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 Good
Fair Faith
Dealing
FCommercial Agreement
By Eugene A. DiPrinzio
T he doctrine of good faith
and fair dealing has been
used in many legal settings.
Frequently, its use and interpretation
have been vague and mysterious.
Courts and practitioners alike have
typically described it as an unsettled
legal doctrine that creates hazy con-
tractual implications, and they have
treated it disparately. The doctrine is
an unwritten clause in every contract
that can result in rights and duties
that remain undefined until the court
or jury speaks. Courts have applied it
to a variety of pre-contract and con-
tract scenarios. In many cases, it com-
prises an additional cause of action in
breach of contract litigation. Over the
years, the doctrine of good faith and
fair dealing has expanded to a variety
of real estate and commercial law
settings. This expansion has led to
significant departures from parties'
intentions in the negotiation, construc-
tion and enforcement of real estate
and other commercial agreements.
Background
Under § 205 of the Restatement
(Second) of Contracts (1979) (Restate-
ment), "every contract imposes upon
each party, a duty of good faith and
fair dealing in its performance and in
its enforcement." The UCC also
addresses the implied covenant.
For example, UCC § 1-203 creates
an obligation of good faith in every
contract, and § 1-201(19) requires
honesty-in-fact in the conduct or
transaction concerned.
Because this definition of the
implied duty is vague, in commercial
and real estate transactions courts
have interpreted "honesty-in-fact"
to impose standards for commercial
conduct in contractual undertakings.
As one court stated, "the doctrine is
intended to minimize the time, effort,
and expense of writing and monitor-
ing contracts." Bicycle Corp. of Am. v.
Meridian Bank, 1995 U.S. Dist. LEXIS
17421, at *10 (E.D. Pa. Nov. 21, 1995).
Meridian Bank arose from a leveraged
buy out transaction. The bank was a
major undersecured creditor of a
financially troubled company that two
investors had purchased. The bank
had required the investors either to
assume or retire the existing debt of
the company before the purchase. The
bank improved its collateral position
with additional personal guarantees
and a large pledged account.
The restructured company was
unable to handle the new debt load,
and workout negotiations ensued.
Those negotiations broke down when
the bank refused to indemnify and
release one of the principals. Because
"
the parties failed to reach a satisfac-
tory workout of the existing debt,
the company was unable to obtain
additional loans that might have
saved it. The borrower and its princi-
pals alleged that the bank left the
company in financial ruin because it
failed to restructure the existing loans
or extend additional credit. They
argued that the bank's hard bargain-
ing was tantamount to a breach of the
implied covenant of good faith and fair
dealing. The court found that the plain-
tiffs failed to state a claim and granted
the bank's motion to dismiss. Never-
theless, the case is instructive because
it provides the framework for the doc-
trine of good faith and fair dealing in a
debtor-creditor relationship. See also
Restatement § 205 and cmt.
In analyzing the duty, most courts
have distinguished between the time
before a contract is formed, such as
during preliminary negotiations, and
the point at which a contract has been
formed. The decisions almost univer-
sally hold that no duty of good faith
arises in the formative stages of a con-
tract unless the parties have entered
into a binding preliminary agreement
or letter of intent. E.g., Shelley v. Trafla-
gar House Pub. Ltd. Co., 918 F. Supp.
515 (D.P.R. 1996); Teachers Ins. &
Annuity Ass'n ofAm. v. Tribune Co.,
670 F. Supp. 491 (S.D.N.Y. 1987).
Alternate theories of liability, such as
breach of fiduciary duty, misrepre-
sentation, negligence, promissory
estoppel and fraud, may also impose
such liability. E.g., Woods Corporate
Assocs. v. Signet State Holdings, Inc.,
910 F. Supp. 1019 (D.N.J. 1995);
SS&LC Group, Inc. v. The Ryland
Group, Inc., 1996 U.S. Dist. LEXIS
6430 (D. Md. 1996).
Once some form of contractual
relationship is established, the duty
of good faith performance arises as
part of the'bargain and supersedes
the parties' unwritten intentions or
desires, especially as they implement
the transaction.
