Good Faith and Outsourcing

April 3, 2012

It is increasingly common to see duties of ‘good faith‘ imposed in outsourcing and other commercial contracts. However, this concept is poorly defined in English law and its effect on a commercial contract is uncertain.

In a recent case (Compass Group UK and Ireland Ltd (t/a Medirest) v Mid Essex Hospital Services NHS Trust [2012] EWHC 781 (QB)), a customer repeatedly and grossly miscalculated the service credits due under a long-term catering contract. The duty imposed on both parties involved to act in ‘good faith’ played a critical role in determining the outcome of this case as the court held that the customer’s behaviour was a clear breach of an express obligation to act in good faith, thus entitling the supplier to terminate the contract. It takes little imagination to see the relevance of the ruling to IT outsourcing and the wider outsourcing environment.

Hospital catering services in Essex

The customer, Mid-Essex Hospital Trust, entered into a long-term catering agreement with a supplier, Medirest. The contract contained a detailed service description and service level specification. Failure to meet these service levels allowed the Trust to deduct service credits, which could be deducted from the monthly charges. It also led to the accumulation of ‘service points’.

Importantly, service credits applied on an ongoing basis until Medirest either remedied the failure to the satisfaction of the Trust or took steps to prevent a reoccurrence of that failure. Thus, a single service failure could result in multiple service credits. The judge found that calculations made using this mechanism ‘led to a poisoning of the relationship between the parties‘.

The contract also contained an obligation on the parties to ‘co-operate with each other in good faith‘. The interaction between this obligation and the service credit regime was central to the dispute.

Initial problems with the service

The service started in April 2008. There were a number of problems with the service initially. For example, during the first three months there was a bedding-in period in which service credits were not payable. However, Medirest wrongly assumed this also meant there was no obligation to report on its performance against those service levels.

In response to this lack of reporting, the Trust began its own monitoring of Medirest’s performance including executive walk-arounds and checks in accordance with the Department of Health’s national cleanliness standards. These checks took place in August and September and uncovered a number of minor service failures, which would later prove significant. The failings included:

4 August. Box of ketchup sachets, out of date on 4 May, found in cupboard. This was not a brand used by Medirest and the box was removed immediately.’

20 August. Mousse out of date on 19 August. Removed immediately in the presence of Trust staff.’

However, after these initial teething problems, the service settled down. Various reports from patient groups and the like indicated a high level of satisfaction with both the food and the service from Medirest’s staff.

Service credits – £84,000 for an out-of-date mousse

Despite the apparent improvements to the service, the Trust issued a formal warning notice in December 2008 which triggered an obligation on Medirest to prepare an improvement plan. The Trust instructed its staff to review the plan and ‘pull it to bits’.

The plan was finally agreed at the end of January 2009, but at that point the Trust sent in its calculation of the number of service points accrued and service credits outstanding. It stated that Medirest had accrued 52,000 service points and the deductions for the period July 2008 to December 2008 came to £587,207.67, more than half the service fees payable during that period. The Trust suggested that this sum be paid over a six-month period.

Despite requests by Medirest for further details, the Trust provided a breakdown of these figures only in March. It became clear that the Trust had interpreted the service credit regime in a way that triggered multiple service credits from each of the minor service failures in August and September. The service credits incurred as a result of the out-of-date box of ketchup sachets had increased from £30 to £46,320. The service credits for the mousse which was one day over its use-by date had ballooned from £30 to £84,450.

Medirest contested the Trust claims strongly. It calculated that it had only accrued 18,000 service points and the service credits were only £37,665. The main difference between the two figures was Medirest’s view that service credits stopped running once the Trust was aware that the failure had been remedied or had been informed of the steps taken to remedy the failure. For example, the out-of-date mousse had been immediately removed in the presence of the Trust’s staff. There was no need to formally notify the Trust that the failure had been remedied.

Despite attempts to resolve the dispute, the relationship deteriorated and the Trust started to withhold significant amounts from payments to Medirest.

The contract comes to an end

Medirest responded with a notice to the Trust stating that it was in material breach. Medirest demanded that the Trust repay the sums withheld under the contract and re-issue the service credit schedule with appropriate corrections. If the Trust did not, Medirest would exercise its right to terminate the contract.

The Trust repaid the sums withheld but did not re-issue the service credit schedule. Medirest therefore served a termination notice. The Trust also served its own termination notice. After further negotiations, the parties agreed that the contract would terminate on 23 October 2009 without prejudice to whose termination was effective.

The Trust’s termination

The Trust’s notice of termination was based on Medirest having accumulated 1,400 service points, a figure that had easily been exceeded even on Medirest’s own calculations. Despite this, Medirest claimed that the notice was invalid as the Trust attempted to terminate the contract from a specified date in the future (being three weeks from the notice date). Medirest argued that there were no provisions in the contract allowing the Trust to keep the contract ‘alive’ and where termination was to be given on notice, a specified period of either six months or one month (dependent upon clauses 28.3 and 28.4 of the contract respectively), written notice was needed. Cranston J however ruled that there was ‘nothing in these arguments…[and] the very nature of the contract was supportive of the right of the Trust to give notice to terminate at a future date’. Ultimately under clause 28.1 of the contract (the clause with which the Trust issued its notice of termination), the contract allowed for termination to occur via a written notice, without being prescriptive on the time frame with which the notice had to be given and with no requirement for the notice to have an immediate effect.

