Civil Law in the United States (USA) and Good Faith and Fair Dealing Litigation

1. Introduction

The implied covenant of good faith and fair dealing is a fundamental principle of U.S. contract law. It generally requires parties to a contract to perform and enforce their contractual obligations honestly and in a manner that does not improperly destroy or undermine the other party's reasonably expected contractual benefits.

The doctrine is recognized in most U.S. jurisdictions, although its exact scope varies by state. It is generally understood as an implied obligation arising from the contractual relationship rather than as a completely independent contractual promise. (Legal Information Institute)

For example, a contract may give a company discretion to determine a price, approve a transaction, terminate an agreement, calculate a commission, or evaluate performance. The good-faith doctrine may prevent that discretion from being exercised arbitrarily, dishonestly, opportunistically, or for a purpose inconsistent with the contract.

At the same time, good faith does not normally allow a court to rewrite an express contractual provision. This limitation is particularly important in litigation.

2. Meaning of Good Faith and Fair Dealing

The doctrine has two closely related concepts.

Good faith

Generally concerns honesty, sincerity, and the absence of improper motives or opportunistic conduct.

Fair dealing

Concerns whether a party's conduct, viewed in the context of the agreement, improperly deprives the other party of the benefit reasonably contemplated by the contract.

The doctrine therefore attempts to balance two principles:

Freedom of contract + honest contractual performance.

It does not generally require parties to act altruistically or to place the other party's interests above their own.

3. Legal Foundation

A. Common law

The covenant developed through American contract jurisprudence.

Courts historically used concepts such as:

prevention;

cooperation;

reasonable expectations;

honest performance;

prevention of opportunistic conduct.

Modern courts frequently describe these principles as the implied covenant of good faith and fair dealing.

B. Restatement (Second) of Contracts

Section 205 of the Restatement (Second) of Contracts provides the basic formulation:

“Every contract imposes upon each party a duty of good faith and fair dealing in its performance and its enforcement.”

The doctrine is therefore ordinarily concerned with performance and enforcement, rather than creating unlimited obligations during contract negotiations.

C. Uniform Commercial Code

For transactions involving goods, UCC §1-304 provides that every contract or duty within the UCC imposes an obligation of good faith in performance and enforcement. (Legal Information Institute)

UCC §1-201 defines good faith generally as honesty in fact and observance of reasonable commercial standards of fair dealing. (Legal Information Institute)

For merchants, UCC Article 2 contains an especially important formulation requiring honesty in fact together with reasonable commercial standards of fair dealing in the trade. (Legal Information Institute)

4. Elements of a Good-Faith Claim

The precise elements vary by jurisdiction, but a typical contractual good-faith claim requires consideration of:

1. Existence of a contract

There must ordinarily be an underlying contractual relationship.

2. Contractual obligation or benefit

The plaintiff must identify a right or benefit arising from the contract.

3. Conduct inconsistent with good faith

The defendant allegedly:

acted dishonestly;

exercised contractual discretion arbitrarily;

frustrated the contract's purpose;

withheld cooperation;

prevented performance;

manipulated contractual mechanisms;

deprived the plaintiff of expected contractual benefits.

4. Causation

The conduct must have caused legally cognizable contractual harm.

5. Damages or other appropriate relief

The plaintiff must establish an appropriate remedy under applicable law.

5. What Good Faith Does NOT Mean

Good faith does not mean:

every contract must be economically equal;

one party must sacrifice its own interests;

every commercially harsh decision is bad faith;

courts can rewrite unfavorable contracts;

every breach automatically becomes a bad-faith breach;

an express contractual right can always be overridden.

This limitation is extremely important.

A party can make a bad business decision without acting in bad faith.

Likewise, a party can exercise a contractual right against the economic interests of the other party without necessarily violating the covenant.

6. Major Forms of Bad-Faith Conduct

A. Opportunistic exploitation

A party discovers that the other party overlooked an important contractual provision and deliberately exploits the mistake in a manner inconsistent with the agreement's reasonable expectations.

B. Abuse of discretion

A contract gives one party discretion, but the party uses it:

arbitrarily;

irrationally;

dishonestly;

for an unrelated purpose.

C. Prevention of performance

A party deliberately prevents the other party from satisfying its contractual obligations.

D. Manipulation of conditions

A party intentionally manipulates an event or contractual condition in order to avoid its own obligation.

