The Duty of Good Faith In Contracts: Mutual Expectations Set the Parameters

By John E. Flanagan

Courts and lawyers are familiar with the maxim that "the law implies a covenant of good faith into every contract."¹ The duty, which has fallen in and out of favor through the years, has a long history in common law and Wisconsin jurisprudence.² Currently, the duty of good faith is prominent in lender-liability and franchisee-franchisor disputes.³ Certainly, lawyers must consider this cause of action any time a breach of contract action is brought.

Courts and lawyers have struggled to define the concept of good faith, absent defined facts to which it can be applied. As an example of this struggle, courts have devoted pages of discussion setting forth general parameters of the duty before deciding if the facts of the particular case before it justify imposition of liability under this doctrine.⁴ The duty of good faith is a chameleon. Similar to the famous remark of former Justice Potter Stewart describing his definition of pornography as "I know it when I see it," lawyers and judges have an intuitive hunch when an action for breach of duty of good faith may exist. Nevertheless, while the duty is broad by necessity, since it applies to "all contracts," recent Wisconsin Court of Appeals decisions, especially those in Foseid, Schaller and Wausau Medical Center, have by implication defined the outer parameters of the duty owed by concentrating on the mutual expectations of the parties to the agreement.⁵

These cases point to the need for attorneys preparing to press or defend cases involving allegations of the breach of good faith to define the expectations of the parties to the agreement.

Determining Parameters of the Duty Owed

Paramount in the courts' determination of the scope of the duty of good faith is the purpose of the contract itself. This is consistent with the first rule of contract construction. That is, the mutual intention of the parties at the time of contracting is paramount in construing the contract.⁶ Therefore, unlike the tort of bad faith applicable to the insurer/insured relationship, the duty of good faith "does not create a separate duty of fairness and unreasonableness which can be independently breached." ⁷ Rather, courts have characterized the duty, similar to provisions in the UCC, as a "gap filler." ⁸ The duty of good faith is used to impose conditions in the performance of the contract which, if not imposed, would allow one party to take unfair advantage of the other thereby denying to the other the benefit of the bargain struck.⁹

The extent of the duty is controlled by the parties' expectation when entering into the agreement. Courts, therefore, need to examine - and lawyers need to present - evidence of the parties' expectations early in the case. The best way to determine the parties' expectations is to start with the written contract, if one exists. Courts appropriately have held that if the written agreement provides that the party alleged to have breached the duty can take certain action, it cannot be a breach of the duty of good faith if the party does take such action.¹⁰ This is obviously the easiest application of the duty of good faith since the agreement itself defines the mutual expectation of the parties where the potential for such action is described in the agreement. There can be no unfair taking advantage of the other party in such circumstances.

But what if the contract is not in writing or, if it is, fails to list the action now claimed to constitute a breach? Does the duty of good faith apply, and if so, to what extent?

The answer for lawyers and courts attempting to apply the doctrine again is found in looking at the agreement's purpose, since it is not the relationship of the parties that creates the duty ¹¹ but rather the expectation of the parties as expressed in the agreement. Courts must assume that parties do not enter into contracts to cheat each other; the social utility of contracts is to facilitate trade and exchange. Courts must assume the parties entered into a contract with certain expectations as to the other's performance to reach an anticipated result.

Courts find a breach of good faith where the mutually anticipated result, as implied in the contract terms, is intentionally frustrated by the others' performance. Therefore, a person who agrees in a mutual and reciprocal will with her spouse that when she dies the remainder of her estate will be willed to their children, but then intentionally strips her estate of assets during her lifetime by giving the assets to her second husband, violates the duty of good faith. While when the promisor died she left her "estate" to the promised beneficiary, thus honoring the literal terms of the agreement, in reality the beneficiary received nothing because of the promisor's actions. The expectation of the result of the parties' performance - that one would not intentionally deprive the other of the bargain struck - which existed at the time of the contract, was breached.¹²