To determine if a given action
violates the implied covenant of
good faith, courts generally inquire
whether the parties would have
mutually prohibited the action if they
had considered it at the time the con-
tract was formed. Meridian Bank, 1995
U.S. Dist. LEXIS 17421, at *11-12.
Courts analyze whether a party has
breached its contractual obligations
by (1) abusing its power by acting
unreasonably, (2) exceeding the
scope of its reasonable discretion,
(3) usurping the benefits of the con-
tract as negotiated or (4) undertaking
enforcement remedies for a non-
material default that are overly
oppressive or burdensome.
Characterizing behavior as
oppressive or unreasonable is subjec-
tive; courts will analyze an abuse of
discretion claim in the specific con-
text in which the discretion is exer-
cised. Courts find that a party to a
contract should be able to expect that
the other parties will behave in a
manner consistent with the mutual
benefit of all parties. Some courts,
however, have refused to find that
a defendant violated the implied
covenant of good faith and fair deal-
ing when the plaintiff has another
cause of action accruing from the
same nucleus of facts. Meridian Bank,
1995 U.S. Dist. LEXIS 17421, at *12
(citing Parkway Garage,Inc. v. City of
Philadelphia,5 F.3d 685 (3d Cir. 1993);
Forms, Inc. v. American Standard,Inc.,
546 F. Supp. 314 (E.D. Pa. 1982), aff'd,
725 F.2d 667 (1983)).
The Implied Covenant in
Commercial Agreements
One of the pitfalls of the doctrine
of good faith and fair dealing is that,
even in the context of a preliminary
document, term sheet or other pro-
posal, it can trap the parties in a legal
commitment that is not readily appar-
ent or intended. This result occurs
when a preliminary document meets
the standards of an enforceable con-
tract because both parties manifested
an intention to be bound by the agree-
ment, the terms of the agreement are
sufficiently definite to be enforced and
consideration was present. If these
fundamental elements exist, then each
of the parties to the transaction will
have an obligation to negotiate in
good faith and deal fairly with the
other party to complete the contract.
Different forms of commercial
agreements have been the subject of
litigation construing this doctrine.
Lending
*Loan commitments. Once
accepted by a borrower, letters, term
sheets and loan commitments can
obligate the lender and prospective
borrower to negotiate in good faith
to reach a final agreement on any
remaining terms. E.g., Clardy Mfg. Co.
v. Marine Midland Business Loans, Inc.,
1995 U.S. Dist. LEXIS 20896 (N.D. Tex.
May 19, 1995), rev'd in part and aff'd
in part, 889 F.3d 347 (5th Cir. 1996);
InternationalMinerals & Mining Corp.
v. Citicorp North Am., Inc., 736 F. Supp.
587 (D.N.J. 1990).
In Clardy,the district court held
that the lender failed to follow its
own loan commitment underwriting
guidelines when it issued a proposal
letter outlining financing that was
critical to an operating company des-
perate for working capital and funds
to buy out its principal shareholder.
The case disturbed lenders because
the letter expressly stated that it was
not intended to be a commitment to
lend. Based on other extraneous facts,
including the loan officer's actions,
the court used a "reasonable person"
standard to conclude that the bor-
rower's performance met the require-
ments for the loan. The bank's denial
of the loan was both objectively unrea-
sonable and a breach of good faith. In
essence, the lender's failure to abide by
its own underwriting criteria resulted
in a liability of $8 million, plus legal
fees. On appeal, however, the Fifth
Circuit Court of Appeals reversed
the finding that a contract had been
achieved as a matter of law and
dismissed all damage claims. The
purported commitment letter was too
indefinite, and significant terms were
missing, so that the borrower's reliance
on the letter was unreasonable.
e Tripartite agreements. Tripar-
tite agreements are contracts among
a borrower, interim lender and per-
manent lender, setting the terms on
which the permanent lender will take
out the interim loan. In the context
of failed tripartite agreements, some
courts have held that there is no inde-
pendent cause of action for breach of
an implied covenant of good faith.
Instead, separate tort claims for fraud
or misrepresentation may result from
future negotiations on the terms of
such agreements if a decision is sub-
ject to one party's sole discretion.