E. Refusal to cooperate

Where cooperation is reasonably necessary for performance, deliberate obstruction may constitute bad faith.

F. Frustration of contractual benefits

A party technically performs some contractual language but intentionally destroys the benefit the other party reasonably expected to receive.

7. Case Law 1 — Market Street Associates v. Frey

Market Street Associates Ltd. Partnership v. Frey, 941 F.2d 588 (7th Cir. 1991)

This is one of the most frequently cited American cases on contractual good faith.

Facts

A lease contained a provision allowing the tenant to purchase the property under specified circumstances.

The tenant later discovered that the provision could be used to its advantage because the other party had apparently overlooked it.

The tenant attempted to exercise the contractual right.

Issue

Was the tenant acting in bad faith by taking advantage of the other party's failure to recognize the contractual provision?

Holding

Judge Richard Posner explained that good faith can restrict opportunistic conduct, particularly where one party knowingly exploits circumstances that the parties could not reasonably have contemplated when drafting the contract.

The court nevertheless concluded that the factual question of good faith required further proceedings rather than summary judgment. (Justia Law)

Importance

The case demonstrates that:

Good faith does not require altruism, but it can prevent opportunistic exploitation of another party's contractual mistake.

8. Case Law 2 — Kham & Nate's Shoes v. First Bank

Kham & Nate's Shoes No. 2, Inc. v. First Bank of Whiting, 908 F.2d 1351 (7th Cir. 1990)

Facts

Kham & Nate's Shoes was experiencing financial difficulties and had a lending relationship with First Bank.

The borrowers argued that the bank had violated the implied covenant of good faith by exercising contractual rights concerning the financing relationship.

Holding

The Seventh Circuit emphasized that the covenant of good faith does not give courts authority to rewrite the parties' agreement or create obligations contrary to its express terms.

The doctrine operates within the contractual framework selected by the parties. (Justia Law)

Importance

The case is particularly useful for the defense:

Good faith cannot be used simply to impose obligations that the parties deliberately omitted from their contract.

9. Case Law 3 — Tymshare, Inc. v. Covell

Tymshare, Inc. v. Covell, 727 F.2d 1145 (D.C. Cir. 1984)

Facts

William Covell was a salesperson whose compensation depended partly on sales quotas.

Tymshare had contractual authority to adjust quotas. The company retroactively increased Covell's quota, substantially affecting his commissions.

Covell argued that the company had exercised its contractual authority in bad faith.

Holding

The D.C. Circuit explained that an express contractual power can still be subject to good-faith limitations depending upon the parties' reasonable understanding of the purpose for which the power was granted.

However, the court concluded that the evidence did not sufficiently establish bad faith on the facts presented and reversed the district court's judgment. (Justia Law)

Importance

The case illustrates an important rule:

Contractual discretion is not necessarily unlimited simply because the contract uses broad language.

10. Case Law 4 — Carma Developers v. Marathon Development

Carma Developers (Cal.), Inc. v. Marathon Development California, Inc., 2 Cal. 4th 342, 826 P.2d 710 (1992)

Facts

The dispute concerned a commercial lease containing provisions dealing with assignment and transfer.

One party argued that the other had violated the implied covenant of good faith and fair dealing.

Holding

The California Supreme Court recognized the general implied covenant but emphasized that its scope is limited by the express purposes and terms of the contract.

The court stated that the covenant ordinarily cannot be used to prohibit conduct that the contract expressly authorizes. (Justia Law)

Importance

Carma Developers establishes an important limitation:

The implied covenant cannot normally be used to contradict an express contractual right.

11. Case Law 5 — Dalton v. Educational Testing Service

Dalton v. Educational Testing Service, 87 N.Y.2d 384, 639 N.Y.S.2d 977, 663 N.E.2d 289 (1995)

Facts

Brian Dalton took the SAT twice.

His second score was substantially higher, and Educational Testing Service questioned the validity of the score because of handwriting differences.

ETS cancelled the score.

Dalton argued that ETS had failed to exercise its contractual discretion fairly.

Holding

The New York Court of Appeals recognized the implied covenant and explained that where a contract gives one party discretion, that discretion cannot ordinarily be exercised in an arbitrary or irrational manner.

The court found that ETS had breached its contractual obligations because of the manner in which it handled relevant information. (Justia Law)

Importance

The case is particularly useful for understanding discretionary contractual powers.

