The Growing Uncertainty about Good Faith in American Contract Law

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The Growing Uncertainty about Good Faith in American Contract Law Howard O Hunter* For many years the concept of the implied covenant of good faith seemed to have a settled understanding in American law. That is no longer the case as varying approaches to deﬁning the substance of the covenant reﬂect differences in approach by ‘neoformalist’ and ‘contextualist’ courts. In their recent article entitled ‘Good Faith in Australian Contract Law’, John Carter and Elisabeth Peden describe the state of the law in Australia as ‘unsettled’ and in ‘ﬂux’.1 A few years ago one might have characterised the state of American law on good faith to be ‘settled’ and to be an understood part of the common law of contracts and the law of sales under the Uniform Commercial Code. In the past 10 to 15 years, however, a number of cases have made the concept of good faith uncertain, and one might well characterise American law in much the same way as Carter and Peden have characterised Australian law. This article brieﬂy outlines the current understandings of the concept in various American courts to complement and to amplify the conversation begun by Carter and Peden in their article. Certainly the implied covenant of good faith is well established as part of American contract law. The doctrine is applicable to all contracts covered by the UCC by virtue of s 1-203,2 and the common law rule is contained in s 205 of the Restatement 2d of Contracts. Although the concept of good faith has its origins in ancient law, the modern common law version in the United States dates from the famous opinion of Judge Benjamin Cardozo in Wood v Lucy, Lady Duff-Gordon.3 In that case the New York Court of Appeals found substance in an exclusive dealing contract by reading it to include an implied obligation on the part of the dealer to use reasonable efforts to sell the products licensed.4 In the past several decades there have been scores, perhaps hundreds, of cases that have involved questions of contractual good faith. The existence of the doctrine and its pervasiveness are not in doubt. But American * Professor of Law, Emory University. 1 J W Carter and Elisabeth Peden, ‘Good Faith in Australian Contract Law’ (2003) 19 JCL 155. 2 The reference is to the earlier version of the UCC because that is the version in effect in the various states as a statute. The most recent revisions to the UCC approved by the American Law Institute and the National Conference of Commissioners of Uniform State Laws put ‘good faith’ in the deﬁnitions section, 1-201(20), as follows: ‘Good faith, except as otherwise provided in Article 5, means honesty in fact and the observance of reasonable commercial standards of fair dealing’. The explicit incorporation of commercial reasonability within the deﬁnition of good faith clariﬁes possible areas of confusion under the former version of the Code (which, of course, remains the legally operative version). See Official Comment 20 to s 1-201. 3 Wood v Lucy, Lady Duff-Gordon, 222 NY 88; 118 NE 214 (1917). 4 Similarly, the buyer in a requirements contract will be expected to have some requirements absent excusing calamity. See eg Empire Gas Corp v American Bakeries Co, 840 F 2d 1333 (7th Cir 1988). 1 2 (2004) 20 Journal of Contract Law courts have become divided on exactly what the doctrine means and how it is to be applied. Is the implied covenant a substantive term? If so, what is its content and how is that to be determined? Or is the concept simply a ‘gap ﬁller’ to be used sparingly when the parties have left terms open or have used ambiguous language? Can good faith modify or override the application of an express term? Does it mean anything more than the absence of bad faith? What is the relationship between good faith and party autonomy? How is the absence of good faith to be shown if the underlying contract is evidenced by an integrated document and the parol evidence rule applies? The answers to these various questions divide current American courts, roughly, into two camps. One might be called the ‘neoformalist’ camp in which party autonomy and the strict application of the language of an agreement are valued highly. The other might be called the ‘contextualist’ camp in which courts take a more active role in construing