Litigating the Implied Covenant of Good Faith

December 12, 2016Articles The New York Law Journal

The implied covenant of good faith and fair dealing is a departure from traditional contract law. This covenant or duty often is in derogation of the doctrine of the parties "freedom to contract," whereby a gloss is imposed on express terms, and contractual terms are judicially imposed where the parties choose or neglected to address certain issues. The cases are challenging to both win and defend, and the results are unpredictable because the parties did not expressly contract to limit their risk.

These cases all start with the notion that a party, through action or inaction, caused harm to the other, depriving them of the fundamental purpose of their contract. The strategy in these cases is to demonstrate the reasonableness or unreasonableness of the parties conduct, and to explain the process by which the conduct occurred. This is one of the few instances where the motive of the parties to a contract may be determinative of a commercial outcome.

Understanding the Duty of Good Faith And Fair Dealing

Section 205 of Restatement (Second) of Contract provides "[e]very contract imposes upon each party a duty of good faith and fair dealing in its performance and its enforcement." Not all jurisdictions follow the Restatement, and some reinterpret the duty under the jurisprudence of each state. State law will generally prohibit opportunistic behavior that impairs a long-term contractual relationship of mutual dependence and cooperation. The duty is judicially imposed to require the parties to act honestly and observe commercial standards of fair dealing in the trade. The covenant may be invoked to clarify or supply a missing term and to limit the exercise of discretion to fulfill the reasonable expectations of the parties.

Uniform Commercial Code §1-201(b)(7) defines "good faith" as honesty in fact and the observance of reasonable commercial standards of fair dealing in the trade. The UCC would thus permit expert testimony on "reasonable commercial standards of fair dealing in the trade" as a factual matter.

Depending on the jurisdiction, the duty would require:

1. Acting in a fair and equitable manner so as to guarantee freedom from coercion or intimidation;

2. The absence of language in the contract that would prohibit the conduct;

3. The absence of bad faith.

Restatement (Second) of Contracts §205 provides a partial list of bad faith examples, such as subterfuge and evasive conduct; overt actions to undermine the relationship; inaction when action should have been taken; avoidance or denial of the spirit of the contract; lack of diligent behavior or slacking off performance; willful rendering of imperfect performance, abuse of power to clarify ambiguous or defective terms; interference with or failure to cooperate in the other party's performance. The comments add that other evidence includes trying to force a party out of business, concealing the true nature of ownership and control of the business and refusing to operate consistent with the contractual standards provided.

Burden of Persuasion

Regardless of the burden of proof or persuasion, bad faith can be demonstrated where the evidence does not support the stated reason for the corporate action.

The claimant always has the burden of proof as in any contract breach case. But unlike breach of contract cases, the express words of the contract can only provide limited comfort because motive has a role in these cases. The best defense to the claim of unfair treatment is establishing that the parties contracted for this outcome. If the express language of the contract permitted this result, or gave a party a right to accomplish this result, a dispositive motion may succeed. As long as the result is within the realm of reasonable expectation, then the exercise of an express contractual right generally will not be successfully challenged under the implied duty.

The issue of motive arises where a question arises whether given the facts, this is a reasonable outcome. In other words, whether the express language of the contract results in unintended consequences due to the factual context. A landlord defaulting a lease for non-payment of rent is a reasonable exercise of express contractual rights, however, motive becomes an issue if the landlord has unsuccessfully attempted to evict the tenant and an excusable reason outside the control of the tenant caused the landlord not to receive the rent. Unlike a lease where little discretion is vested in the performance by the parties, long-term licensing or franchise agreements have branding and performance issues which arise during the term that simply cannot be anticipated. These are the types of contracts where the implied duty, and consequently the motive of the parties, may become relevant.

Dealing With Burden Shifting Language in the Contract

Express terms generally limit the imposition of the implied covenant, but the use of contract clauses to shift the burden of scrutiny can be problematic. Express contractual clauses that target the precise issue in dispute are much easier to defend than trying to use "catch-all" provisions that vest exclusive or absolute discretion on broad issues. The catch-all provisions are not particularly effective, and may be used as evidence that the contract is unfairly written, favoring the dominant party.

Judicious use of "sole" discretion on certain items is effective and defensible. But an integration clause alone may not be enough to prevent a tribunal for filling in gaps in express contracts, as opposed to adding new terms to the written expression of the parties' agreement.

Drafters have attempted, usually unsuccessfully, to write a deferential standard into the agreement for reviewing the good faith and fair dealing. The "business judgment rule" used to presume proper corporate action by officers and directors in justifying corporate decisions has been engrafted into agreements to encourage courageous actions as a matter of discretion. The business judgment rule presumes that officers and directors made their decision in an informed manner, and consistent with the best interests of the corporation. Only where this presumption is rebutted must the directors and officers prove the transaction is fair and reasonable.

The problem with this approach in ordinary contracts is that one party has this one-sided provision which is intended to insulate a party from the consequences of its wrongful decisions. It demonstrates that the parties are not on an even playing field, and is evidence of oppression. Even though the parties have the freedom to contract for these presumptions, the effect of the provision may be evidence of the evil that is claimed in the dispute.

An example of this is the outcome in Mercedes-Benz USA v. Carduco, 2016 Tex. App. LEXIS 3254 (Tex. App. March 31, 2016). The Texas Court of Appeals upheld a jury verdict awarding an auto dealership more than $21 million in compensatory damages and $115 million in punitive damages.1 The dealer bought the franchise based on an understanding that relocation was available after purchase. After purchase, the relocation was denied because another prospect was ready to open in the desired area. The court held that the good faith and fair dealing imposed by statute trumped the absolute discretion expressed in the contract that the manufacturer enjoyed to decline relocation. The bad faith was shown because the manufacturer did not disclose the existence of the prospect to the dealer before the purchase, or until the request for relocation. This is the type of conduct contained in the catalog of bad faith acts in the Restatement, tantamount to fraud and resulting in punitive damages.

Proving That Erroneous Judgment Is Not Necessarily Bad Faith

Successful defense may require a showing that erroneous judgment and the consequences are not the product of bad faith. Absent willful behavior, most implied covenant cases fail. The parties prevail when they can articulate the efforts expended before deciding on the corporate action. Showing transparency in the decision-making, the communication during the process, and consideration of all other alternatives will support the argument that it was a fair decision.

In this context where all parties are acting in their economic self- interest, it is important to show that even though it may be a zero-sum game, no party was entirely subjugated or totally victimized by the discretionary decision. Fairness may be demonstrated by showing the greater utility that benefits all, rather than simply the singular interests of the counter party.

Conclusion

Implied covenant cases do not enjoy a high success rate, but they do enjoy unpredictable damages. The unpredictability encourages counsel to use more creativity in pleading breaches of the duty, causing every dispute to be cloaked with allegations of ulterior motive or retribution.

Proof of open, honest, considered communication taking into thoughtful account all possibilities and alternatives is the best defense. Clients should document their decision-making and alternatives considered, communicate with the affected parties and fully explain the reasons for the considered decision. This is an important exercise because it provides a sounding board for the decision, and will play well before the trier of fact.

End notes:

1. The punitive damages were remitted to $600,000. 2016 WL 4939377 (Sept. 15, 2016).

Reprinted with permission from the December 12, 2016 issue of The New York Law Journal. (c) 2016 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.