12. Case Law 6 — Fortune v. National Cash Register Co.

Fortune v. National Cash Register Co., 373 Mass. 96, 364 N.E.2d 1251 (1977)

Facts

An employee earned commissions on a major transaction.

The employer terminated him shortly before the transaction was completed and attempted to avoid paying the commission.

Holding

The Massachusetts Supreme Judicial Court recognized that contractual discretion concerning termination could be subject to the implied obligation of good faith.

Importance

The case became influential in demonstrating how good faith can prevent a party from using a contractual termination mechanism primarily to defeat an accrued economic benefit.

It is also important in employment-contract litigation, although jurisdictions differ significantly regarding implied-covenant claims in employment relationships.

13. Case Law 7 — Seidenberg v. Summit Bank

Seidenberg v. Summit Bank, 791 A.2d 616 (N.J. Super. Ct. App. Div. 2002)

The case involved contractual rights and allegations that one party's conduct undermined the other party's expected contractual benefits.

The New Jersey court emphasized that the implied covenant requires parties to refrain from conduct that destroys or injures the other party's reasonable contractual expectations.

Importance

The case illustrates the distinction between:

exercising a contractual right; and

exercising that right in a manner designed to undermine the bargain itself.

14. Case Law 8 — Guz v. Bechtel National, Inc.

Guz v. Bechtel National, Inc., 24 Cal. 4th 317, 8 P.3d 1089 (2000)

This is an important employment-contract case.

Facts

Guz was an employee who alleged that his employer violated the implied covenant of good faith and fair dealing when his employment was terminated.

Holding

The California Supreme Court explained that the covenant cannot be used to create substantive rights that are inconsistent with the parties' contractual relationship.

For example, the covenant does not automatically transform at-will employment into employment terminable only for cause.

Importance

The case illustrates a critical principle:

The implied covenant protects contractual expectations; it does not create a new contract that the parties never made.

California's current jury instructions likewise emphasize that the covenant rests upon an underlying contractual obligation and cannot be used to require conduct expressly permitted by the contract. (Justia)

15. Case Law 9 — Centronics Corp. v. Genicom Corp.

Centronics Corp. v. Genicom Corp., 132 N.H. 133, 562 A.2d 187 (1989)

Facts

The dispute involved an escrow arrangement and the exercise of contractual discretion concerning the release of funds.

Holding

The New Hampshire Supreme Court explained that good faith can restrict discretionary contractual powers where their exercise affects the other party's contractual rights.

Importance

The case is particularly useful for demonstrating that good faith may become significant when:

one party controls a contractual decision;

the contract leaves discretion open;

that discretion directly affects the other party's economic rights.

16. Core Principles Derived from the Cases

17. Good Faith and Express Contract Terms

This is perhaps the most important examination issue.

Suppose a contract says:

“The lender may terminate the agreement upon 30 days' notice for any reason.”

The borrower later argues:

“Termination is unfair and therefore violates good faith.”

The answer depends upon the jurisdiction and contractual context.

But generally, if the contract genuinely gives an unrestricted termination right, a court will be reluctant to use the implied covenant to eliminate that express right.

This is consistent with Carma Developers and Kham & Nate's Shoes.

The covenant is therefore subordinate to the basic bargain reflected in the contract.

18. Good Faith and Contractual Discretion

The doctrine becomes particularly important when one party possesses discretion.

Examples include:

determining commissions;

approving expenses;

deciding whether performance is satisfactory;

setting delivery schedules;

calculating royalties;

evaluating test results;

approving transfers;

exercising renewal rights;

determining whether a contractual condition has been satisfied.

A court may ask:

Was the discretion exercised honestly?

Was it exercised for the purpose contemplated by the contract?

Was the decision arbitrary or irrational?

Was the discretion manipulated to deprive the other party of the bargain?

Dalton and Tymshare are particularly useful examples.

19. Good Faith vs. Bad Faith

Good-faith conduct

A party:

honestly interprets the contract;

communicates relevant information;

cooperates where reasonably necessary;

exercises discretion for legitimate contractual purposes;

follows established contractual procedures.

Bad-faith conduct

A party:

deliberately sabotages performance;

conceals information to defeat the bargain;

manipulates a contractual condition;

exercises discretion for an unrelated purpose;

deliberately prevents the other party from receiving an earned benefit;

exploits a contractual ambiguity opportunistically.

