By Nicole Farahan
The Implied Covenant of Good Faith and Fair Dealing
Contracting parties can choose to waive many duties. One duty, however, cannot be waived nor contracted around: the Implied Covenant of Good Faith and Fair Dealing (the “Covenant”). Even though the duty is not explicitly stated in an agreement between contracting parties, hence the term implied, the Covenant imposes an obligation on parties to act in good faith and deal fairly with other parties to a contract.[1]
The following article will explore how the Covenant came about and what the duty entails, both legally and practically. Initially, the article will begin with the Covenant’s definition as used in the Uniform Commercial Code (“UCC”) and the Second Restatement of Contracts (“Restatement”). Then, it will discuss how courts have applied the evolving definition of the Covenant.
Background
The Uniform Commercial Code
The UCC is a comprehensive set of laws governing all commercial transactions in the United States. Section 1-304, titled Obligations of Good Faith, states: “Every contract or duty within [the UCC] imposes an obligation of good faith in its performance and enforcement.”[2] While this obligation does not provide a basis for an independent cause of action, failure to perform or enforce a contract in good faith constitutes a breach of contract. In the UCC’s general definitions, “good faith” is defined as “honesty in fact and the observance of reasonable commercial standards of fair dealing.”[3] The UCC prohibits parties from contractually waiving the duty of good faith. However, parties may still agree to set forth the applicable standards by which their performance of the agreement will be measured. But such standards will be unenforceable if they are “manifestly unreasonable.”[4]
The Second Restatement of Contracts
Because the UCC only applies to the sale of goods and does not include service, real estate, or employment contracts, the Restatement broadened the scope of the application of the duty of good faith and fair dealing to all contracts. It should be noted that the Restatement is not an approximation of the law but, rather, purports to be legally binding via a distillation of extensive case law. While it is not really binding law, it incorporates binding law in its language and should be treated as the law to the extent that such language approximates court holdings. Conversely, to address any ambiguities prevalent in the Restatement, several states have adopted respective Uniform Commercial Codes consisting of a comprehensive set of laws governing commercial transactions.
The Restatement § 205, titled Duty of Good Faith and Fair Dealing, states: “Every contract imposes upon each party a duty of good faith and fair dealing in its performance and its enforcement.”[5] The Restatement’s comments define “good faith” as “faithfulness to an agreed common purpose and consistency with the justified expectations of the other party.”[6] It further articulates “good faith” as “honesty in fact in the conduct or transaction concerned.”[7] But, it recognizes that the duty requires more than “honesty” in performing an agreement.[8]
The Restatement uses examples of “bad faith” to assist in defining “good faith.” Some examples include: evasion of the spirit of the bargain; lacking diligence and lacking off; willful rendering of imperfect performance; abuse of power to specify terms; interference or failure to cooperate in the other party’s performance.[9] Just like the UCC, the Restatement makes clear that the appropriate remedy for a breach of the duty of good faith varies with the circumstances.[10]
Case Law
Courts have recognized the Covenant for over eighty years and have often had trouble defining it, let alone judging whether a party breached its duty of good faith. There is no uniform definition applied by all courts, though many have tried to create a standard. The general standard applied in most courts today is that “neither party shall do anything which will have the effect of destroying or injuring the right of the other party to receive the fruits of the contract.”[11] In the following cases, courts tackled the challenge of trying to define what good faith and fair dealing means, and how it can be applied practically.
While some states utilize the Covenant “to effectuate the intentions of parties, or to protect their reasonable expectations,” other states employ the Covenant to ensure that a party does not “violate community standards of decency, fairness, or reasonableness.”[12]
The Covenant has often raised questions about what parties to a contract can expect from each other, especially in a commercial setting. To try to resolve this ambiguity, courts often differentiate between expectations, while also imposing minimal good faith requirements for performance by the parties.
In a 1933 case, Kirke La Shelle Co. v. Paul Armstrong Co., the New York State Court of Appeals first described what it believed to be the definition of the Covenant:
“In the last analysis those cases only apply the principle that in every contract there is an implied covenant that neither party shall do anything which will have the effect of destroying or injuring the right of the other party to receive the fruits of the contract, which means that in every contract there exists an implied covenant of good faith and fair dealing.”[13]
In defining the Covenant, many courts have continued to use the same language: “destroying or injuring the right of the other party to receive the fruits of the contract.” But this general and broad definition does not make it easy to answer whether a duty of good faith has been breached and, while it may sound simple, courts still wrestle with the concept. Courts have continued to make clear the Covenant is a separate and distinct duty from explicit good faith clauses in contracts.
