion which, if exercised arbitrarily or capriciously, may adversely affect the interests of the other.

The purpose of this article is to consider how far the concept of good faith has been utilised in the Australian courts as a mechanism to control the exercise of contractual discretions.

The role of good faith in Australian contract law remains unsettled.

The first question is whether, assuming that a contract does not contain an express obligation to act in good faith, contracting parties are nevertheless bound by an implied duty to act in good faith and, if so, what is the juridical basis for such an implication.

The debate as to the place of good faith in contemporary Australian contract law started in 1992 with the judgment of Priestley JA in Renard Constructions (ME) Pty Ltd v Minister for Public Work (1992) 26 NSWLR 234. His Honour held that to bring about a valid termination of a construction contract under a show cause regime, the principal must act reasonably both in issuing the show cause notice and in assessing the contractor’s response.

There are basically two different approaches as to the circumstances in which a duty of good faith may be implied into a commercial contract.

On the one hand, the New South Wales Court of Appeal in a series of decisions¹  has held that it is appropriate to imply into all commercial contracts as a matter of law that the parties will act in good faith towards each other.

On the other hand, the Court of Appeal of Victoria has rejected the proposition that an obligation of good faith should be implied indiscriminately into all commercial contracts. In Esso Australia Resources Pty Ltd v Southern Pacific Petroleum NL [2005] VSCA 228, Warren CJ in explaining the basis of her approach said:

The modern law of contract has developed on the premise of achieving certainty in commerce. If good faith is not readily capable of definition then that certainty is undermined. It might be that a duty of good faith is no more than a duty to act reasonably in performance and enforcement, a long established duty.

However, the Victorian Court did accept that in a particular fact situation a duty of good faith may be implied based upon the presumed intention of the parties in that situation. In this scenario there is no universal approach to all commercial contracts but rather a focus on the individual contract in question.

The second question concerns the content of a duty of good faith.

In Strzelecki Holdings Pty Ltd v Cable Sands Pty Ltd [2010] WASCA 222, Pullin JA in dealing with an express obligation in a Memorandum of Understanding to act in good faith said:

The phrase "in good faith" is not yet a term of art because a term of art is a word or phrase used in a precise sense in a particular subject or field. The precise meaning or sense of the word has not yet been worked out. The natural and ordinary meaning of the phrase "good faith" means honesty of purpose.

In my opinion, the MOU only required the parties to deal with each other honestly.

The following expressions have, from time to time, been used by the Australian courts as identifying the content of good faith:²

• To act honestly
• To act reasonably
• To act with fidelity or loyalty to the bargain
• To act reasonably and with fair dealing having regard to the interests of the parties, and
• To co-operate in achieving the contractual objects.

The High Court of Australia has yet to rule on the nature and content of the obligation of good faith. In the absence of such authority the Australian appellate courts have historically adopted Sir Anthony Mason’s so-called tripartite analysis which he provided in his 1993 Cambridge University lecture. Sir Anthony suggested that the notion of good faith incorporates the combination of the following 3 elements:

• An obligation to co-operate in achieving the contractual objects (fidelity to the bargain)
• Compliance with honest standards of conduct, and
• Compliance with standards of conduct that are reasonable.

More recently the Full Federal Court in Virk Pty Ltd (in liq) v YUM! Restaurants Australia Pty Ltd [2017] FCAFC 190 has moved away from the Mason analysis and identified good faith in terms of the quality of conduct. In dealing with the point, the Court noted:

Rather it goes to the quality of the conduct, here in exercising the price setting power, to discern whether it was capricious, dishonest, unconscionable, arbitrary or the product of a motive which was antithetical to the object of the contractual power. Conduct attended by any of those qualities could never be said to be in good faith. Consideration of the relevant conduct within these confines informs the question whether or not the power has been exercised in good faith.

Practical significance

The relevance of good faith has been considered by the Australian Courts in two areas.

First, termination for convenience.

Secondly, termination under a show cause regime.

In respect of a termination for convenience power, the balance of recent authority³  indicates that the exercise of the power is not constrained by considerations of good faith although there remains a duty to act honestly which is a universal duty. However, principals need to be cautious in exercising such a power where it is transparently for an extraneous purpose and where it would defeat the legitimate commercial expectations of the contractor. Such conduct may potentially be regarded as dishonest. Even if the power is expressed in terms of an absolute discretion and exercisable for any reason, there may still be a risk that the exercise of the power could be challenged on bad faith grounds. In the majority of commercial contracts the exercise of a termination for convenience power would, in all likelihood, be effective although each case would require an appropriate factual investigation to assess risk in the particular circumstances.

Turning to termination under a show cause regime. In the recent decision of the New South Wales Court of Appeal in Bundanoon Sandstone Pty Ltd v Cenric Group Pty Ltd [2019] NSWCA 87, the Court held that a principal under a construction contract who issues a show cause notice in accordance with a termination regime must act in good faith in considering the contractor’s response. In circumstances where a principal had a closed mind and was not interested in the content of the response, the principal’s subsequent termination of the contract constituted a wrongful repudiation. The NSW Court of Appeal noted that the principal’s real motive in initiating the show cause process was to deprive the contractor of a specific economic benefit and take that benefit for itself.

Key conclusions

The current state of Australian law on the concepts of good faith and reasonableness (as constraints) may be summarised in the following propositions:

• Whether a duty of good faith is to be implied into a contract as a matter of law remains unsettled.
• A contracting party is subject to an overarching implied duty to act honestly and with fidelity to the bargain, that is, to act co-operatively to achieve the objects of the contract. This is an independent principle of the common law and is not concerned with good faith as such. However, co-operation has been viewed as a component of good faith.
• If parties to a contract expressly agree to act in good faith or the duty is otherwise to be implied, then, in the exercise of a contractual power or discretion, a party must not act capriciously, arbitrarily or for an improper or extraneous purpose. This appears to be the core of good faith in the modern law of Australia.
• An express or implied obligation to act in good faith does not impose the obligation of a fiduciary, and a party subject to the obligation may always have regard to its own legitimate commercial interests in the performance of a contract.
• A duty of good faith will not block the operation of the express terms of the contract. The duty may be expressly excluded.
• In the composite expression good faith and reasonableness, the concept of reasonableness is not to be viewed distinctly from good faith.