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Shareholders beware! Shareholder duties & good faith

2 February 2023

Consideration of the impact of Re Compound Photonics Group Ltd; Faulkner v. Vollin Holdings Ltd [2022] EWCA Civ 1371

Shareholder duties

Unlike directors, it is a well-established principle that the role of shareholders within limited companies is finite. For brevity and in simple terms, the limited duties/role required from shareholders can primarily be grouped under four main headings:

1. Voting requirements;
2. General meetings;
3. Involvement in winding up of a company and
4. Unfair prejudice actions.

In addition to the above, there is an underlying contractual relationship between shareholders and a limited company that is governed by the terms of the relevant memorandum, articles of association and often by the terms of any separate shareholders’ agreement (this essentially represents a contract with the shareholders).

What is a duty of good faith? Is there a duty of good faith? Historic approach of the Courts in interpreting a shareholder’s duty of good faith

For completeness, acting in good faith simply refers to acting with honest intent, fairly, and not to act in a manner that is inconsistent with the reasonable expectations of the contracting parties.

Historically, the Courts of England and Wales took a draconian approach when seeking to interpret good faith into contracts. Therefore, the subjective nature of good faith clauses within shareholder contracts has caused a wide variety of interpretations and ambiguity. The purpose behind such clauses is to try and ensure that the parties do not mislead or deceive each other and to prevent the contracting parties from negating the rules and purpose of the contract.

What is the up to date position? Case digest: Re Compound Photonics Group Ltd; Faulkner v. Vollin Holdings Ltd [2022] EWCA Civ 1371

Recent case law has suggested that a more objective test of good faith may be adopted in some circumstances. In the abovementioned case, the Court provided guidance as to what is required to demonstrate a breach of the duty of good faith.

By way of brief background, the case concerned the removal of two directors from office who had been appointed by the minority shareholders. The articles of association sought to entrench the position of those directors, by providing that the board could not vote to remove them. However and in contrast, the shareholders’ agreement failed to contain a provision prohibiting the majority shareholders from voting those particular directors off the board. Interestingly, in this particular case there was a clause in the shareholders’ agreement clarifying that the shareholders would at all times act in good faith to each other.

In its judgment, the High Court found that the minority shareholders had been unfairly prejudiced by the forced removal of the directors. Accordingly, the majority shareholders appealed the case.

The Court of Appeal overturned the High Court’s decision, ruling that the Defendants did not breach the good faith clause in the shareholders’ agreement and therefore, had not unfairly prejudiced the minority shareholders. When considering the existing case law on the meaning of the obligation of good faith, the Court of Appeal sought to narrow the interpretation of the principles, noting that good faith would need to be determined on the facts of each case. In summary, the Court of Appeal found that a duty of good faith could potentially be breached by conduct that is in bad faith but is not necessarily dishonest, such as that which would be regarded as commercially unacceptable to reasonable and honest people.

What does this mean moving forward?

As there has been inconsistency and a lack meaningful definition of good faith where shareholder duties are concerned, those involved in limited companies have historically been unsure as to the extent of those shareholder duties under the law. The subjective nature of good faith clauses has caused a wide variety of interpretations. Shareholder contracting parties frequently seek to include express contractual obligations to act in good faith under an agreement (which would most likely be embroiled in a shareholders’ agreement).

In conclusion, while there remains a relatively high degree of ambiguity as to how good faith is defined and applied in practice, the case highlighted in this article signals a change in the Court’s approach to good faith clauses. The Court navigates the ambiguity, by opting for a less stringent approach and placing more emphasis on the interpretation of the commercial context and facts. This case serves as a useful reminder that when negotiating a contract, in certain circumstances, it may be advisable to expressly exclude the contractual duty of good faith, so as to avoid uncertainty as to the future interpretation of that contract. It is of utmost important that any shareholders’ agreement is carefully drafted.

Article Author: Eve O’Dowd

Further advice required?

If you require any advice on shareholder and/or director duties, please contact Paul James in our Corporate team paul.james@redkitelaw.co.uk or Rhian Davies in our commercial litigation team rhian.davies@redkitelaw.co.uk