the concept of good faith to have an independent substantive content. All courts seem to agree that, at a minimum, good faith means the absence of bad faith within the context of the agreement. A case regularly cited is Tymshare, Inc v Covell,5in which Judge Antonin Scalia (now a member of the United States Supreme Court) wrote the majority opinion. Covell, a sales representative for a company that sold data processing services, was compensated on a salary plus commission basis. The litigated dispute was about Tymshare’s changes in Covell’s sales quotas allegedly for the purpose of manipulating the commissions that would be due to him. One question was whether Tymshare had violated the implied covenant of good faith in the handling of the commissions. In discussing good faith, Judge Scalia relied heavily on a well-known article by Professor Robert Summers6 in which Professor Summers characterised good faith as an ‘excluder’ term. Judge Scalia took this to mean that ‘good faith’ excludes conduct that would be ‘bad faith’ within the conﬁnes of the particular agreement.7 Obviously it must do more than exclude conduct of such bad faith that it would be actionable as a tort, or the concept would be meaningless. The substance of good faith derives from the expectations of the parties as expressed in the agreement itself, and so the scope of what is meant by good faith will change from agreement to agreement and party to party. In Judge Scalia’s words, the concept honours ‘the reasonable expectations created by the autonomous expressions of the contracting parties’.8 In that one sentence are the seeds of subsequent variances among the courts. What are the ‘reasonable expectations’ of the parties and how are they to be determined? How much weight is due the ‘autonomous expressions’ of the parties? All courts seem to agree that the contract itself provides the matrix upon which to analyse the obligation of good faith, but the methodologies vary depending on which phrase within Scalia’s sentence seems to dominate 5 727 F 2d 1145 (DC Cir 1984). 6 Robert S Summers, ‘“Good Faith” in General Contract Law and the Sales Provisions of the Uniform Commercial Code’ (1968) 54 Va L Rev 195. 7 727 F 2d 1145 at 1152. 8 727 F 2d 1145 at 1152. Good Faith in American Contract Law 3 the development of a judicial opinion — reasonable expectations or party autonomy. The case that most clearly articulates the viewpoint of the neoformalists is Kham & Nate’s Shoes No 2, Inc v First Bank of Whiting,9 a 1990 decision of the federal Court of Appeals for the Seventh Circuit. Kham & Nate’s ran four retail shoe stores in Chicago. The business ﬁrst started borrowing money from the Bank of Whiting in 1981 when it took out a $50,000 loan. That loan was renewed, paid in part, and rolled over until 1983 when the outstanding balance was down to $42,000. The bank and the store continued to have a lending relationship, but the store began to have cash ﬂow problems and the bank baulked when the store asked for another loan. The bank suggested either a government-backed loan for a small business or a reorganisation under Chapter 11 of the Bankruptcy Code. Kham & Nate’s opted for the latter and, after ﬁling for reorganisation, the bank agreed to open a $300,000 line of credit, subject to cancellation on ﬁve days’ notice. The contract further provided that ‘nothing herein shall constitute a waiver of the right of the Bank to terminate ﬁnancing at any time’.10 The debtor took down $75,000 shortly after the line of credit was agreed upon, and about a month later, the bank announced that it would make no additional advances. The debtor argued, inter alia, that the bank’s termination of the line of credit violated the implied covenant of good faith and that it led to a series of ﬁnancial reversals which caused the business to go into a rapid decline. The bankruptcy judge before whom the matter ﬁrst came agreed with the debtor in many particulars. The judge thought the bank would have been secure in making additional advances and that the cut-off came at a most inopportune moment.11 Certainly the termination came very soon after the debtor had gone into a reorganisation — partly at the suggestion of the bank — and very soon after the bank had agreed to a $300,000 line of credit against which it had willingly allowed the debtor to draw down $75,000. The case appeared