The Implied Covenant of Good Faith and Fair Dealing Under U.S. Law

The Implied Duty of Good Faith and Fair Dealing in the U.S.

In the United States, references to contracting parties' implied obligation to act in good faith can be found as far back as the late 1800s. See, e.g., Brakeley v. Tuttle, 3 W.Va 86 (WV, July Term 1868). Today, the good-faith covenant is implied in every agreement. It has been synthesized in the Restatement (Second) on Contracts ' 205, and a good-faith covenant has been codified in the Uniform Commercial Code (UCC) (Section 1-203) with respect to agreements that fall within the scope of the UCC. The Restatement (Second) on Contracts explains that “[e]very contract imposes upon each party a duty of good faith and fair dealing in its performance and its enforcement.” Very similarly, UCC Section 1-203 states that “[e]very contract or duty within this Act imposes an obligation of good faith in its performance or enforcement.”

“Good faith” in this context means more than not acting intentionally in bad faith. Focus is on the honesty of the party, though it does not require the party to exercise any particular level of care. The Restatement refers to the good-faith covenant as “the rule of the pure heart and the empty head.” The Restatement further emphasizes that the purpose of the covenant is to ensure that the contract is interpreted in line with the parties' mutual expectations, that parties do not willfully avoid performing as expected or otherwise rob the other party of the expected bargain. For example, a party should not evade the spirit of the bargain, intentionally perform its contractual obligations below standard, abuse its right to specify performance requirements, or fail to cooperate in the other party's performance.

Thus, the good-faith covenant should not be treated as a cure for a party that realizes after the fact that the deal it struck was not fair. The good-faith covenant does not apply to contract negotiations ' only to the interpretation and enforcement of the agreement the parties reached. And while the good-faith covenant can be used to interpret ambiguous contract terms, it does not override express terms. The covenant also does not help where the agreement is silent. It is not intended as a gap-filler to create an agreement on terms that were never reached by the parties. In other words, the good-faith covenant is a tool used to interpret ambiguous contract terms. It is not a general obligation to act fairly and honestly toward the other contract party beyond the express contract terms.

These limitations on the good-faith covenant already limit its scope, but there are also inherent practices in U.S. legal culture that may further limit its applicability. In the United States, we can boast that we have some of the longest and most detailed agreements in the world. Historically, U.S. contracts have been significantly longer and more detailed than contracts in many other countries. Leaving aside the reason for our contract drafting style, the result is that parties here leave less to chance than do those in some other countries. Since the covenant will not override express contract terms, this tradition of detailed contracts limits the applicability of the covenant, as the need to apply it presumably is less than where contract terms, by tradition, may be broader and more ambiguous.

Franchise Law

Long-term contracts, such as franchise agreements, are particularly susceptible to claims of breach of the good-faith covenant. When drafting a long-term contract, it is difficult to foresee all future scenarios and, consequently, provisions are often intentionally broad and sometimes open-ended. Many cases, such as the much-discussed Scheck v. Burger King , 756 F.Supp 543 (S.D. Fl. 1991), deal with territorial encroachment issues, but alleations of the breach of the good-faith covenant are not limited to encroachment claims. These claims can relate to just about any provision in a franchise agreement. Recent examples include a franchisor's alleged failure to find conveniently located accounts (Teng-Moua v. Jani-King of Minnesota, Inc., 810 F.Supp.2d 882 (D. Minn. 2011)); alleged efforts by a franchisor to circumvent a franchisee's sale of its franchised location (Coldwell Banker Real Estate, LLC v. Plummer & Associates, Inc., (2009 WL 3230840, Oct. 2, 2009 D N.J.); and an alleged constructive termination/failure to act in good faith in connection with a franchisee default (Century 21 Real Estate LLC v. All Professional Realty, Inc., 889 F.Supp.2d 1198 (E.D. Cal. 2013)). Even though the facts and circumstances differ widely, a red thread can be found in that courts throughout the United States start their analysis by reciting more or less the same statement:

Under New Jersey law, there is an implied covenant of good faith and fair dealing in every contract.

