Understanding Contract Law: The Implied Covenant of Good Faith and Fair Dealing

A legal contract’s basic function is to state the rights and obligations of each party. In addition, the document typically covers what will happen under a variety of possible scenarios. This list of stipulations can be quite lengthy, especially in contracts between corporate entities.

Because it is impossible to anticipate every “if/then” situation, the law relies on what is called an Implied Covenant of Good Faith and Fair Dealing. In short, those signing a contract are agreeing to act in good faith to uphold the terms of the contract. This means they will be fair and honest, and will not do anything that would prevent the terms of the contract from happening as agreed.

As the name says, The Implied Covenant of Good Faith and Fair Dealing is implied and does not need to be spelled out. It is automatically part of every contract, covering any situation that is not expressly written in the text. 

In other words, there are unwritten rules in every contract that must be followed. Anyone entering into a contract must understand and abide by these rules. If they do not, they risk a battle in court. 

A Recent Interpretation of the Implied Covenant

Vice Chancellor J. Travis Laster of the Delaware Court of Chancery recently authored an opinion of the Implied Covenant of Good Faith and Fair Dealing in corporate transactions. His explanation was related to the case of American Healthcare Administrative Services, Inc. v. Aizen.

The Company (American Healthcare Administrative Services, Inc.) filed suit against Mr. Aizen, (the Company’s former CEO) for breach of the implied covenant in a contract drawn up between the Company and another entity. The case is complex, so a bit of background will help put it into context.

• The Company had a contract to sell assets to another business entity. 
• CEO Aizen was to act as the Company’s representative, overseeing escrowed funds. He was given sole discretion to make decisions about the funds held to cover purchase price adjustments.
• When the deal was complete, the CEO was to release the funds to the Company for distribution to its shareholders.
• Under a separate employment agreement, the CEO would receive various benefits upon completion of the transaction, including a multi-million dollar bonus, monthly payments, and a consulting engagement.
• Upon completion of the asset sale, the CEO refused to release the escrowed funds. He alleged that the Company failed to make promised payments to him. He wanted to hold the funds until his dispute was resolved, so the money would be available for his potential settlement.
• The Company terminated his employment and sought to terminate the employment agreement, alleging his breach of the Implied Covenant of Good Faith and Fair Dealing.

How the Implied Covenant of Good Faith Applies to This Case

The court decided that both sides had satisfied all contractual conditions for releasing the escrow funds. Keeping the funds in escrow as a source of recovery for a personal dispute was in breach of the CEO’s obligations to act in good faith in regard to the contract for the asset sale. 

The Delaware Supreme Court held that the Implied Covenant of Good Faith and Fair Dealings is meant to handle gaps in a contract that neither party anticipated. This applies when one of the parties alleges that another’s actions were arbitrary or unreasonable and stood in the way of the expected outcome spelled out in the contract.

In this case, the CEO had an obligation to distribute the escrow funds when appropriate. The parties did not anticipate that a dispute would arise between the CEO and the Company, so there is a gap in the contract. The situation is not mentioned (nor would anyone expect it to be) and there are no provisions for what should happen to the funds in the situation. Even so, the CEO’s failure to follow through was deemed arbitrary and unreasonable, and a breach of good faith.  

When and How to Invoke the Implied Covenant

When determining whether to invoke the implied covenant, a court first decides whether there is a gap that needs to be filled. If the language of the contract covers a particular issue, the implied covenant will not apply. If the contract is silent on the subject, the implied covenant might fill the gap. The implied covenant will not infer language that contradicts a clear contractual right. 

If a contractual gap exists, the court must determine whether the implied covenant should fill it. Not all gaps should be filled. For example, if the parties negotiated over a term and rejected it, using the implied covenant would grant a contractual right or protection that the party failed to secure at the bargaining table. 

The implied covenant enforces only those terms that the parties would have agreed to during their original negotiation—if they had thought to address them. The covenant usually covers contractual terms that are so obvious that the drafter would not have felt the need to include them in the agreement.

The Exercise of Discretion in a Contract

One of the CEO’s arguments in the case in question was that he was given “sole discretion” to oversee the escrow funds. But the courts make it clear that “sole discretion” does not grant someone carte blanche to do whatever they wish. 

In this case, the Delaware Supreme Court held that the CEO was not relieved of his obligation to use that discretion in good faith. And the CEO’s authority should have aligned with what would have been agreed upon during negotiations, had the parties thought to address the issue. 

The implied covenant restrains the CEO’s exercise of discretion under the agreement. The general rule is that the implied covenant requires a party in a contractual relationship to refrain from arbitrary or unreasonable conduct which has the effect of preventing the other party to the contract from receiving the fruits of the bargain. That rule operates with special force when a contract confers discretion on a party. At a minimum, the implied covenant requires that the party be empowered with the discretion to use it in good faith.

Abiding By the Implied Covenant of Good Faith

When lawsuits invoke the implied covenant, the court looks to the contract itself for any gaps. It then determines what the parties would have agreed upon had the issue arisen during negotiations. 

When entering into a legal contract, it is important to remember that there are implied terms beyond what exists in the text. These terms emphasize the need for all parties to exercise good faith and fairness. The parties have agreed on a common purpose, and all actions should be consistent with those expectations. 

It is best to seek legal advice before entering into any contract. Contact Swiecicki & Muskett, LLC for practical solutions to all of your business and legal issues.