to be similar to KMC Inc v Irving Trust Co12 in which the federal Court of Appeals for the Sixth Circuit, four years earlier, had used the concept of good faith to support a borrower’s claim against a lender for failure to give notice before refusing to make additional advances under a ﬁnancing agreement. In the Kham’s case the bank had given the required ﬁve days’ notice, but the surprise seemed to be the alacrity with which the bank backed away from its recently negotiated agreement. Judge Easterbrook and his colleagues, however, took a different view. The bank had the authority under the agreement to cut off credit. It did so and it did not have to lend any more money even if others might have behaved differently. There was no need to inquire further into the relationship between the parties or the degree to which the borrower’s expectations may have been raised by the bank’s agreement to open the line of credit or by the involvement 9 10 11 12 908 F 2d 1351 (7th Cir 1990). 908 F 2d 1351 at 1353. See Re Kham, 97 Bankr 420 (Bankr ND Ill 1989). 757 F 2d 752 (6th Cir 1986). 4 (2004) 20 Journal of Contract Law of bank representatives in creditor discussions during the bankruptcy proceedings.13 Firms that have negotiated contracts are entitled to enforce them to the letter, even to the great discomfort of their trading partners, without being mulcted for lack of ‘good faith’. Although courts often refer to the obligation of good faith that exists in every contractual relation, this is not an invitation to the court to decide whether one party ought to have exercised privileges expressly reserved in the document. ‘Good faith’ is a compact reference to an implied undertaking not to take opportunisitic advantage in a way that could not have been contemplated at the time of drafting, and which therefore was not resolved explicitly by the parties. The decision received some harsh criticism,14 but the court’s deference to the literal language of the contract has resonated in numerous subsequent cases. For example, the Fourth Circuit upheld the decision of a Washington, DC, bank not to modify its prime rate after a reduction in the discount rate of the Federal Reserve Bank and subsequent reductions in prime rates by other major banks against the claims of creditors that failure to do so violated the covenant of good faith.15 The court stated that ‘an implied duty of good faith cannot be used to override or modify explicit contractual terms’.16 The court went on to note that the loan agreement was an integrated document, and, therefore, evidence of other understandings or expectations would not be relevant.17 Two years after the decision in Kham & Nate’s, the question of good faith was back before the Seventh Circuit in another dispute between a bank and its debtors. The debtors’ arguments were not strong, and the case was easily resolved in favour of the bank. Judge Easterbrook, however, used the opportunity to comment further on the good faith covenant.18 As a method to ﬁll gaps, it has little to do with the formation of contracts . . . and nothing to do with the enforcement of terms actually negotiated . . . Gap ﬁlling methods such as good faith do not ‘block use of terms that actually appear in the contract’. The Eighth Circuit followed the same line. In a 1996 decision, Judge Richard Arnold wrote that:19 The law does not allow the implied covenant of good faith and fair dealing to be an everﬂowing cornucopia of wished for legal dictum; indeed, the covenant cannot give rise to new obligations not otherwise contained in a contract’s express terms . . . The implied covenant simply prohibits one party from ‘depriv[ing] the other party of its expected beneﬁts under the contract’. Carrying the ‘gap-ﬁller’ concept even further, the Eighth Circuit in 2001 13 908 F 2d 1351 at 1357. 14 See Dennis M Patterson, ‘A Fable from the Seventh Circuit: Frank Easterbrook on Good Faith’ (1990) 76 Iowa L Rev 503. 15 Riggs National Bank of Washington, DC v Linch, 36 F 3d 370 (4th Cir 1994). 16 36 F 3d 370 at 373. 17 36 F 3d 370 at 374. 18 Continental Bank, NA v Everett, 964 F 2d 701 at 705 (7th Cir), cert denied, 506 US 1035 (1992). 