Breach of Implied Covenant of Good Faith and Fair Dealing

The implied covenant of good faith and fair dealing is an essential principle embedded in every contract, ensuring that each party acts fairly and in alignment with the agreed-upon purposes. This covenant prevents parties from taking actions that would undermine the other’s ability to receive the contract’s benefits. Breaching this implied covenant can occur through direct interference, intentional inaction, or actions that subvert the agreement’s purpose. When a breach occurs, the harmed party may seek damages to recover losses caused by the breach.

By Brad Nakase, Attorney

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What is a breach of the covenant of good faith and fair dealing?

Duty of Good Faith and Fair Dealing

Every contract establishes a duty for each party to act in good faith and deal fairly during the performance and enforcement of the contract. Acting in good faith means staying true to the agreed-upon objectives and aligning actions with the other party’s reasonably justified expectations.  (Major v. Western Home Ins. Co. (2009) 169 Cal.App.4th 1197.)

For instance, if a buyer and seller enter into a contract for the purchase of goods, both parties are expected to follow through on their obligations in a manner that respects the purpose of the agreement and the mutual benefits intended.

Purpose of the Implied Covenant of Good Faith and Fair Dealing

The core purpose of the implied covenant of good faith and fair dealing is to ensure that neither party engages in conduct that would harm the other party’s right to receive the agreed benefits of the contract. For example, if a landlord and tenant agree to a lease, the landlord should not take actions that would unfairly prevent the tenant from enjoying the leased property, such as failing to provide necessary maintenance or improperly attempting to evict the tenant. (Major v. Western Home Ins. Co. (2009) 169 Cal.App.4th 1197.)

What is an example of fair dealing and good faith?

  • Timely Performance of Obligations
    An example of fair dealing and good faith is when a contractor and a client agree on specific deadlines for completing various stages of a construction project. The contractor acts in good faith by diligently meeting deadlines and notifying the client of any delays. The client, in return, releases payments as agreed without imposing unreasonable demands.
  • Honest Disclosure of Relevant Information
    Another example of fair dealing and good faith occurs in a business partnership where both partners agree to share relevant financial information. If one partner discovers a discrepancy, they act in good faith by promptly informing the other and transparently addressing the issue. This openness aligns with their mutual expectations.
  • Offering Reasonable Flexibility in Unforeseen Circumstances
    An example of fair dealing and good faith can be seen in a commercial lease agreement where a tenant encounters unexpected financial difficulties. The landlord, instead of immediately enforcing penalties, agrees to a short extension on rent after the tenant demonstrates a genuine effort to comply. This flexibility respects the underlying purpose of the contract.
  • Providing Assistance to Achieve Mutual Goals
    A supplier and distributor working under a distribution agreement illustrate an example of fair dealing and good faith. If the distributor faces logistical issues, the supplier offers reasonable assistance to resolve the matter, rather than penalizing the distributor. This cooperation supports the mutual goal of brand expansion.
  • Avoiding Actions that Undermine the Agreement
    In a service contract between a consultant and a company, an example of fair dealing and good faith would be when the company continues to provide the necessary data and resources for the consultant to fulfill their reporting obligations. By doing so, the company avoids actions that would undermine the agreement and ensures both parties can meet their commitments.

Can you waive the implied covenant of good faith and fair dealing?

In most cases, parties cannot waive the implied covenant of good faith and fair dealing, as it is a fundamental principle embedded within every contract. This covenant ensures that neither party takes actions to deprive the other of the benefits of the agreement. Courts generally uphold the implied covenant to maintain fairness and consistency in contract enforcement, even if parties attempt to exclude it explicitly.

For example, suppose a franchise agreement contains a clause stating that the franchisor can terminate the agreement at their sole discretion. If the franchisor terminates in a way that violates the reasonable expectations of the franchisee, such as acting arbitrarily or unfairly, the franchisee may still claim a breach of the implied covenant, despite the contractual clause. This is an example of fair dealing and good faith being protected even against express attempts to waive it.