Furthermore, there were clauses in the contract (such as those governing the transfer of employees under TUPE) outlining specific steps that would need to be taken prior to the termination of a contract; these would make it commercially impossible for immediate termination to occur.  This was a contract for the provision of services (ie serving meals to patients on wards), and an immediate termination stopping all services would lead the Trust into a precarious situation of placing innocent patients at risk. Cranston J concluded that the crux of the issue lay in the fact that ‘the contract does not come to an end when the notice is served but when the notice period expires’.

Medirest’s termination – the duty to act in ‘good faith’

The key question however was whether Medirest was also entitled to terminate – was the Trust in material breach of its obligation to ‘co-operate in good faith‘?

Cranston J reviewed a number of authorities on this somewhat nebulous term concluding as follows.

·                 The duty to co-operate necessarily encompassed the duty to work together to resolve the problems which would almost certainly occur from time to time in a long-term contract of this nature: Anglo Group plc v Winther Brown & Co Ltd (1997) TCC 413. It also necessarily required the parties not to take unreasonable actions which might damage their working relationship.

·                 Where a clause in a commercial contract is subject to interpretation, the court should ‘generally adopt the interpretation which more closely accords with commonsense’: Rainy Sky v Kookmin Bank [2011] UKSC 50.

·                 The duty of good faith required the Trust to observe reasonable commercial standards of fair dealing, to be faithful to the agreed common purpose and to act consistently with justified expectations: Berkeley Community Villages v Pullen [2007] EWHC.

·                 The meaning of the obligation of good faith had to take its colour from the commercial nature of the contract: CPC Group Ltd v Qatari Diar Real Estate Investment Co [2010] EWHC 1535. In this case, there was a long-term contract that would require continuous and detailed co-operation between the parties at a number of levels.

·                 Without bad faith it was hard to understand how there could be a breach of the duty of good faith: Manifest Shipping Co v Uni-Polaris Shipping Co [2001] UKHL 1.

Cranston J also concluded that there was also an implied term that the Trust would act rationally – ie not in an arbitrary, capricious or irrational manner: Socimer v Standard Bank [2008] EWCA 116. The litmus test as to the implication of such a term is whether, without it, the ‘consequences would contradict what a reasonable party would understand the contract to mean’: Attorney General of Belize v Belize Telecom Ltd [2009] UKPC 10. The placing of this implied term is clearly to prevent an abuse of power, and has been further attested to by Moore-Bick LJ, who held that such an implied obligation was ‘likely to be implicit in any commercial contract under which one party is given the right to make a decision on a matter which affects both parties whose interests are not the same’: JML Direct Ltd v Freestat UK Ltd [2010] EWCA Civ 34.

Material breach 

In the circumstances, the judge had little doubt that the Trust had breached its duty of good faith and the much more limited duty to act rationally. Its calculation of service credits due under the contract, including the £46,320 for the ketchup and £84,450 for the mousse, was described by the judge at various points as ‘patently absurd‘ and ‘produced in the most cavalier fashion‘.

Not only were the service level calculations, in the Trust’s own admission, ‘in many respects indefensible‘ but the Trust sought to withhold payment on the basis of these calculations and failed to respond positively to Medirest’s attempts to resolve the dispute. All of this damaged, and ultimately destroyed, the working relationship between the parties.

This was not only a breach but also a ‘material breach’ for the purposes of the contractual termination provision. The judge adopted the formulation for determining a ‘material breach’ used by Neuberger J in Phoenix Media Ltd v Cobweb Information:

Materiality involves considering the following: the actual breaches, the consequence of the breaches to [the innocent party]; [the guilty party’s] explanation for the breaches; the breaches in the context of [the] Agreement; the consequences of holding [the] Agreement determined and the consequences of holding [the] Agreement continues.’

In this case the breaches were substantial, with the Trust threatening to withhold a significant proportion of the service fees based on its ‘indefensible’ service credit calculation. The Trust’s refusal to back down when those calculations were disputed created uncertainty about whether Medirest would actually be paid for its services.

Medirest was therefore entitled to exercise its contractual right to terminate for ‘material breach’.

Do obligations of good faith and outsourcing mix?

While of obvious relevance to IT lawyers engaged in the outsourcing field, the facts of this case are somewhat unusual and it may be unwise to read the decision across to other situations. For example, the judge accepted that a duty of good faith would not have prevented the Trust from managing the contract in a challenging manner provided it used fact and common sense. However, it is clear that good faith obligations can have substance and can take effect in unexpected ways, in this case much to the customer’s disadvantage.

Will Robinson is of Counsel, working in the Technology, Media and Communications practice at Linklaters, London.