Furthermore, suppose a party had a lease with another in which the lessor was to negotiate financing property improvements but, if agreement could not be reached, allowed the lessee to purchase the property at a predetermined formula price. Also, assume that the lessee in negotiations realized that the lessor forgot about the formula purchase price provision buried in the agreement and, after cursory negotiations over financing for the improvements, demanded sale of the property at the formula price (since, in the meantime, the property's value increased above the formula price).¹³ At the outset, the parties did not expect that in performing the agreement one of the parties would allegedly take such opportunistic advantage of the other's oversight in order to deprive the other of the fruits of the agreement - that is, a long-term lease of property owed by the lessor/financier.

Another example is an exclusive dealing contract where one party is to purchase all of its requirements from the other at a predetermined price. If the purchaser intentionally overstates its purchases to take advantage of a price rise in the market in order to resell the excess goods in the market, thereby harming the seller, the party has violated the duty of good faith.¹⁴

Other recent cases in Wisconsin, which have found no violation of the duty of good faith, have similarly examined the mutual expectations of the parties to the agreement to determine if a party's conduct deprived the other of the mutually anticipated benefit. These cases illustrate again the importance of determining the scope of the agreement to define the duty of performance.

In Schaller v. Marine National Bank of Neenah ¹⁵ the plaintiff sued Marine Bank for failing to honor overdrawn checks written by the business. The bank had in the past on occasion honored various overdraft checks written by the plaintiff but then stopped doing so without notice, allegedly causing the plaintiff to default on its obligations and lose business. The Wisconsin Court of Appeals noted that a creditor/debtor relationship between the bank and its customers is created when the customer deposits money with the bank and then again when the bank agrees to honor the overdraft. Given the long-standing banking practice that allows banks, on a check-by-check basis, to determine if the bank will honor the overdraft, the court of appeals initially held there was no implied agreement beyond this point which would obligate the bank in the future to continue to honor checks insufficiently funded. Once it was determined there was no agreement to honor future checks - that is, there was no mutual expectation of such a result - the court quickly disposed of the good faith claim since there was "no agreement with the bank allowing it to withdraw its account or obliging the bank to inform the plaintiff of a potential overdraft." ¹⁶ Therefore, there was no proper expectation that the bank agreement with its depositor required the bank to honor future overdrafts. Since the contract did not extend to cover the parties' conduct, neither did the duty of good faith.

Another potential restriction hinted at in Schaller is that the duty of good faith is limited where the nonbreaching party has the ability to protect itself from harm. While this sounds like mitigation, it really goes to an element of the duty of good faith. That is, is there truly an opportunity in the agreement for one party to strip the other of the contract benefits? In Schaller the court of appeals noted that all the plaintiff had to do to avoid harm resulting from the returned checks was to better monitor the status of its own account.¹⁷ If it is within the alleged nonbreaching party's ability to avoid the harm then there should be no "gap" to fill, such that a party could take opportunistic advantage of the other contracting party. In other words, the other party is not "over the barrel," subject to the other's performance.

Recently, the court of appeals again addressed the scope of the duty of good faith in Foseid v. State Bank of Cross Plains.¹⁸ Foseid is another example where lower courts have struggled with the concept of good faith. Foseid defaulted on several large notes owed to the defendant banks. One of the banks obtained judgments against Foseid on the notes, but told him if certain properties were sold by a date certain, Foseid would receive a discount off the amount owed. Foseid tried to sell the properties but was unsuccessful at first. He then received several extensions of the date from the bank. The bank eventually held to a date certain that Foseid failed to meet. As a result, Foseid, who later sold the property after the last date certain, failed to achieve the discount.

The jury held that the bank did not violate the "discount" agreement, but it did violate the duty of good faith. The trial court struck the verdict since it believed that the question of good faith had been submitted to the jury in the form of a tort special verdict question, and the trial court realized after trial that tortious breach of the duty of good faith does not exist in Wisconsin.