Courts make clear the Covenant is not to be used lightly and without limits. To help define the duty, the following and recent analysis comes from Delaware, the heart of business law. The Delaware Supreme Court articulated the Covenant in a 2019 decision, Oxbow Carbon & Minerals Holdings, Inc. v. Crestview-Oxbow Acquisition, LLC,quoting an array of cases as support:
A “cautious enterprise” that “is ‘best understood as a way of implying terms in the agreement,’ whether employed to analyze unanticipated developments or to fill gaps in the contract’s provisions.” “Delaware’s implied duty of good faith and fair dealing is not an equitable remedy for rebalancing economic interests after events that could have been anticipated, but were not, that later adversely affected one party to a contract.” Rather, “the covenant is a limited and extraordinary legal remedy.” As such, the implied covenant “does not apply when the contract addresses the conduct at issue,” but only “when the contract is truly silent” concerning the matter at hand. Even where the contract is silent, “[a]n interpreting court cannot use an implied covenant to re-write the agreement between the parties, and ‘should be most chary about implying a contractual protection when the contract could easily have been drafted to expressly provide for it.’”[14]
In its articulation of the Covenant, the court explicitly emphasized the difference between contractual agreements between consumers, and agreements between business entities. In stating that the Covenant should not be used as an “equitable remedy for rebalancing economic interests,” it points to Oxbow to emphasize that the parties are “sophisticated businesspersons or entities.”[15]
Further, the Supreme Court in Northwest, Inc. v. Ginsberg explicitly stated that parties could not contract out of the Covenant. There, the issue was whether the Airline Deregulation Act preempted a state-law claim for breach of the implied covenant of good faith and fair dealing. The breach of the Covenant related to rates because the program awarded mileage credits to customers, who could redeem them for tickets and upgrades, reducing the price they paid for a ticket. The Supreme Court found the claim for breach of the Covenant under Minnesota law was preempted because itprevented the parties from contracting out of the Covenant.[16] This case exemplifies how strong the Covenant is: a state’s implied covenant rules would escape preemption only if the law permitted an airline to contract around those rules in its frequent flyer agreement. Since it did not do so, the court found the airline breached the Covenant.[17]
In a California appeal, Racine & Laramie, Ltd. v. Department of Parks & Recreation, the court articulated the Covenant as follows:
The implied covenant of good faith and fair dealing rests upon the existence of some specific contractual obligation. The covenant of good faith is read into contracts in order to protect the express covenants or promises of the contract, not to protect some general public policy interest not directly tied to the contract’s purpose. In essence, the covenant is implied as a supplement to the express contractual covenants, to prevent a contracting party from engaging in conduct which (while not technically transgressing the express covenants) frustrates the other party’s rights to the benefits of the contract.
[18]
It is important that this court also recognized the duty is triggered once a contract is formed.[19] In other words, there is no obligation to deal fairly or in good faith absent an existing contract; there are other duties that can be invoked during the negotiation stage. But, once a contractual relationship exists, the Covenant is “limited to assuring compliance with the express terms of the contract and cannot be extended to create obligations not contemplated in the contract.”[20] Thus, while the duty is mandatory and cannot be waived, it does have limits. As such, when a party to a contract believes another party is acting in bad faith, it does not necessarily give that party the right to invoke the Covenant. As the Racine court in clarified:
“Inasmuch as there was no express contractual obligation to negotiate a modification of the contract, the court held that the department’s conduct, even if unreasonable, unfair, or otherwise bad faith negotiations tactics, was not a breach of any contract term. The court held that there is no obligation to bargain for a new or amended contract in good faith, absent a preexisting agreement, statute, or special circumstances imposing such obligation.”[21]
Moreover, not only does the Covenant apply to contracts made between private persons, but the duty is also imposed on the United States. This is because when the United States enters into contract relations, its rights and duties are governed by the law applicable to contracts between private individuals.[22] In First Nationwide Bank v. United States, the Government tried to argue its contractual obligation was its promise to pay 90% reimbursement of covered asset losses and that it had no obligation to preserve the tax treatment of such reimbursement. The Government argued since it had no obligation as to future tax treatment, it could be charged with violating the Covenant. The court held, however, that the Covenant requires a “party to respect and implement the contract in accordance with its terms.”[23] As such, the Government’s removal of the material tax benefit violated the Covenant.
