Commercial agreements often require the parties to act ‘reasonably’ or ‘in good faith’ to resolve their differences or reach agreement on unresolved matters. These sound like simple obligations, but determining what they actually require in particular contexts is notoriously difficult to discern, especially the requirement to act in good faith. A recent case sheds some light on these issues and demonstrates that they can sometimes require more than you might expect.
Since this article was first published, the Court of Appeal has overturned the trial judge’s decision. Please see the ‘Court of Appeal’ section at the end of this article for more details.
Who needs to know?
Anyone who is involved in drafting or negotiating commercial contracts.
Recent Case
The recent case of North East Solutions Pty Ltd v Masters Home Improvement Pty Ltd [2016] VSC 1 arose from Woolworths’ now defunct plans to develop the ‘Masters’ hardware chain in Australia.
Woolworths was looking to develop a site near Bendigo, Victoria. It signed a binding letter of offer with a developer and subsequently signed a more formal agreement for lease. In high level terms, the developer was to acquire the site, construct the store in accordance with Woolworths’ specifications and then lease the site to Woolworths for a term of 12 years with 6 further terms of 5 years each.
At the time of entering into these documents, the specifications had not yet been finalised and consequently the construction cost was not yet known. The parties seemed to have a gauge on what it would cost to build a Bunnings store on the site, although the Masters store was likely to be a bit different and likely to be a bit more expensive. The letter of offer was entered into on 2 June 2009 and relevantly stated: “Should the design brief differ in cost to [a Bunnings store], the difference in cost is to be made [by Woolworths] by payment as a lump sum. Rider Hunt quantity surveyors, are to verify the cost difference”.
About 7 months later, the more formal agreement for lease was eventually entered into. This dealt with things slightly differently. In high level terms, it required the developer to calculate the construction costs based on the finally approved specifications and to provide Woolworths with details of its costings on an open book basis. The relevant clauses also required the developer to “advise” Woolworths whether the developer “required” Woolworths to contribute to the construction costs and the amount of the contribution (if any). Unlike the letter of offer, the agreement for lease did not contemplate a difference in cost benchmarked against a Bunnings store. Rather, the agreement for lease simply required the developer to calculate a cost, notify Woolworths of that cost and to advise whether the developer wanted Woolworths to contribute to that cost. There was nothing in the agreement for lease which put any flesh on the bones about how the cost contribution amount was to be determined. Under the agreement for lease, this was left as a matter to be negotiated. The agreement for lease stated that Woolworths and the developer must “acting reasonably and in good faith” attempt to resolve “any differences” they may have in relation to the cost calculation or the amount of requested contribution or the manner in which the contribution would be made. If these matters could not be agreed within a specified time period, the agreement for lease stated that either party could terminate the arrangement and walk away.
As it eventuated, no agreement was reached and Woolworths terminated the agreement for lease. The developer then alleged that Woolworths had breached the agreement by failing to act reasonably and in good faith to resolve the differences.
Implication and Entire Agreement
Before considering whether Woolworths acted reasonably or in good faith, it is important to note a fundamental aspect of the case regarding the interaction between the letter of offer and the subsequent agreement for lease.
The agreement for lease contained an ‘entire agreement’ clause. Unfortunately a copy of this clause is not set out in the judgment, however, normally this type of clause would have the effect of superseding and replacing any prior agreements i.e. the agreement for lease should have replaced the letter of offer. This is what Woolworths argued. However, the developer argued that certain aspects of the letter of offer survived or were somehow incorporated into or implied into the agreement for lease notwithstanding that the two documents were quite different in several key respects (see above) and separate by a period of many months. Normally, this would preclude the incorporation or implication of inconsistent terms into the subsequent and more formal document which purports to be the ‘entire agreement’.
Somewhat surprisingly, the Court agreed with the developer. The Court stated:
“In my view, the principles applicable to the construction of commercial contracts, such as the Letter of Offer and the Agreement for Lease, the subject of submissions by [the developer] are applicable in the present circumstances and would enable [the developer] to call in aid the provisions of the Letter of Offer insofar as they have not been abrogated or varied by clear provisions of the Agreement for Lease. For the preceding reasons the entire agreement provisions to which Woolworths make reference do not provide anything in the nature of such an abrogation or variation. Quite clearly, the commercial parties to the Letter of Offer intended its terms to have meaning and to be binding. It follows that the commercial context and the factual matrix in which the Agreement for Lease was entered into by corporate entities associated with and contemplated, at least in general terms, by the parties to the Letter of Offer must be accommodated and given effect to by implication or incorporation into the terms of the Agreement for Lease”.
Whilst this aspect of the case does not take up much of the judgement, in our view, the Court’s conclusion on this point is fundamental to the way in which it went on to approach the question of whether Woolworths acted reasonably and in good faith. As framed by the Court’s conclusions on incorporation and implication, Woolworths had actually agreed to pay the cost difference and it was simply a matter of reaching agreement on the amount of that contribution. This is quite a different scenario from what the agreement for lease (when looked at on its face in isolation) contemplated. It contemplated a period of negotiation with a view to potentially agreeing on certain matters with no parameters, benchmarking or guidance (other than the requirement to act reasonably and in good faith) with each party reserving the right to terminate if agreement could not be reached. Framed in this way, the agreement for lease was more akin to an option or a bare agreement to agree with each party reserving the right to walk away if the cost contribution could not be agreed. However, this is not how the Court approached it. Please see our comments below about how the Court of Appeal overruled the judge at first instance on this point.