The court of appeals upheld the trial court's reversal, but for a different reason. The court of appeals noted that even though the terms of the "discount agreement" were not breached, this did not preclude an action in contract for breach of the duty of good faith as a matter of law. Citing Estate of Chayka the court of appeals noted that the claim still exists even though all terms of the agreement have been satisfied if the parties' performance accomplishes what the parties sought to prevent.¹⁹ Again, the court focused on the expectation of the parties to the agreement. Once this was done, the court of appeals concluded that the bank had not created any obligation to continue extending the date for plaintiffs to sell the property. The plaintiff could not seriously argue that the parties expected or intended that the bank would continue to provide extensions of the deal offered. Therefore, as with the other Wisconsin cases, the mutually anticipated benefits of the agreement, at the time of the agreement, defined the parameters of the duty of good faith.

The Impact on Litigation in Wisconsin

The lesson from these cases is that the initial duty of the trial court and lawyers is to determine what evidence exists to establish the parties' mutual expectation as to the contract's purpose or expected benefits. The court should be able to identify the basic benefit of the agreement, or at least a range of important benefits, from the written contract itself or the parties' testimony.

If the claimed breach of the duty of good faith either does not relate to or deprive the other party of the contract's purpose or expectation of benefit, then summary judgment or directed verdict is appropriate.²⁰

If the parties do not dispute the scope of the parties' mutual expectation of the anticipated benefit, and the alleged breacher's conduct if proven true would deprive the other of that benefit, then the trier of fact should determine the good faith performance of the alleged breacher.

If, however, there is conflicting evidence of the contract's purpose or anticipated benefit, then a special verdict question may be appropriate inquiring into the scope of the parties' mutual expectation at the time of contracting. If the jury agrees with the plaintiff as to the agreement's purpose, then, as just noted, the jury would consider whether the defendant violated the duty of good faith in performing the agreement by intentionally depriving the other of the agreement's anticipated benefits.

This last determination leads to consideration of the jury instruction. The instruction itself is somewhat vague (likely necessarily so) and not entirely consistent, such that courts have noted it does not control all types of good faith cases presented.²¹ The jury instruction provides:

"Every contract implies good faith and fair dealing between the parties and a duty of cooperation on the part of both parties. The law implies a promise against arbitrary or unreasonable conduct.
"Good faith means honesty in fact in the conduct or transaction concerned, that is, an honest intention to abstain from taking unfair advantage of another, through technicalities of law, by failure to provide information or to give notice, or by other activities which render the transaction unfair.
"There must be an adherence to those reasonable standards of fair dealing which the parties, taking into account the circumstances in which they are doing business, have a right to expect.

"Good faith is required at every point, from negotiation through performance." ²²

Indeed, one phrase missing in the instruction, to be consistent with the recent case law, is that the alleged breacher must deprive the other of the agreement's anticipated benefit. Obviously, not every dispute in a contract's performance should be actionable as a breach of good faith if the party is not being deprived of the purpose of the agreement.

Furthermore, the instruction's emphasis on reasonable standards of conduct may be misinterpreted as overriding the intent to take opportunistic advantage of the other, as emphasized in the second paragraph of the instruction. First, the reference in the instruction to reasonable standards of conduct is better understood as instructing on the parameters to establish the mutual expectations of the parties to a contract when the parties' intent is not set forth in writing (for example, where the parties' intent or contract's purpose is not set forth in a "whereas" clause in the contract). In Schaller, industry practices were used to establish the parties' mutual expectation.²³ Second, while in the appropriate case the jury could be instructed that the parties' intent can be measured by certain objective criteria such as industry practices (since again the expectation of the parties in a commercial setting can be assessed by what others in the industry expect), the linchpin of the breach of good faith action is still the parties' intent to take unfair opportunistic advantage of the other in performance of the contract.²⁴

Conclusion

The duty of good faith does not arise from the relationship of two contracting parties; rather it arises from the contract itself. To define the parameters of the duty, the expectation of the parties as to the anticipated benefit of the contract must be determined first. Once this is done, the parties' performance can be analyzed by the court or trier of fact to determine whether the party intentionally deprived the other of the benefits of the agreement.