19 Comprehensive Care Corp v Rehabcare Corp, 98 F 3d 1063 at 1066 (8th Cir 1996), citing Morton v Hearst Corp, 779 SW 2d 268 at 273 (Mo App 1989). Good Faith in American Contract Law 5 stated that good faith does not impose a general requirement for a party to act reasonably. It merely provides a method for dealing with circumstances not contemplated at the time of contracting. Indeed, it does not even act as a limit on the exercise of discretion if one party is granted discretionary authority by the agreement.20 By comparison, federal courts in the Tenth Circuit, applying local state law, have employed a more expansive view of the good faith doctrine. In a 1994 decision a federal court in Utah described the doctrine as protecting a party’s reasonable expectations ‘to receive the fruits of the contract’.21 In the court’s view the implied covenant does not contradict or exclude express terms, but it does govern express terms in that they must be exercised consistently with the parties’ reasonable expectations.22 To determine whether the behaviour of the parties had been consistent with the implied covenant, the court relied on a 1991 Utah Supreme Court decision in which that court stated:23 An examination of express contract terms alone is insufficient to determine whether there has been a breach of the implied covenant of good faith and fair dealing. To comply with his obligation to perform a contract in good faith, a party’s actions must be consistent with the agreed common purpose and the justiﬁed expectations of the other party. The purpose, intentions, and expectations of the parties should be determined by considering the contract language and the course of dealings between and conduct of the parties. In the particular case the court found no breach of the implied covenant, but the distinction lies in the methodology for reaching that conclusion. If ‘good faith’ is merely an excluder or gap-ﬁlling device applicable only when a term is patently ambiguous or absent, then the court’s responsibility ends if the agreement contains an express term that allows one party to do what the other contends to be a violation of the implied covenant. If, however, ‘good faith’ is a concept that inheres substantively in all contract provisions, then a court may inquire into the language, the course of dealings, trade practices, and the conduct of the parties to determine whether the actions complained of are reasonable or whether they prevent the other party from enjoying the expected beneﬁts of the agreement. One approach is formalistic and deferential to party autonomy. The other involves courts more in a post hoc analysis of the parties’ conduct and in a contextual review of the intentions expressed in the agreement. In many instances the results may not differ greatly. Courts, in general, are reluctant to upset the negotiated risk allocations of the parties. If a term is explicit, a court will not be likely to question the language of the agreement even if one party has ‘unbridled discretion’,24 unless the exercise of that 20 United States v Basin Electric Power Cooperative, 248 F 3d 781 at 796–98 (8th Cir 2001). 21 AI Transport v Imperial Premium Finance, Inc, 862 F Supp 345 at 348 (D Utah 1994). 22 862 F Supp 345 at 348, citing Big Horn Coal Co v Commonwealth Edison Co, 852 F 2d 1259 at 1267 (10th Cir 1988). 23 862 F Supp 345 at 348, citing St Benedict’s Development Co v St Benedict’s Hospital, 811 P 2d 194 at 200 (Utah 1991). The court also relied on comment a to Restatement 2d of Contracts, s 205 (1981). 24 See eg Bank IV Salina, NA v Aetna Casualty & Surety Co, 810 F Supp 1196 at 1205 (D Kansas 1992), citing Big Horn Coal Co v Commonwealth Edison Co, 852 F 2d 1259 at 1267–8 (10th Cir 1988), citing Tymshare v Covell, 757 F 2d 1145 at 1153 (DC Cir 1984). 6 (2004) 20 Journal of Contract Law discretion has been ‘dishonest’ within the meaning of the contract.25 Courts also are reluctant to use the implied covenant as a means to upset generally accepted contractual rights and obligations, such as a decision by a lender about extending credit,26 a termination of an at-will employee,27 a refusal to waive an anti-assignment clause,28 or refusal by a manufacturer to approve the relocation of a dealer.29 The neoformalist method of analysis places a premium on the allocation of risks negotiated at the outset and on the long-term policing effects of the market. An approach that allows review of the reasonableness of the exercise of discretion within the context of the relationship allows a court to consider whether conduct has been consistent