This discretion, however, will not
constitute tortious overreaching if it is
exercised reasonably. E.g., LLMD of
Mich., Inc. v. Marine Midland Realty
Credit Corp., 789 F. Supp. 657 (E.D.
Pa. 1992). The LLMD case involved
interim financing for a land acquisi-
tion. The interim and permanent
lenders failed to conclude a tripartite
agreement for the terms on which
the permanent lender would take out
the interim lender. The court found
genuine issues of material fact to exist
in the parties' exercise of good faith
that precluded summary judgment in
favor of the lender. The court also
found that Michigan law does not
recognize an independent cause of
action for breach of an implied
covenant of good faith.
9 Renewals and refinancings.
When a loan has matured, a lender
usually will not breach the duty of
good faith and fair dealing if it refuses
"One of the pitfalls of the doctrine of good faith
and fair dealing is that, even in the context of a
preliminary document, term sheet or other proposal,
it can trap the parties in a legal conunitment that is
not readily apparent or intended."
to offer the borrower extended, addi-
tional or modified financing terms.
For example, in Bloomfield v. Nebraska
State Bank, 465 N.W.2d 144 (Neb.
1991), the court held that a lender
did not breach a covenant of good
faith by failing to renew the bor-
rower's expiring line of credit, regard-
less of his circumstances. See also
Nelson v. Prod. Credit Ass'n, 930 F.2d
599 (8th Cir.), cert. denied, 112 S.Ct.
417 (1991) (finding no breach of a
fiduciary or common law duty to a
borrower based on an oral agreement
to refinance existing debt); Cate v. First
Bank (N.A.) - Billings, 865 P.2d 277
(Mont. 1993) (finding no breach of
duty of good faith and fair dealing by
bank that refused to offer additional
financing to a lawyer once his original
overdue loans were paid).
The Nelson court affirmed a lower
court decision rendering judgment
notwithstanding the verdict in a lender
liability case. There, the lender purport-
edly breached an agreement to finance
ranchers who had developed a three
year plan to handle financial instabil-
ity. The essence of the plaintiffs' claim
involved a breach of good faith and
fair dealing by the lender, which con-
tinued to fund a losing ranching opera-
tion, and the purported actions of its
loan officer in requiring the borrowers
to implement a workout plan. The
court found insufficient facts to sustain
the $1.2 million judgment against the
lender because of its purported mis-
leading promises or because it may
have voluntarily assumed a duty to
provide extended financing.
Similarly, in FirstNationalBank v.
Twombly, 689 P.2d 1226 (Mont. 1984),
the court found no breach of good faith
by a bank that called a demand loan
and froze accounts when no workout
was structured. The Twombly court
January/February 1997
ruled that the lender's acceleration of
a promissory note and refusal to
entertain restructuring or workout
negotiations with the borrowers did
not breach its obligation of good faith
and fair dealing. Under Twombly, a
lender has no implied obligation to
engage in workout negotiations if there
is a stated maturity on an obligation or
the obligation has a demand feature.
e Workouts. In the wake of eco-
nomic recession, several cases have
explored a lender's duty of good faith
and fair dealing when negotiating
with borrowers to restructure loans
that have matured or require exten-
sion. Meridian Bank, 1995 U.S. Dist.
LEXIS 17421; Twombly, 689 P.2d 1226;
Woods CorporateAssocs., 910 F. Supp.
1019. Oppressive loan documents by
themselves do not require a lender to
forego remedies to liquidate or other-
wise dispose of collateral merely
because a borrower considers those
remedies unfair or overreaching.
Leases
Cases involving leases have dealt
with the obligations of the parties to
negotiate certain economic terms in
good faith. In Channel Home Centers,
Div. of GraceRetail Corp. v. Grossman,
795 F.2d 291 (3d Cir. 1986), a letter of
intent to lease was enforceable against
a shopping center landlord. There, the
owners of a retail shopping mall and
a prospective tenant negotiated a
detailed letter of intent, including
many of the essential lease terms. In
reliance on the letter, the prospective
tenant incurred significant costs in
preparing to occupy the premises.