20. Prevention Doctrine

Good-faith litigation often overlaps with the prevention doctrine.

Under the prevention principle, a party generally cannot deliberately prevent the occurrence of a condition whose occurrence is necessary for the other party to obtain contractual performance and then rely upon that failure.

Example

A buyer's payment obligation becomes due only after an inspection.

The buyer deliberately prevents the inspection from occurring and then argues:

“The inspection never happened, so I do not have to pay.”

A court may treat the buyer's conduct as inconsistent with good faith and the prevention doctrine.

21. Good Faith in Sales of Goods

The UCC gives good faith a particularly important commercial role.

UCC §1-304 imposes good-faith obligations in performance and enforcement. (Legal Information Institute)

For merchants, good faith includes:

honesty in fact; and

reasonable commercial standards of fair dealing.

(Legal Information Institute)

The parties also cannot simply contract away the UCC's basic obligations of good faith, diligence, reasonableness, and care. UCC §1-302 specifically restricts contractual disclaimers of those obligations. (Legal Information Institute)

22. Good Faith in Long-Term Commercial Contracts

The doctrine is particularly significant in long-term agreements.

Examples include:

franchise agreements;

distribution agreements;

supply contracts;

licensing agreements;

joint ventures;

construction contracts;

financing arrangements;

commercial leases;

employment contracts.

Why?

Because long-term contracts cannot anticipate every possible future circumstance.

The implied covenant can sometimes fill genuine contractual gaps while preserving the fundamental bargain.

Market Street Associates is a classic illustration of this concept. (Justia Law)

23. Good Faith in Employment Litigation

Employment cases require special caution.

Some states recognize broader good-faith theories, while others strictly limit them.

Courts frequently distinguish:

Contract claim

Employer breached an employment agreement.

Good-faith claim

Employer exercised contractual rights in a manner inconsistent with the agreement.

Tort claim

Employer committed an independently wrongful act.

These are not automatically interchangeable.

For example, Guz v. Bechtel demonstrates that California does not allow the implied covenant to create contractual job-security rights inconsistent with an at-will employment relationship. (Justia)

24. Good Faith in Insurance Contracts

Insurance is another major field.

Insurers may owe contractual obligations concerning:

investigation;

evaluation;

settlement;

payment;

coverage decisions.

In many jurisdictions, particularly where recognized by state law, unreasonable failure to honor insurance obligations can generate bad-faith insurance litigation.

Insurance bad faith can sometimes extend beyond ordinary breach-of-contract damages and may involve tort remedies, depending on state law.

This is one area where the phrase “bad faith” may have consequences substantially different from an ordinary contractual good-faith claim.

25. Good Faith vs. Fiduciary Duty

These doctrines should not be confused.

Good faith

Normally arises from a contractual relationship.

Fiduciary duty

Arises because one party owes heightened duties of loyalty, care, or trust to another.

A normal commercial contract does not automatically create a fiduciary relationship.

Therefore:

Every fiduciary relationship may involve good-faith obligations, but not every contractual relationship is fiduciary.

26. Good Faith vs. Fraud

Fraud generally requires more than ordinary bad faith.

Fraud may involve:

material misrepresentation;

knowledge of falsity;

intent to induce reliance;

actual reliance;

damages.

A good-faith claim, by contrast, may sometimes be established without proving traditional fraud.

For example, Carma Developers recognizes that the covenant may be violated by objectively unreasonable conduct even without traditional subjective dishonesty, depending upon the jurisdiction and circumstances. (Justia Law)

27. Good Faith vs. Ordinary Breach of Contract

This distinction is essential.

Ordinary breach

The defendant fails to perform an express contractual obligation.

Good-faith breach

The defendant's conduct may technically fit within the contract's language but improperly undermines the contractual bargain or exercises contractual discretion in an impermissible manner.

However, the same conduct can sometimes constitute both an express breach and a breach of the implied covenant.

28. Remedies

The remedies available depend upon the jurisdiction and the underlying cause of action.

A. Compensatory damages

The plaintiff may recover damages caused by the contractual breach.

B. Consequential damages

Available where legally recoverable and sufficiently connected to the breach.

C. Specific performance

May be available in appropriate circumstances, particularly where monetary damages are inadequate.

D. Injunction

A court may prevent continuing conduct that violates contractual rights.

E. Declaratory relief

A court may determine the parties' contractual rights.

