Whether or not the elusive “duty to act in good faith” actually exists in commercial contracts is a matter of considerable debate. The courts appear so uncertain in fact, that they explicitly accept the ambiguity and proceed “just in case” on the basis that such a duty does exist.
This occurred in Kosho Pty Ltd & Anor v Trilogy Funds Management Limited [2013] QSC 135. The Queensland Supreme Court acknowledged that there was little guidance around the existence and nature of a duty to act in good faith. And yet the Court proceeded on the assumption that such a duty existed regardless.
Relevant Facts
While the facts in Kosho are extensive, it is only relevant to highlight the following points. Kosho Pty Ltd (Kosho) bought a large block of land at Nerang to develop the “Abadi Residential Village”.
In 2007, City Pacific Limited (CPL) as the responsible entity of the Pacific First Mortgage Fund (PFMF) entered into a loan agreement with Kosho for $12,610,000 over a period of 18 months (2007 Facility).
In 2009, the parties began negotiating a loan of $16,000,000 to cover the existing debt and $2,193,830 in additional construction costs (2009 Facility). The extension of the 2007 Facility covered the negotiation period for the 2009 Facility.
Special Conditions
A number of special conditions needed to be satisfied before advancing the additional construction costs of the 2009 Facility. Most relevant was Special Condition (s), which read as follows:
This offer of finance is conditional on, and subject to:
- the borrower entering into a deed of assignment and consent in relation to the agreement between the Department of Main Road, Kosho Pty Ltd and Club Cavill Pty Ltd (Assignment Deed). This to be prepared by, and on terms satisfactory to the Lender;
- the borrower causing Club Cavill Pty Ltd to enter into the Assignment Deed;
- the Department of Main Road confirming that it is satisfied with the terms of the Assignment Deed; and
- the Assignment Deed being entered into and binding on the Borrower and Club Cavill Pty Ltd (and the Borrower providing two originals of the Assignment Deed executed by both the Borrower and Club Cavill Pty Ltd to the Lender) within 2 business days of receipt of the Assignment Deed.
On 20 July 2009, Trilogy Funds Management Limited (Trilogy) replaced CPL as the responsible entity of PFMF. Kosho brought the proceedings because Trilogy never advanced the additional construction funds.
Trilogy contended that Kosho never satisfied a number of Special Conditions, including Special Condition (s). Therefore it was not obligated to advance the funds.
What is Good Faith?
Though never authoritatively ruled on by the High Court, many state courts have found that commercial contracts may generally include an implied duty of good faith.
The content of the duty to act in good faith varies widely. It can range from an obligation not to impede performance of the agreement to a duty to co-operate. Applegarth J in Kosho expressed the view that a party acting in the honest pursuit of a legitimate interest would not be breaching the duty of good faith.
This view stems from the widely accepted interpretation of the duty of good faith, which promotes three elements:
- An obligation on the parties to co-operate in achieving contractual objectives;
- Compliance with honest standards of conduct; and
- Compliance with standards of conduct that are reasonable having regard to the interests of the parties.
Co-operation in achieving contractual objectives
Co-operation in achieving contractual objectives does not mean doing something not otherwise required under the contract.
Let’s look at an example. A lender enters into an agreement to provide funds for security subject to a number of special conditions. This was the case in Kosho.
The duty of good faith does not oblige a lender to advance funds regardless of the circumstances. Rather under the contract the lender is only required to advance funds when the special conditions are satisfied.
Compliance with honest standards of conduct
While co-operation in achieving contractual objectives might be broadly understood, honesty as a standard of good faith is more restrictive.
To establish a breach of good faith, a party need only demonstrate that the lender acted for a reason that was “extraneous, dishonest, capricious or arbitrary”. However, this obligation to act with honest standards of conduct doesn’t equate to a duty to act reasonably.
As the court held in Kosho, while Trilogy’s delay in deciding approval with Special Condition (s) was unreasonable, it was not fickle. Therefore it did not breach any duty of good faith.
Compliance with standards of conduct that are reasonable having regard to the interests of the parties
There is no free-standing duty to act reasonably contained in the duty of good faith. However, there is a duty to act reasonably having regard to the interests of the parties. This does not mean it is the lender’s duty to act in the interests of the other party. Nor to subordinate its own interests to that of the borrower. But merely to have regard to the legitimate interest of the borrower in obtaining funding.
In Kosho, the court held that Trilogy had regard to Kosho’s legitimate interest in obtaining funding. But it equally had regard to its own real interest in negotiating a suitable deed. Trilogy took an unreasonable amount of time to negotiate the deed. However, this was not a breach of the duty of good faith. Why? It was reasonable for Trilogy to prioritise its need for a satisfactory deed over the interest of the borrower in obtaining funding.
Conclusions on the Duty of Good Faith
The Kosho decision does not provide us with any further guidance on whether a duty of good faith actually exists in commercial contracts. But it does allow us to see what a duty of good faith might look like. And how the courts might apply it.
Importantly for lenders, the Kosho decision doesn’t extend the requirements of a lender beyond the contractual terms. Nor does it require a lender to act in the interests of the borrower because of the duty of good faith.
However, lenders should be aware that the duty of good faith may impact their business models, depending on the future application of the honest standards of conduct test.
You can find the Kosho decision here, with the relevant paragraphs on the duty of good faith from [125] and following.
Related articles
Assignment of Mortgage & Loan Agreement in Dispute
Construction of Contractual Terms & Priority Between Lenders
This publication is for your general information and interest only. It is therefore not intended to be comprehensive, and does not constitute and must not be relied on as legal advice. You must seek advice tailored to your specific circumstances.