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
 |
John E. Flanagan, Marquette 1984,
is a partner at Michael, Best & Friedrich, Milwaukee, where he
practices commercial litigation. |
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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