The Covenant’s Implications: Three Frequently Used Standards
There is a difference between the Covenant and negotiated, contractual terms that parties can expressly put into the contract itself regarding good faith standards. Parties can address the standard by which they are to perform the agreement by adding specific provisions to their contract. The Covenant applies not only to a party’s performance, but also to a party’s enforcement of an agreement.[24] The following standards that will be discussed are important because business owners, who manage the sale of merchandise using contracts, must comply with all of the reasonable commercial standards of fair dealing within their industry. Specifically, a “commercially reasonable efforts” or a “reasonable efforts” or a “best efforts” provision focuses on the expectations parties should have of each other. While these standards may sound similar, they can lead to different results.
Commercially Reasonable Efforts
“Commercially reasonable efforts” is the lowest standard by which contracting parties can perform their duties. Courts have characterized it as an objective standard requiring a business to use the efforts “that a reasonable business entity would have made under similar circumstances.”[25] Thus, for a party to establish a violation of the clause, it must show the other party violated the relevant standard customarily followed in the industry. Relevant industry standards include contamination prevention efforts for blood banks[26] and treadmill safety zones for recreation clubs.[27]
Reasonable Efforts
A “reasonable efforts” standard falls between “commercially reasonable efforts” and “best efforts” with respect to the measure of the obligation imposed. It requires a party do what is reasonable under the prevailing circumstances.[28] Thus, disputes that arise with this clause involve fact-specific determinations for the jury. [29] It is generally seen to be more demanding than a “good faith” standard, which requires honesty and fairness from the parties. Reasonableness, on the other hand, requires diligence from the acting party. The term “diligence” is defined in an official comment in the UCC, in which it states that the implied obligation to use best efforts requires that parties use “reasonable diligence as well as good faith in their performance of the contract.”[30]
Best Efforts and Some Judicial Interpretation
A “best efforts” standard is the most arduous of the efforts provisions. It imposes a greater burden than a “commercially reasonable efforts” or “reasonable efforts” clause because it requires a party to do everything in its power to satisfy the relevant contractual obligations, without harming its own self-interest in the process.[31] Interpretation of the clause has varied greatly– some courts equate it to “good faith,” while others have held that the standard is “diligence.”[32] Thus, the difference between “good faith” and “best efforts” is that while honesty and fairness are at the heart of “good faith,” diligence is at the heart of “best efforts.”[33] More specifically, “when a contract does not define the phrase ‘best efforts,’ the promisor must use the diligence of a reasonable person under comparable circumstances.” [34] Best efforts does not require a party to ignore its own interests, “spend itself into bankruptcy, or incur substantial losses to perform its contractual obligations. Rather, it requires a party to make such efforts as are reasonable in light of that party’s ability and the means at its disposal and of the other party’s justifiable expectations.”[35]
Best Efforts: New York
Some courts require that “best efforts” provisions explicitly lay out the criteria for satisfying the duty.[36] In Pinnacle Books, Inc. v. Harlequin Enterprises Ltd., the court held a “best efforts” clause “must set forth in definite and certain terms every material element of the contemplated bargain.”[37]
However, other courts do not rely on measurable criteria to determine whether a party has satisfied its “best efforts” obligation. For example, in Kroboth v. Brent, a defendant contracted to sell real property to plaintiffs, contingent upon subdivision approval, and the plaintiffs agreed to use their best efforts to obtain the approval.[38] The court found the plaintiffs failed to meet the standard because they refused to seek certain departmental approval as advised by a planning board.[39] Thus, the court’s finding shows that “best efforts” requires more than “good faith” and a party must pursue all reasonable methods to meet its obligation.
