Court of Appeal overturns previous decision on obligations of good faith

Last year, the English courts ruled that an obligation could be implied into a contract that the parties would not exercise a discretion under that contract in a manner that was arbitary, capricious or irrational.

The case related to an outsourcing contract between an NHS Trust and catering company Compass, trading as Medirest. The contract contained a service level regime, but unusually the “Service Failure Points” (SFPs) awarded for a breach of the service levels, which in turn could lead to a right to terminate, appeared to be determined at the discretion of the NHS Trust (the customer).

As the relationship broke down, the NHS Trust allocated apparently disportionately high SFPs for individual breaches. Amongst the examples quoted by the judge was the award of over 30,000 SPFs and a deduction of £46,000 from the charges for an out of date box of tomato ketchup sachets found in a store room. By way of comparison, the fees were around £180,000 a month, and only 1,400 SPFs were required in a six month period to trigger a right to terminate.

The court held that the Trust had a discretion under the contract and therefore, in accordance with previous case law, a term should be implied not to act in a manner that is arbitary, capricious or irrational. The court in turn held that the Trust was in breach of that obligation and that Medirest was intitled to terminate for breach.

You can read a full summary of the original judgment in this previous blogpost.

The Court of Appeal’s decision
The Trust appealed on a number of grounds. On appeal, the Court of Appeal overturned the lower court’s decision, holding amongst other things that there was no need for the implied term.

Whilst the SFPs and deductions made were clearly absurd, the Court of Appeal took the view that the Trust had misinterpreted and misapplied the SPF and deduction procedure, but that it had not acted dishonestly.

If the Trust awarded itself execessive SFPs or deductions then that would be a breach of clause 5.8 (which dealt with the application of SFPs and deductions) – no further implied term was required to make that work. Indeed, clause 5.8 stated that SFPs and deductions that were not justified were deemed to have been cancelled.

As the SFPs had expired and the Trust had refunded the excessive deductions, the breach had been cured. Medirest was not, therefore entitled to terminate the contract for material breach.

Comment
The Court of Appeal’s judgment clarifies a number of points:

  • An implied term not to act arbitarily, capriciously or irrationally will only be applied where the part in question has genuine discretion about how to exercise a right under a contract, and where there is a range of options. In this case, the Court of Appeal held that the discretation was simply whether or not to exercise a contractual right.
  • Jackson LJ’s view was that any attempt to exclude such an implied term where it might otherwise apply would have to be explicitly stated and agreed by the parties (it could not be excluded by a general exclusion of implied terms).

The case serves also as a general reminder to organisations to ensure that their contractual arrangements are clear and unambiguous. In this case, the contract comprised a standard NHS contract and a procedure from a PFI contract for service failures and deductions. The two did not sit well together. Had the contract been properly drafted, then it is possible that the Trust may not have acted in the way it did, and that the relationship between the parties may not have broken down quite so irrepairably.

The case should also act as a warning to parties to think before terminating for material breach. In this case, it appears that Medirest was already in breach of contract, and that the Trust had also served notice to terminate. However, wrongfully claiming repudiatory breach and ceasing to perform your obligations is likely to lead to a substantial damages claim from the other party. This is particularly so where the terminating party is the supplier under an outsourcing arrangement, where the sudden cessation of the services could cause substantial damage.

Martin Sloan

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