Other Factors
During or possibly prior to the negotiation period, it appears that Woolworths went cold on the Bendigo site. It formed the view that the local council would not approve the development. It also identified a different preferred site in Bendigo. It also had concerns about the financial position of the developer.
Woolworths had an internal budget of up to $1.7 million to spend on contribution to the construction cost. The amount claimed by the developer was significantly higher than this. Woolworths obtained its own independent costings and these were actually even higher than the developer’s costings.
None of these factors were ever disclosed to the developer.
Decision
The Court agreed with the developer. It held that Woolworths failed to act reasonably and in good faith. It awarded the developer $10.875 million plus interest as its damages for loss of opportunity.
The Court held that the requirements to act good faith and to act reasonably will often overlap. They are nevertheless different and not entirely co-extensive. The court noted various cases in which it had been held that acting in good faith actually required the party to also act reasonably. The court also noted other cases in which a requirement to act reasonably did not form part of the obligation to act in good faith. Overall, the court did not need to decide this because the clause in this case expressly required the parties to both act reasonably and in good faith.
Good faith usually requires a party to cooperate in achieving the contractual objectives, to act honestly and not capriciously, arbitrarily or for extraneous purposes. Good faith does not require a party to subordinate its own interests to those of the other party, but as this case demonstrates, it can be hard to draw the line. The requirements of good faith will depend on the facts of each case, including the terms of the relevant contract when viewed as a whole. It is generally considered that a requirement to act reasonably is more onerous than a requirement to act in good faith.
In this case, the Court held that:
The object of this process and of the clause itself was to enable the parties to quantify the difference in cost as between the development of the [Bendigo] site as a Bunnings store and the development of that site as a Masters store, costs which Woolworths had already committed to pay. In my view, it is clear that the content of the duties to act reasonably and to act in good faith must be informed by these circumstances. As [the developer] observes, by way of example, while it may be reasonable for a party not to disclose the basis of its position in a mediation or negotiation, where the object is merely to negotiate in one’s own self-interest, refusing to provide the information necessary to identify differences between the parties, where the object of the duty is to resolve such differences, such conduct will be unreasonable and, depending on the precise circumstances, probably also a failure to act in good faith.
The Court also held that Woolworths’ failure to agree and then terminate was essentially motivated by Woolworths’ change of mind about the site and its concerns about council opposition and the developer’s financial position. The Court held that these were impermissible extraneous reasons and therefore it had acted in bad faith. The Court also held that it was impermissible for Woolworths to even take into account its own internal budget (see above).
In the circumstances, the Court held that a reasonable person in Woolworth’s position would have, at a minimum, done the following:
- invited the developer to attend and participate in the open book review process and encourage its involvement, so that the developer would be informed of any differences identified during that process and be better able to resolve them. In this case, Woolworths failed to invite the developer to attend;
- informed the developer of any differences it had identified in relation to the calculation of the costs and contribution and of any other expectations Woolworths’ may have had in relation to those costs. In this case, Woolworths had basically just said that the developer’s costs were “too high” or “not acceptable”, but did not identify differences;
- communicated to the developer the basis of any conclusion that the costs and contribution amount were “too high” or “unacceptable”, particularly where the estimate provided was a detailed estimate from an experienced builder whose estimates were known to be reliable from other tenders;
- assisted the developer in identifying and obtaining quotes from alternative builders; and
- provided the developer with any documentation, such as reports prepared by Woolworths’ quantity / costs surveyor, that identified the differences and the basis of the differences Woolworths had identified. As mentioned above, Woolworths obtained independent costsings but it never divulged these to the developer.
Practical Points to Take Away
- Obligations to act reasonably or in good faith should be approached with caution. Their requirements are difficult to predict and can be surprising.
- Ensure all communications (internal and external) are consistent with acting reasonably and in good faith. In this case, there were some incriminating internal emails at Woolworths that made it clear that, from its perspective, the deal had fallen over before the negotiations had even started. Likewise, its decision to pursue the alternative site was held against it. Its decision to terminate for failure to agree the costs contribution was really a rouse for the real reason – a change of mind.
- Whilst overlapping, an obligation to act reasonably is likely to be more onerous than an obligation to act in good faith.
- Consideration should be given to including express terms to elaborate on what acting reasonably or in good faith does or does not require. This approach is similar to the way in which express terms are often included to clarify what is involved with other obligations such as ‘reasonable endeavours’.
- As mentioned above, the Court’s conclusion on the entire agreement clause was a fundamental aspect of this case. Consideration should be given to enhancing those clauses and to including specific reference to earlier documents if the intention is that they be entirely superseded and replaced.
Court of Appeal
As flagged when this article was first published, Woolworths appealed the decision to the Court of Appeal. On 27 April 2017, the Court of Appeal handed down a unanimous joint judgment overturning the decision of the judge at first instance. The key points from the Court of Appeal’s decision are:
- The Court of Appeal held that a commitment from Woolworths to ‘pay the difference’ was not to be incorporated, inferred or implied into the agreement for lease.
- After closely scrutinising the evidence, the Court of Appeal held that, on the balance of probabilities, there was an insufficient basis to make various inferences necessary to conclude that Woolworths had, as a matter of fact, failed to act reasonably or in good faith. The evidence is very detailed and not readily summarised in this article.