Best Efforts: Delaware
Unlike some New York courts, Delaware courts do not require a specific set of criteria that parties must follow to find a breach of a best efforts provision.[40] For example, in Conley v. Dan-Webforming Int’l A/S (Ltd.), the court looked at the express terms of the agreement and concluded parties need not only comply with the terms of the agreement, but they also “must use their best efforts to do so.”[41] In determining whether the company used its best efforts, it looked at whether it satisfied the contractual requirements. The court found that in failing to meet a specific reporting requirement, without explanation, the company failed to use its best efforts.[42]
Conclusion
The aforementioned points show why, when drafting contracts, parties must make clear what they intend their obligations and rights be, as to avoid any ambiguities and confusion that may arise between the parties in the future. The cited cases demonstrate courts have trouble defining and differentiating between the different standards of good faith in commercial contracts, as depicted by the three standards above. Even when parties are articulate in drafting, and the contract may seem clear as to what is expected, parties must not forget their implied duty of good faith, the Covenant.
[1] Implied Covenant of Good Faith and Fair Dealing, https://plus.lexis.com/document/?pdmfid=1530671&crid=71d5606a-b336-4b78-8950-9d4e721aa301&pddocfullpath=%2Fshared%2Fdocument%2Fanalytical-materials%2Furn%3AcontentItem%3A5KBF-HTS1-DYFH-X466-00000-00&pdworkfolderid=0f8cbbd0-4316-4173-81a5-cc2c9e3a667b&pdopendocfromfolder=true&prid=94499067-6abd-428e-a4e0-3d87e3d44089&ecomp=mfgg&earg=0f8cbbd0-4316-4173-81a5-cc2c9e3a667b LEXIS (database updated September 2022) [hereinafter Implied Covenant].
[2] U.C.C. § 1-304.
[3] U.C.C. § 1-201.
[4] Id.
[5] Restatement (Second) of Contracts § 205 (Am. Law Inst. 1981).
[6] Id. at cmt. a.
[7] Id.
[8] Id. at cmt. d.
[9] Id.
[10] Id. at cmt. a.
[11] Implied Covenant
[12] Northwest, Inc. v. Ginsberg, 572 U.S. 273, 286 (2014). See Restatement (Second) of Contracts § 205 cmt. a (Am. Law Inst. 1981).
[13] Kirke La Shelle Co. v. Paul Armstrong Co., 188 N.E. 163, 167 (N.Y. 1933).
[14] Oxbow Carbon & Minerals Holdings, Inc. v. Crestview-Oxbow Acquisition, LLC, 202 A.3d 482, 507 (2018).
[15] Id. at 508.
[16] Northwest, Inc. v. Ginsberg, 572 U.S. 273, 287 (2014).
[17] Id. at 289.
[18] Racine & Laramie, Ltd. v. Department of Parks & Recreation, 11 Cal. App. 4th 1026, 1031-32 (1992).
[19] Id.
[20] Id. at 1032.
[21] Id. at 1026.
[22] Mobil Oil Exploration & Producing Southeast, Inc. v. United States, 530 U.S. 604, 607-08, (2000).
[23] First Nationwide Bank v. United States, 431 F.3d 1342, 1350 (2005).
[24] Implied Covenant.
[25] Best Efforts, Commercially Reasonable Efforts, and Reasonable Efforts Provisions in Commercial Contracts, https://www.lexisnexis.com/supp/largelaw/no-index/coronavirus/commercial-transactions/commercial-transactions-best-efforts-commercially-reasonable-efforts-and-reasonable-efforts-provisions-in-commercial-contacts.pdf LEXIS (database updated September 2022).
[26] Howard v. Omni Hotels Management Corp. (2012) 136 Cal.Rptr.3d 739, 759.
[27] Jimenez v. 24 Hour Fitness USA, Inc. (2015) 188 Cal.Rptr.3d 228, 237.
[28] Id.
[29] Id.
[30] U.C.C. §2-306(b)(2) cmt. 5.
[31] Id.
[32] Id.
[33] Id.
[34] California Pines Property Owners Assn. v. Pedotti, 206 Cal. App. 4th 384, 395 (2012).
[35] Id.
[36] David Shine, “Best Efforts” Standards Under New York Law: Legal and Practical Issues, 7 M&A Lawyer 15 (2004).
[37] Pinnacle Books, Inc. v. Harlequin Enterprises, Ltd., 519 F. Supp. 118, 121 (1981).
[38] Kroboth v. Brent, 215 A.D.2d 813 (1995).
[39] Id.
[40] Christopher W. Hamlin, Be Clear When Using Best Efforts, St. Louis Bar J. 2011.
[41] Conley v. Dan-Webforming Int’l A/S, Ltd., 1992 U.S. Dist. LEXIS 20251.
[42] Id.