with expectations. The latter emphasises the role of courts in supporting the intended beneﬁts of the agreement; the former leaves that to the parties and to the marketplace. The growing reluctance of some courts to look behind the explicit language of an agreement to determine whether the conduct of the parties has been consistent with the reasonable expectations and the goals of the agreement reﬂects the general rise of neoformalism.30 The hallmark of this return to some of the approaches of contracts scholars of the late 19th century is reliance on the ‘plain meaning’ of an agreement, which, if all the formal requisites are met, is to be enforced according to its letter. To the extent that strict enforcement creates results that are surprising to a party in the context of what had been thought to be mutual expectations, the cure is to be found in the marketplace, not in the interpretation of the agreement by a court. This approach always has had attractions when the parties have engaged in serious line by line negotiations and are similarly situated. It has not been as widely accepted when there has been less negotiation — especially about the terms at issue — or when the parties are not similarly situated and when the contract at issue is essentially a form agreement. The neoformalists reduce the public role of contract law as an ordering mechanism and turn it into a rule-based matrix that leaves ordering to the marketplace. They also turn upside down the substantial — some would argue radical — shifts in emphasis of the Uniform Commercial Code and the Restatement 2d of Contracts.31 In their article, John Carter and Elisabeth Peden argue that the concept of 25 See eg Taylor Equipment, Inc v John Deere Co, 98 F 3d 1028 at 1032 (8th Cir 1996). 26 See eg Garret v BankWest, Inc, 459 NW 2d 833 (SD 1990). 27 See eg City of Midland v O’Bryant, 18 SW 2d 209 (Tex 2000); Breen v Dakota Gear & Joint Co, 433 NW 2d 221 (SD 1988), but see Jablonski v Sheldon Precision Co, 2000 WL 486930 (Conn Super 2000); Burton v Atomic Workers Fed Credit Union, 119 Idaho 17; 803 P 2d 518 (1990). 28 See eg James v Whirlpool Corp, 806 F Supp 835 (ED Mo 1992). But some courts have applied a ‘reasonableness’ standard in considering anti-assignment clauses. See eg Larese v Creamland Dairies, Inc, 767 F 2d 716 (10th Cir 1985) (franchise relationship); Basnett v Vista Village Mobile Home Park, 699 P 2d 1343 (Colo App 1984) (landlord/tenant). 29 See eg Hubbard Chevrolet Co v General Motors Corp, 873 F 2d 873 (5th Cir), cert denied, 493 US 978 (1989). 30 See John E Murray Jr, ‘Contract Theories and Neoformalism’ (2003) 71 Fordham L Rev 869. 31 See eg above, n 30 at 911–13, and see Charles L Knapp, ‘Taking Contracts Private: The Quiet Revolution in Contract Law’ (2003) 71 Fordham L Rev 761 in which Professor Knapp examines the use of mandatory arbitration clauses in contracts, often in adhesion terms of a standard form agreement, and the effect on the development of the common law of contracts. Good Faith in American Contract Law 7 good faith is inherent in all contracts and that it need not be made explicit within an agreement. Their argument is consistent with American law, but before one suggests a wholesale adoption of the American version of good faith, one must understand that, at present, there remains considerable uncertainty about the full meaning of the concept. For example, Carter and Peden argue that ‘good faith’ means ‘honesty’ but not necessarily ‘reasonably’, ‘except in the sense that a requirement of honest conduct must exclude conduct which no reasonable person could regard as reasonable in the circumstances’.32 Many lawyers, commentators and judges in the United States would agree with the quoted statement, but Judge Easterbrook, his colleagues on the Seventh Circuit, and other judges that have followed the line established in the Kham & Nate’s case might well say that reasonableness of any kind is irrelevant if a term grants discretion to one party or another. The American cases may provide useful examples and guides to the development of the concept of ‘good faith’ during the past century, but an observer must be aware of the shifting currents and the absence of a common understanding of the scope and content of the implied covenant. 32 J W Carter and Elisabeth Peden, ‘Good Faith in Australian Contract Law’ (2003) 19 JCL 155 at 168.