However, there are limited circumstances where parties can narrowly define their obligations in a way that reduces the practical impact of the covenant, but even in those cases, courts still recognize the implied covenant to prevent outright abuses or intentional bad faith actions.

What is the implied covenant of good faith exception?

The implied covenant of good faith exception refers to situations where courts recognize an exception to the general rule that the implied covenant of good faith and fair dealing applies to every contract. This exception typically arises in scenarios where the express terms of the contract explicitly permit actions that would otherwise seem unfair or contrary to the expectations of the parties. Essentially, the exception applies when contract provisions expressly limit or override the implied covenant.

For example, in an employment-at-will agreement, the employer has the right to terminate an employee without cause. Although the implied covenant generally requires fair dealing, the express at-will clause can create an exception, allowing the employer to terminate an employee without breaching the implied covenant, as long as the termination is not based on bad faith actions like discrimination or retaliation. This is an example of fair dealing and good faith being limited by express contract terms.

Another example of the implied covenant of good faith exception is when a loan agreement explicitly allows a lender to call a loan due at any time, provided certain conditions are met. If the lender exercises this right within the express terms of the contract, it may not be considered a breach of the implied covenant, even if the borrower feels it is unfair.

The exception highlights that while the implied covenant is fundamental, express contractual provisions that clearly define the parties’ rights can limit or override its application, as long as those provisions are not unconscionable or contrary to public policy. Thus, this exception is an example of fair dealing and good faith being constrained by clear contract language.

What are the elements of breach of implied covenant of good faith and fair dealing?

Element 1: Valid Contract

An action for breach of the implied covenant of good faith and fair dealing requires the existence of an underlying agreement. This could include a formal contract, a letter of intent, or even a preliminary agreement to use best efforts to reach an agreement. (Racine v. Laramie, Ltd. v. Department of Parks & Recreation (1992) 11 Cal.App.4th 1026.)

For example, if two parties sign a preliminary agreement to negotiate in good faith to reach a final contract for the sale of goods, and one party deliberately stalls or undermines those negotiations, they could be in breach of this preliminary agreement.

  • No Implied Covenant of Good Faith and Fair Dealings During Negotiations: The implied covenant of good faith and fair dealing does not apply during pre-contractual negotiations. (Copeland v. Baskin Robbins U.S.A. (2002) 96 Cal.App.4th 1251.)

For instance, if two parties are negotiating terms for a potential joint venture and one party decides to pursue another opportunity, there would be no breach of the implied covenant because the duty of good faith and fair dealing has not yet attached to a binding agreement.

  • Implied Covenant Functions to Protect Express Covenants of the Contract: The implied covenant of good faith and fair dealing serves to protect the express covenants of a contract rather than safeguarding general public policy interests unrelated to the contract’s purpose. (Wolf v. Walt Disney Pictures & Television (2008) 162 Cal.App.4th 1107.)

For example, in a distribution agreement, if the contract includes an express provision for minimum purchase requirements, the implied covenant would ensure that neither party takes actions that undermine the agreed purchase commitments.

  • Implied Covenant Has No Relation to Any Statutory Duties: The covenant of good faith and fair dealing is strictly an implied term of a contract and does not extend to statutory duties that may separately exist. (Kirkpatrick v. Wells Fargo Bank, N.A. (2017) Cal.App.Unpub. LEXIS 4057 (citing Smith v. City and County of San Francisco (1990) 225 Cal.App.3d 38).)

For instance, if a bank follows statutory duties but fails to uphold a specific term within its contract with a customer, the breach would be evaluated based on the contract, not the statutory obligations.

  • Conflicts with a Contract’s Express Grant of Discretionary Power: Courts are hesitant to imply the covenant of good faith and fair dealing if doing so conflicts with an express grant of discretionary power within the contract. This is unless the literal interpretation of the provision would render the contract illusory or unenforceable. (Third Story Music, Inc. v. Waits (1995) 41 Cal.App.4th 798.)