Onderdonk v. Presbyterian Homes, 85 N.J. 171, 182 (1981).

The implied covenant prohibits a party to the contract from doing anything that “will destroy or injure the right of the other party to receive the fruits of the contract.” Feldman v. U.S. Sprint Commc'ns Co., 714 F.Supp. 727, 731 (D.N.J. 1989). However, the “function of the court is to enforce the [agreement] as written, not to write for the parties a different or a better contract.” Liqui-Box Corp. v. Estate of Elkman, 238 N.J.super. 588, 599-600 (App.Div. 1990); Century 21 Real Estate LLC v. All Professional Realty, Inc., 889 F.Supp.2d 1198 (E.D. Cal. 2013).

The variations between different cases primarily consist in that the governing law differs; consequently, so do the cases cited in support of the statement.

Broaden the Implied Covenant?

After a general hiatus from new state franchise bills, the last year has seen increased activity in several states. For example, legislators have sought introduction of new franchise relationship statutes in Maine, Massachusetts and Pennsylvania. These bills are noteworthy for several reasons, but not the least because they all attempt to broaden the scope of the good-faith covenant through statute.

Each of the three bills uses the same definition of good faith that can be found in UCC Article 2, which regulates contracts for the sale of goods: “honesty in fact and the observance of reasonable commercial standards of fair dealing in the trade.” Good-faith obligations can then be found throughout the bills, but each bill also includes a section that specifically addresses good faith and fair dealing. If adopted, these provisions would obligate franchisors to do nothing that would have the effect of destroying the franchisee's expected fruits of the contract. While these provisions at first glance may appear to do nothing more than to codify the existing common law rule, it appears the bills attempt to introduce a covenant of good faith and fair dealing that goes significantly further.

The provision may be interpreted as creating a good-faith covenant that goes beyond just being a tool for interpreting express contract provisions, and instead creates an independent cause of action. Were the bills adopted, and were the provisions therein interpreted as creating an independent cause of action, they might have a significant impact on franchising in the U.S. Franchise relationships are complex, and franchisors and franchisees are not infrequently at odds about how to best implement and grow a franchise system. Because the bills include many provisions that go significantly beyond the scope of existing franchise relationship regulation, they are likely to face significant opposition and are not likely to be adopted into law. But if they were, they would have a profound impact on the scope of the good faith covenant in those states, and most likely lead to additional litigation among franchisors and franchisees.

Conclusion

Even though the implied covenant of good faith and fair dealing continues its long-standing position in U.S. law as a tool to temper abusive interpretations of ambiguous contract terms, the old adage “penny wise, pound foolish” stands. In practice, the good faith covenant will be of limited help to parties that failed to consider the consequences of their desired business transaction and to paper it accordingly.

A cuddled cowboy, though, is still a cowboy, and under U.S. law parties should not expect courts to step in and change their bargain. Parties are well advised to spend time before they enter into agreement to ensure that, as much as possible, the express terms of their agreements are clear and cover all necessary situations. Relying on the good faith covenant to save the day later on is not advisable, and, in spite of current legislative efforts, that will likely not change in the foreseeable future.

Beata Krakus is an officer in the Chicago office of Greensfelder, Hemker & Gale, P.C. Krakus is a member of the firm's Franchising & Distribution and Corporate Practice Groups and can be reached at [email protected] or 312-345-5004.

It is a truth universally acknowledged that even the most well-written agreement never covers all potential issues that may arise in the future, and that when the rubber hits the road, the parties to the agreement never interpret its terms the same way. Agreement terms that seemed clear and sufficient to the parties at a time when they were both excited about entering into business with each other look significantly different after some major change or shift in circumstances. When circumstances change, the parties often find that the agreement does not cover the exact situation they are now facing. Instead, depending on how their contract is interpreted, one of the parties may be able to take advantage of the contractual silence or ambiguity and act in a way that causes detriment to the other.