F. Punitive damages

Generally not available for an ordinary breach of contract merely because the defendant acted in bad faith.

An exception may arise where the conduct independently constitutes an actionable tort or where a particular statute authorizes enhanced damages.

This distinction is extremely important.

29. Defenses to Good-Faith Claims

1. Express contractual authorization

The defendant may argue:

“The contract expressly allowed me to do exactly what I did.”

This can be powerful under cases such as Carma Developers.

2. No contractual duty

There may be no underlying contractual obligation supporting the alleged covenant.

3. Contractual discretion was properly exercised

The defendant may show the decision was commercially reasonable and within the contemplated purpose of the agreement.

4. No damages

Even if questionable conduct occurred, the plaintiff must establish legally recoverable injury.

5. No causation

The alleged bad-faith conduct may not have caused the plaintiff's losses.

6. Statute of limitations

The lawsuit may have been filed too late.

7. Economic-loss limitations

Depending on the jurisdiction and theory, tort damages may be unavailable where the dispute is fundamentally contractual.

30. Important Litigation Questions

When a court evaluates a good-faith claim, it may ask:

What does the contract expressly provide?

What benefit did the plaintiff reasonably expect?

What contractual power did the defendant exercise?

For what purpose was that power granted?

Was the power exercised honestly?

Was the conduct arbitrary or irrational?

Did the defendant prevent performance?

Did the defendant deliberately frustrate the bargain?

Would recognizing the claimed obligation contradict an express term?

What damages resulted?

31. Hypothetical Example

Suppose Company A enters into a five-year distribution agreement with Company B.

The agreement states that B receives a 10% commission on sales.

A later discovers that B is about to receive a very large commission because of a major customer transaction.

A deliberately changes its internal accounting method solely to classify the transaction differently and prevent B from receiving the commission.

B sues.

The court would examine:

the exact commission provision;

A's contractual discretion;

the purpose of that discretion;

whether A manipulated the calculation;

whether the conduct was contemplated when the contract was drafted;

whether B reasonably expected the commission.

If A's conduct was a deliberate attempt to defeat B's contractual benefit rather than a legitimate exercise of contractual discretion, a good-faith claim may become viable.

32. Another Hypothetical — Express Right

Now assume the contract expressly states:

“Company A may exclude sales made through affiliated companies from the commission calculation.”

A excludes affiliated-company sales.

B argues:

“That is unfair.”

The good-faith claim is considerably weaker because the contract expressly authorized the exclusion.

Under the reasoning reflected in Carma Developers, a court ordinarily should not use the implied covenant to prohibit conduct that the contract expressly permits. (Justia Law)

33. Comparative Case Table

34. Overall Legal Test

For an exam or research answer, the doctrine can be reduced to the following formula:

Valid contract

↓

Contractual right or benefit

↓

Defendant's performance/enforcement conduct

↓

Was the conduct honest and consistent with the contract's purposes?

↓

Did it improperly frustrate the plaintiff's reasonably expected contractual benefit?

↓

Does the claim contradict an express contractual term?

↓

Causation + legally cognizable damages

↓

Appropriate remedy

35. Conclusion

The implied covenant of good faith and fair dealing is one of the most important doctrines in American contract law. It prevents parties from using contractual powers as instruments of dishonesty, opportunism, arbitrary decision-making, prevention, or deliberate frustration of the bargain.

The leading principles can be summarized as follows:

Market Street Associates v. Frey — good faith can prevent opportunistic exploitation. (Justia Law)

Kham & Nate's Shoes v. First Bank — good faith does not authorize courts to rewrite contracts.

Tymshare v. Covell — contractual discretion may be constrained by the parties' reasonable contractual expectations. (Justia Law)

Carma Developers v. Marathon — the covenant generally cannot contradict an express contractual right. (Justia Law)

Dalton v. Educational Testing Service — discretionary contractual decisions should not be arbitrary or irrational. (Justia Law)

Fortune v. National Cash Register — contractual powers may not always be manipulated to defeat an earned contractual benefit.

Guz v. Bechtel — the covenant cannot be used to manufacture contractual rights inconsistent with the underlying agreement. (Justia)

Therefore, good faith is neither a requirement that contracting parties act selflessly nor a judicial license to rewrite contracts. Its principal function is to ensure that parties exercise their contractual rights and perform their contractual obligations consistently with the bargain they actually made and without improper conduct that defeats the other party's legitimate contractual expectations.