Endnotes

¹ In re Chayka's Estate, 47 Wis. 2d 102, 107, 176 N.W.2d 561, 564 (1970).

² See E. Allan Farnsworth, Farnsworth on Contracts, 7.17a (1990).

³ E.g.Vylene Enter. Inc. v. Naugles Inc. , 90 F.3d 1472 (9th Cir. 1996); Foseid v. State Bank of Cross Plains, 197 Wis. 2d 772, 541 N.W.2d 203 (Ct. App. 1995), rev. denied, 199 Wis. 2d cxxxii, 546 N.W.2d 469 (1996).

⁴ E.g. Market St. Assoc. Ltd. Partnership v. Frey, 941 F.2d 588, 593-96 (7th Cir. 1991).

⁵ Schaller v. Marine Nat'l Bank of Neenah, 131 Wis. 2d 389, 403-04, 388 N.W.2d 645 (Ct. App. 1986); Foseid v. State Bank of Cross Plains, 197 Wis. 2d 772, 541 N.W.2d 203 (Ct. App.1995), rev. denied, 199 Wis. 2d cxxxii, 546 N.W.2d 469 (1996); Wausau Med. Ctr. S.C. v. Asplund, 182 Wis. 2d 274, 515 N.W.2d 34 (Ct. App. 1994).

⁶ Mass by Giant v. Ziegler, 172 Wis. 2d 70, 79, 492 N.W.2d 621 (1992).

⁷ Hauer v. Union State Bank of Wautoma, 192 Wis. 2d 576, 597 n.7, 532 N.W.2d 456, 464, n.7 (Ct. App. 1995).

⁸ Orig. Gr. Am. Choc. Chip Cookie v. River Valley, 970 F.2d 273, 280 (7th Cir. 1992).

⁹ In re Chayka's Estate, 47 Wis. 2d at 107, 176 N.W.2d at 564.

¹⁰ See e.g., SuperValue Stores Inc. v. D. Mart Food Stores Inc. , 146 Wis. 2d 568, 577, 431 N.W.2d 721, 726 (Ct. App. 1988).

¹¹ Hauer, 192 Wis. 2d at 597 n.7, 532 N.W.2d at 464 n.7.

¹² In re Chayka's Estate, 47 Wis. 2d at 107, 176 N.W.2d at 564.

¹³ Market St. Assoc. v. Frey, 817 F. Supp. 784, 788 (E.D. Wis. 1993).

¹⁴ Empire Gas Corp. v. American Bakeries Co. , 840 F.2d 1333, 1337 (7th Cir. 1988).

¹⁵ Schaller, 131 Wis. 2d 389, 388 N.W.2d 645 (1986).

¹⁶ Id. at 403, 388 N.W.2d at 651.

¹⁷ Id.

¹⁸ Foseid, 197 Wis. 2d 772, 541 N.W.2d 203 (Ct. App. 1995), rev. denied 199 Wis. 2d cxxxii, 546 N.W.2d 469 (1996).

¹⁹ Id. at 795-96, 541 N.W.2d at 212-13; see also footnote 12.

²⁰ See Schaller, 131 Wis. 2d at 403-04, 388 N.W.2d at 651; Foseid, 197 Wis. 2d at 796-98, 341 N.W.2d at 213.

²¹ Cf. Orig. Gr. Am. Choc. Chip Cookie, 970 F.2d at 280 (noting that under Illinois law reasonableness is not the test of the duty of good faith).

²² Wis. J.I. - Civil 3044.

²³ See endnotes 15-17.

²⁴In re Chayka's Estate, 47 Wis. 2d at 107 n.7, 176 N.W.2d at 564 n.7; Market St. Assoc. Ltd. Partnerhsip, 941 F.2d at 596-97.

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