How to handle the silent or ambiguous contract is a universal dilemma. Each legal system approaches the issue somewhat differently, but generally there are two approaches. The first approach is simply to disregard the issue and stick to the express terms of the agreement. With this approach, the parties only have to follow the express agreement and are otherwise free to act as they wish, independent of the consequences of their action to the other party. If their agreement did not document or foresee a situation, they are each free to act in a way they believe is in their own best interest (provided, however, that statutory law may provide gap-filler provisions).

The other approach is to recognize that even though parties may have failed to address everything in the agreement expressly, they still have some type of obligations towards each other to act fairly. We refer to this obligation as the “implied covenant of good faith and fair dealing” (hereinafter referred to as the “good-faith covenant”). We'll call the first approach the “cowboy approach” and the second one the “cuddled approach.” Not to hold you in suspense: The U.S. has adopted a kind of cuddled cowboy approach ' courts recognize the good-faith covenant, but they will not go so far as to fill in reasonable terms where the parties themselves failed to do so.

The Implied Duty of Good Faith and Fair Dealing in the U.S.

In the United States, references to contracting parties' implied obligation to act in good faith can be found as far back as the late 1800s. See, e.g., Brakeley v. Tuttle , 3 W.Va 86 (WV, July Term 1868). Today, the good-faith covenant is implied in every agreement. It has been synthesized in the Restatement (Second) on Contracts ' 205, and a good-faith covenant has been codified in the Uniform Commercial Code (UCC) (Section 1-203) with respect to agreements that fall within the scope of the UCC. The Restatement (Second) on Contracts explains that “[e]very contract imposes upon each party a duty of good faith and fair dealing in its performance and its enforcement.” Very similarly, UCC Section 1-203 states that “[e]very contract or duty within this Act imposes an obligation of good faith in its performance or enforcement.”

“Good faith” in this context means more than not acting intentionally in bad faith. Focus is on the honesty of the party, though it does not require the party to exercise any particular level of care. The Restatement refers to the good-faith covenant as “the rule of the pure heart and the empty head.” The Restatement further emphasizes that the purpose of the covenant is to ensure that the contract is interpreted in line with the parties' mutual expectations, that parties do not willfully avoid performing as expected or otherwise rob the other party of the expected bargain. For example, a party should not evade the spirit of the bargain, intentionally perform its contractual obligations below standard, abuse its right to specify performance requirements, or fail to cooperate in the other party's performance.

Thus, the good-faith covenant should not be treated as a cure for a party that realizes after the fact that the deal it struck was not fair. The good-faith covenant does not apply to contract negotiations ' only to the interpretation and enforcement of the agreement the parties reached. And while the good-faith covenant can be used to interpret ambiguous contract terms, it does not override express terms. The covenant also does not help where the agreement is silent. It is not intended as a gap-filler to create an agreement on terms that were never reached by the parties. In other words, the good-faith covenant is a tool used to interpret ambiguous contract terms. It is not a general obligation to act fairly and honestly toward the other contract party beyond the express contract terms.

These limitations on the good-faith covenant already limit its scope, but there are also inherent practices in U.S. legal culture that may further limit its applicability. In the United States, we can boast that we have some of the longest and most detailed agreements in the world. Historically, U.S. contracts have been significantly longer and more detailed than contracts in many other countries. Leaving aside the reason for our contract drafting style, the result is that parties here leave less to chance than do those in some other countries. Since the covenant will not override express contract terms, this tradition of detailed contracts limits the applicability of the covenant, as the need to apply it presumably is less than where contract terms, by tradition, may be broader and more ambiguous.

Franchise Law

Long-term contracts, such as franchise agreements, are particularly susceptible to claims of breach of the good-faith covenant. When drafting a long-term contract, it is difficult to foresee all future scenarios and, consequently, provisions are often intentionally broad and sometimes open-ended. Many cases, such as the much-discussed Scheck v. Burger King , 756 F.Supp 543 (S.D. Fl. 1991), deal with territorial encroachment issues, but alleations of the breach of the good-faith covenant are not limited to encroachment claims. These claims can relate to just about any provision in a franchise agreement. Recent examples include a franchisor's alleged failure to find conveniently located accounts ( Teng-Moua v. Jani-King of Minnesota, Inc. , 810 F.Supp.2d 882 (D. Minn. 2011)); alleged efforts by a franchisor to circumvent a franchisee's sale of its franchised location ( Coldwell Banker Real Estate, LLC v. Plummer & Associates, Inc. , (2009 WL 3230840, Oct. 2, 2009 D N.J.); and an alleged constructive termination/failure to act in good faith in connection with a franchisee default ( Century 21 Real Estate LLC v. All Professional Realty, Inc. , 889 F.Supp.2d 1198 (E.D. Cal. 2013)). Even though the facts and circumstances differ widely, a red thread can be found in that courts throughout the United States start their analysis by reciting more or less the same statement:

