Why is the term Good Faith used in Contracts?

You’ve probably seen or heard about the concept of acting in ‘good faith’ in contracts. The idea behind the concept is where one party has the power or ability under a contract to exercise a right or to do something, that the exercising of that right or the doing of the thing should be done in ‘good faith’.

Well that’s great you say. But what does that really mean? What does it mean for a party to exercise its rights under a contract in ‘good faith’?

What does the term Good Faith mean?

The term good faith has actually been defined by judges in Australian case law and has 3 elements.

What are the 3 elements of Good Faith?

The three elements of good faith are:

  1. A loyalty to the promise – this is the duty to co-operate in achieving the contractual objects, or to do necessary things to enable the other party to have the benefit of the contract;           
  1. Honesty – the obligation to act honestly and not lie, mislead or deceive; and           
  1. Reasonableness — the obligation to act reasonably having due regard to the legitimate interests of the other party and to the terms, aims and purposes of the contract (note that this concept is still up for debate between judges and is seen by come judges as being controversial).

Because good faith can sometimes be open to interpretation, courts in Australia have tended to vary in the importance they’ve placed on it. In this article, we’ll run through the basics of good faith, with references to legal cases where it’s been an issue.

What are the 3 elements of Good Faith

First element: loyalty to promise

Loyalty to the promise is important to all contracts and is generally considered by the courts to be an implied part of any contract. The idea here being that as both parties to the contract have willingly entered into the contract that shows that both parties want to get something out of the contract, so the parties to the contract should act in a way that is loyal or consistent with those promises that are in the contract.

Second element: honesty

In Australia, the concept of honesty is considered central to the obligation to act in good faith and is considered to be a contractual obligation. Parties to a contract are expected to behave with honesty. Sometimes, courts have defined honesty as an assumption that parties to a contract will not act in bad faith, rather than that they will actively act in good faith.

Third element: reasonableness

While most judges accept that loyalty to the promise and honesty are always elements of good faith, the role of reasonableness is often disputed in Australian contract law. But it can and is argued that reasonableness is an inevitable part of good faith.

However as stated above the concept of reasonableness and whether this element should be part of the elements of good faith is not settled by the courts.

Where does the duty of good faith come from?

The desire for one party to a contract or the other to impose an obligation of ‘good faith’ on the other party to the contract has been resisted by the courts at times as some judges are concerned that it can’t be defined accurately enough.

However in New South Wales the courts have tended to give more weight to the concept of ‘good faith’ than those in other states, saying that in their view the concept is a meaningful concept that can be understood by both parties to a contract and, as such, the obligation for the parties to act in good faith when doing things under the contract has been incorporated into the terms of the contract.

Good faith does not mean ‘in the interest of the other party’

While there is debate over the exact meaning of the element of ‘reasonableness’ and whether it forms part of the definition of good faith,  what is clear is that the obligation to act in good faith does not require a party to the contract to act in the interests of the other party to the contract.

The case of Macquarie International Health Clinic v Sydney South West Area Health Service concerned contracts that made provision for the development of a 200 bed private hospital and car park by Macquarie on land owned by Area Health and subsequent leases over the hospital and car park. 

The contract between Macquarie and Area Health obliged both parties to act with good faith. A central aspect of the project was that the private hospital be located very close, or next to, Royal Price Alfred Hospital.

There was a clause in contract that prohibited Area Health, for five years from the date of the first admission to Macquarie’s private hospital, from recommending, supporting, or approving another private hospital which Macquarie reasonably believed would materially adversely affect the revenue derived from the hospital. 

In 1999, Area Health served notices of default on Macquarie and eventually notices of termination, then taking possession of the land. They alleged that there had been a breach of contract, because of Macquarie’s failure to comply with the contractual timetable and its obligation to pay an amount equal to the rent period for the delays. 

Macquarie sued Area Health for recovery of possession of the land and damages. The case went to appeal, and the appeal court judge said of good faith:

“A contractual obligation of good faith does not require a party to act in the interests of the other party or to subordinate its own legitimate interest to the interests of the other party; although it does require it to have due regard to the legitimate interests of both parties”..

The Court of Appeal identified several instances in which the obligation to act in good faith was breached by Area Health. They included Area Health’s support for another private hospital on a site adjoining Royal Prince Alfred Hospital, making the Macquarie hospital unviable.

The Court of Appeal found that Area Health had breached its contractual obligation of good faith by failing to inform Macquarie of the planning processes, failing to give them an opportunity to persuade Area Health to take a different course and by failing to give Macquarie an opportunity to revise its plans or withdraw from the project.

So obligations to act in Good Faith can have some real teeth. Be careful. If you have any concerns about whether the obligation to act in good faith should be incorporated into a contract give us a call here at the Contract Company.

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