For example, if a contract gives one party express authority to approve or deny modifications at its sole discretion, a court would likely uphold this provision unless it makes the contract meaningless or contradicts the parties’ clear intentions.

Element 2: Duty of Good Faith and Fair Dealing

The covenant imposes a duty on each party to avoid actions that would render performance of the contract impossible and to actively work towards achieving the contract’s purpose. (Lueras v. BAC Home Loans Servicing, LP (2013) 221 Cal.App.4th 49.) For example, in a home renovation contract, if the homeowner fails to provide access to the contractor at the agreed times, making it impossible to complete the work, the homeowner would be violating the duty of good faith and fair dealing. The contractor could seek damages for breach of implied covenant of good faith and fair dealing to cover resulting losses and delays.

  • Scope of Duty: The scope of the duty imposed by the implied covenant of good faith and fair dealing depends on the specific purpose and terms of the contract. (The McCaffrey Group, Inc. v. Superior Court (2014) 224 Cal.App.4th 1330.)

    For instance, in a software licensing agreement, if the licensor fails to provide necessary updates that allow the licensee to use the software effectively, the licensee could claim damages for breach of implied covenant of good faith and fair dealing. The licensor’s failure to fulfill this duty impacts the intended purpose of the licensing agreement.

  • Contradictory and Ambiguous Contracts: When a contract is ambiguous or contains contradictory provisions, the implied covenant of good faith and fair dealing can guide the interpretation and enforcement of the agreement. (Mitchell v. Exhibition Foods (1986) 184 Cal.App.3d 1033.)

    For example, if an employment agreement has conflicting clauses about the eligibility for bonuses, a court might rely on the implied covenant to interpret the terms in a way that aligns with the parties’ expectations. If an employer interprets the ambiguity in a way that unfairly denies bonuses to employees, the employees could seek damages for breach of implied covenant of good faith and fair dealing.

  •  Contract Between Merchants: In contracts between merchants, good faith requires both honesty and adherence to reasonable commercial standards in the trade. (Com. Code § 2103(1)(b).)

    For example, if a supplier regularly misses delivery deadlines without a valid reason in a distribution contract with a retailer, the retailer could claim damages for breach of implied covenant of good faith and fair dealing due to the supplier’s failure to meet the expected standards of the industry.

  • Objectively Reasonable Conduct: The essence of the covenant of good faith and fair dealing is objectively reasonable conduct. (Badie v. Bank of Am. (1998) 67 Cal.App.4th 779.)

    For example, if a bank unilaterally adds a burdensome new fee to customer accounts without notice or an option to opt-out, this action would not be considered objectively reasonable. The affected customers could claim damages for breach of implied covenant of good faith and fair dealing due to the bank’s unfair practices.

  • Applies to Both Performance & Enforcement of the Contract: The duty of good faith and fair dealing applies during both the performance and enforcement of a contract. (Carma Developers (Cal.), Inc. v. Marathon Development California, Inc. (1992) 2 Cal.4th 342.)

    For instance, if a landlord in a commercial lease unreasonably withholds approval for necessary renovations, thereby preventing the tenant from effectively using the property, the tenant could seek damages for breach of implied covenant of good faith and fair dealing. The landlord’s actions hinder the performance and intended use of the contract.

  • Bad Faith in Performance of a Contract: Bad faith in the performance of a contract can include deliberate inaction or actions that undermine the agreement. (Jacobs v. Tenneco W. (1986) 186 Cal.App.3d 1413.)

    For example, if an employer intentionally delays paying an employee’s earned commissions without a valid reason, it may be considered a breach. The employee could pursue damages for breach of implied covenant of good faith and fair dealing due to the employer’s intentional delay in payment.