Under New Jersey law, there is an implied covenant of good faith and fair dealing in every contract.

Onderdonk v. Presbyterian Homes , 85 N.J. 171, 182 (1981).

The implied covenant prohibits a party to the contract from doing anything that “will destroy or injure the right of the other party to receive the fruits of the contract.” Feldman v. U.S. Sprint Commc'ns Co. , 714 F.Supp. 727, 731 (D.N.J. 1989). However, the “function of the court is to enforce the [agreement] as written, not to write for the parties a different or a better contract.” Liqui-Box Corp. v. Estate of Elkman , 238 N.J.super. 588, 599-600 (App.Div. 1990); Century 21 Real Estate LLC v. All Professional Realty, Inc. , 889 F.Supp.2d 1198 (E.D. Cal. 2013).

The variations between different cases primarily consist in that the governing law differs; consequently, so do the cases cited in support of the statement.

Broaden the Implied Covenant?

After a general hiatus from new state franchise bills, the last year has seen increased activity in several states. For example, legislators have sought introduction of new franchise relationship statutes in Maine, Massachusetts and Pennsylvania. These bills are noteworthy for several reasons, but not the least because they all attempt to broaden the scope of the good-faith covenant through statute.

Each of the three bills uses the same definition of good faith that can be found in UCC Article 2, which regulates contracts for the sale of goods: “honesty in fact and the observance of reasonable commercial standards of fair dealing in the trade.” Good-faith obligations can then be found throughout the bills, but each bill also includes a section that specifically addresses good faith and fair dealing. If adopted, these provisions would obligate franchisors to do nothing that would have the effect of destroying the franchisee's expected fruits of the contract. While these provisions at first glance may appear to do nothing more than to codify the existing common law rule, it appears the bills attempt to introduce a covenant of good faith and fair dealing that goes significantly further.

The provision may be interpreted as creating a good-faith covenant that goes beyond just being a tool for interpreting express contract provisions, and instead creates an independent cause of action. Were the bills adopted, and were the provisions therein interpreted as creating an independent cause of action, they might have a significant impact on franchising in the U.S. Franchise relationships are complex, and franchisors and franchisees are not infrequently at odds about how to best implement and grow a franchise system. Because the bills include many provisions that go significantly beyond the scope of existing franchise relationship regulation, they are likely to face significant opposition and are not likely to be adopted into law. But if they were, they would have a profound impact on the scope of the good faith covenant in those states, and most likely lead to additional litigation among franchisors and franchisees.

Conclusion

Even though the implied covenant of good faith and fair dealing continues its long-standing position in U.S. law as a tool to temper abusive interpretations of ambiguous contract terms, the old adage “penny wise, pound foolish” stands. In practice, the good faith covenant will be of limited help to parties that failed to consider the consequences of their desired business transaction and to paper it accordingly.

A cuddled cowboy, though, is still a cowboy, and under U.S. law parties should not expect courts to step in and change their bargain. Parties are well advised to spend time before they enter into agreement to ensure that, as much as possible, the express terms of their agreements are clear and cover all necessary situations. Relying on the good faith covenant to save the day later on is not advisable, and, in spite of current legislative efforts, that will likely not change in the foreseeable future.

Beata Krakus is an officer in the Chicago office of Greensfelder, Hemker & Gale, P.C. Krakus is a member of the firm's Franchising & Distribution and Corporate Practice Groups and can be reached at [email protected] or 312-345-5004.