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Vol. 70, No. 2, February 1997
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
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John E. Flanagan, Marquette 1984, is a partner at Michael, Best &
Friedrich, Milwaukee,
where he practices commercial litigation. |
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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