  • Good Faith in Enforcement: The duty of good faith extends to the assertion, settlement, and litigation of contract claims. (Dairy Farmers of Am. v. Cacique, Inc. (2011)

    For instance, if a party in a contract lawsuit uses tactics to delay proceedings or make it prohibitively costly for the other party to pursue their claim, this would be an example of acting in bad faith. The aggrieved party could seek damages for breach of implied covenant of good faith and fair dealing based on the unfair litigation tactics employed during enforcement.

Element 4: Causation and Damage

The breaching party is liable for all damages that proximately result from their conduct. (PPG Industries, Inc. v. Transamerica Ins. Co. (1999) 20 Cal.4th 310.)

For example, if a contractor fails to complete a construction project on time due to intentional delays, the client could seek damages for breach of implied covenant of good faith and fair dealing to cover additional costs incurred from hiring another contractor to finish the work or for losses resulting from the delay.

Uncertainty of Exact Amount of Damages Does Not Bar Recovery: If it is clear that a party has suffered contract damages, courts or juries are encouraged to apply a liberal standard when determining the amount of damages. Uncertainty about the exact amount should not be a reason to deny recovery altogether. (Stevenson v. Dougherty (2013)  (citing California Lettuce Growers, Inc. v. Union Sugar Co. (1955) 45 Cal.2d 474).)

For instance, if a supplier fails to deliver critical components needed for a manufacturing process, causing the manufacturer to suffer lost profits, the manufacturer may still recover damages for breach of implied covenant of good faith and fair dealing, even if the exact loss of profit is somewhat difficult to quantify precisely.

What are the damages for breach of implied covenant of good faith and fair dealing?

Damages for a breach of the implied covenant of good faith and fair dealing aim to compensate the non-breaching party for losses incurred due to the other party’s bad faith actions. Generally, these damages are categorized as either compensatory damages or, in some exceptional cases, punitive damages. The primary goal is to restore the injured party to the position they would have been in had the implied covenant not been breached.

  1. Compensatory Damages
    Compensatory damages cover the actual financial loss the non-breaching party suffered due to the breach of good faith. This can include lost profits, expenses incurred as a result of the breach, or loss of benefits that were reasonably expected under the contract. For example, if a supplier fails to deliver critical goods on time out of bad faith, causing a distributor to lose a major sale, the distributor could seek compensation for lost profits. This is an example of fair dealing and good faith requiring the at-fault party to pay for the foreseeable losses.
  2. Consequential Damages
    Consequential damages extend to cover losses that arise indirectly from the breach of the implied covenant, as long as these losses were reasonably foreseeable. For example, if an employer wrongfully terminates an employee in bad faith and the employee suffers reputational damage, the employee may seek damages for loss of future job opportunities. This is another example of fair dealing and good faith being honored by compensating for extended impacts of the breach.
  3. Punitive Damages
    In cases involving egregious conduct, such as intentional or malicious breaches of the implied covenant, courts may award punitive damages. Punitive damages are intended to punish the breaching party and deter similar conduct in the future. For instance, in an insurance contract where the insurer deliberately denies a valid claim in bad faith to avoid payouts, the insured might receive punitive damages to penalize the insurer. This serves as an example of fair dealing and good faith being reinforced by punishing severe breaches.
  4. Emotional Distress Damages
    In certain cases, a breach of the implied covenant may lead to emotional distress for the non-breaching party, especially if the contract involves personal matters or relationships. For instance, in an employment contract where the employer acts in bad faith by creating a hostile work environment, the employee may seek damages for the resulting emotional distress. This is another example of fair dealing and good faith aiming to compensate not just financial but also personal harm.

In summary, damages for breaching the implied covenant of good faith and fair dealing generally seek to provide compensation for the actual and foreseeable losses suffered by the non-breaching party. However, when the breach involves egregious conduct, punitive damages may also be awarded, demonstrating an example of fair dealing and good faith being strongly protected.

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