The Implied Covenant of Good Faith and Fair Dealing as a Litigation Tool

by Jerry Meek

A New Jersey landlord whose tenant had failed to properly exercise an option was obligated to tell the tenant of his mistake prior to the option’s expiration. In Massachusetts, a beverage supplier was liable to its distributor for terminating their agreement after the supplier learned that the distributor was attempting to form an association of the supplier’s distributors, even though the agreement allowed for termination at will. A New York law firm could pursue a claim against its client after the client rejected two settlement agreements in order to prevent the firm from getting its contingent fee.

Underlying each of these decisions is the “implied covenant of good faith and fair dealing” – a doctrine recognized in North Carolina but largely underused, despite its potential as a powerful litigation tool. Its standard formulation is pretty unassuming: “In every contract there is an implied covenant of good faith and fair dealing that neither party will do anything which injures the right of the other to receive the benefits of the agreement.” In other words, it’s not enough to do what the contract says you must do; you’ve got to do it in good faith. And sometimes good faith requires you to do things not expressly required by the contract.

In some states, the implied covenant gives rise to a separate cause of action in tort, with all of the damages customarily available in tort. But in North Carolina, rather than permitting an independent claim for relief in tort, the doctrine sounds in contract, giving rise to an affirmative claim for breach of contract even when the adverse party has complied with the express terms of an agreement. In addition, the doctrine can be used as a defense to a breach of contract claim, by arguing that the adverse party’s breach of an implied covenant eliminates the need to perform.

The doctrine is usually described as a “gap-filler.” In this view, parties are either unable to anticipate all of the possibilities which may arise after the contract’s execution or unwilling to incur the transaction costs of safeguarding against all such possibilities. The implied covenant, therefore, upholds the parties’ intent by enforcing the agreement in the way that they would want it to be enforced had they had the prescience or resources to anticipate the dispute. Under these circumstances, it is presumed, the parties had to have intended that all would act in good faith.

In theory, therefore, the implied covenant purports to bolster the written contract. In reality the doctrine has a strong anti-formalist and counter-textualist strain, coexisting uncomfortably with other established areas of contract law.

Take, for example, the notion of “efficient breach.” While no appellate court in North Carolina has ever used this term, it is well accepted that certain breaches are to be encouraged because they maximize economic efficiency. This amoral view of contracts was captured most famously by Oliver Holmes’ remark that “the duty to keep a contract at common law means a prediction that you must pay damages if you do not keep it – and nothing else.” In a world in which certain breaches are not only tolerated, but encouraged, the concept of a breach for lack of “good faith” seems odd.

Moreover, like virtually all states, North Carolina applies the parol evidence rule to contract interpretation. Where there’s a final integrated agreement – usually an agreement containing a merger or integration clause – evidence of prior or contemporaneous negotiations is not permitted, except to clarify an ambiguity in the agreement. But the implied covenant does more than clarify ambiguities. It imposes obligations over and above the obligations expressly agreed to by the parties as embodied in the contractual language chosen by the parties. As a result, an implied covenant which purports to be a doctrine of contract law can scarcely be reconciled with the parol evidence rule.

None of this, of course, makes the implied covenant a necessarily bad principle of law (in fact, the North Carolina Court of Appeals has observed that the implied covenant has been “wisely and justly” imposed). But it does, I think, explain the rarity with which the doctrine rears its head in business litigation. The doctrine runs so counter to the conception of contracts as products of mutual assent through negotiations embodied in a written document that it is often overlooked as a viable claim for, or defense to, breach of contract. In fact, all too often the implied covenant has been a tool of last resort, employed only when the prospects of succeeding on the express terms of the contract are dim.

But as lawyers, we ignore the implied covenant at our clients’ peril.

First, the possibilities for invoking the implied covenant – both as an affirmative claim for breach and as a defense – are wide-ranging, largely because the contours of the doctrine are remarkably undefined. This is perhaps by design. After all, the doctrine’s usefulness as a “gap-filler” is diminished as it becomes more clearly defined, as the gap to be filled will forever vary. But even the broad description of the doctrine presents more questions than answers. When Courts refer to the implied covenant of “good faith” and that of “fair dealing,” are they describing the same thing? Or, as the words suggest, is the former a subjective assessment of a party’s conduct while the latter is an objective assessment measured against industry standards or even the parties’ prior course of dealing? Moreover, what is good faith? What seems like a relatively straightforward concept led the drafters of § 205 of the Restatement (Second) of Contracts to define it by defining “bad faith” and leaving its opposite to inference.

In fact, in North Carolina, there are only two obvious limitations on the doctrine: courts have declined to apply the implied covenant of good faith and fair dealing to at-will employment contracts or so as to impose obligations contrary to the express provisions of the contract. Outside of these two areas, the implied covenant’s possibilities represent a treasure trove for successful advocacy.

Second, a credible implied covenant claim or defense will dramatically increase the chance of surviving summary judgment. Often, actions for breach of contract based upon the express language of the agreement are resolved by the Court at summary judgment. If there’s a trial, damages may be the only issue. But whether there has been a breach of the implied covenant is an inherently fact-intensive inquiry, often ill-suited to disposition at the summary judgment stage. At least one North Carolina Court has noted that the implied covenant requires “wrongful intent,” the type of determination for which the jury is believed to be well suited. For the same reason, a jury’s favorable determination of the issue is more likely to be upheld on appeal than a Judge’s legal determination of breach of an express provision.

Third, as a claim arising in contract, breach of the implied covenant gives rise to characteristically breach of contract damages (generally, expectation or reliance damages). The typically more generous damages in tort are unavailable. But by emphasizing the bad faith conduct of the other party, the implied covenant lends itself naturally in the human mind to award extra-contractual damages, however inappropriate it may be to do so. And when – as is often the case – a claim for breach of an express provision is coupled with an implied covenant claim, the opportunity exists to present potentially damning evidence to the jury which could have a powerful impact on the jury’s deliberations as to damages.

The potential power of the implied covenant as a litigation tool should also be of interest to non-litigators who negotiate and draft contracts. Because under North Carolina law the implied covenant cannot impose an obligation contrary to the contract’s express provisions, there is an incentive to draft agreements with careful attention to the most common disputes for which the implied covenant is invoked. While a court likely will not uphold a mutual agreement by the parties to reject all obligations to act in good faith, it should respect the expressly established rights of the parties, even when principals of good faith and fair dealing might counsel otherwise.

[This article originally appeared in the Campbell Law Observer, February 2011.]