Before a lease was fully negotiated,
a competitor of the tenant entered
into a lease with the owners. The
court found the letter of intent to be
enforceable because most of the
salient terms of the lease had been
negotiated and the tenant had given
consideration for its future posses-
sion. Channel shows that a prelimi-
nary letter of intent can bind the
parties to engage in a course of fair
dealing in future negotiations. Note,
however, that if the signed proposal
fails to embody most of the important
terms of the transaction, no duty to
negotiate in good faith may exist.
This is not to say that courts will
not modify or impose additional terms
to lease agreements when a true
inequity or egregious conduct is pre-
sent or perceived. For example, in
Ervin v. Amoco Oil Co., 885 P.2d 246
(Colo. Ct. App. 1994), aff'd in part
and rev'd in part on other grounds,
908 P.2d 493 (1995), the jury revised
the economic terms of a standard fran-
chise lease agreement for oil retailers
because a service station franchisor
breached its duty of good faith and fair
dealing. The Ervin court found that the
franchisor unreasonably exercised its
superior bargaining position and uni-
lateral discretion to overcharge its
franchisees for service bay usage. The
decision is noteworthy because the
jury essentially rewrote the terms of
an agreement that had already been
negotiated by the parties, supposedly
on an arm's length basis.
Letters of Intent
Probably the most dangerous
document for the unwary practitioner
is a letter of intent (LOI)-sometimes
referred to as an "agreement in princi-
pal," a "non-binding agreement," a
"conditional agreement" or a "prelim-
inary agreement." By putting any
expression of accord in writing, real
estate or commercial lawyers may
obligate their clients to an extent not
intended or even considered at the
time of the initial drafting. An LOI fre-
quently includes a disclaimer that the
parties will not be legally bound until
a binding final agreement is executed.
Nevertheless, the good faith and fair
dealing doctrine may turn a best
efforts clause of an LOI into a binding
commitment to achieve a final con-
tract. Channel, 795 F.2d at 291; Chase v.
Consol. Foods Corp., 744 F.2d 566 (7th
Cir. 1984) (finding that an LOI created
an obligation to negotiate in good
faith for the sale of one party's special
divisions to another).
In A/S Apothekernes Laboratoriumfor
Specialpraeparaterv. I.M.C. Chemical
Group, 873 F.2d 155 (7th Cir. 1989), the
court discussed the distinction between
pre-contractual obligations under an
LOI and the performance obligations
that emanate from a binding agree-
ment. The court also confirmed that the
purpose and function of a preliminary
LOI is not to bind the parties to their
ultimate contractual objective. Rather,
its only purpose is to provide the initial
framework from which the parties may
negotiate a final agreement.
In this case, an attempt to purchase
a company's division was unsuccess-
ful because the parties could not ulti-
mately agree on certain issues. The
court held that an agreement to nego-
tiate is not a promise that negotiations
will become fruitful. The court also
refused to require the seller to negoti-
ate a deal that could not be finalized
without further corporate authoriza-
tion. Two other circuit court cases,
Feldman v. Allegheny InternationalInc.,
850 F.2d 1217 (7th Cir. 1988), and
Altheimer & Gray v. Sioux Manufactur-
ing Corp., 983 F.2d 803 (7th Cir.), cert.
denied, 114 S. Ct. 621 (1993), stand for
the proposition that signed letters of
intent require the parties to conduct
future negotiations in good faith.
Other Commercial
Documents
Joint venture agreements. Dif-
ferent rounds of negotiations in an
unfulfilled venture agreement do not
contravene the duty of good faith and
fair dealing if the agreement requires
"best efforts" to satisfy a condition
precedent. E.g., SDK Inv., Inc. v. Ott,
1996 U.S. Dist. LEXIS 1678 (E.D. Pa.
Feb. 15, 1996); Satellite Broadcasting
Cable, Inc. v. Telef6nica de Espafia, S.A.,
807 F. Supp. 210 (D.P.R. 1992). In Satel-
lite Broadcasting,the court found that a
condition precedent can be deemed
fulfilled when the obligated party vol-
untarily prevents its fulfillment. One
joint venturer cannot impede the ful-
fillment of a condition precedent and
then claim that the condition cannot
be satisfied. Therefore, as with the
implied covenant of good faith, the
courts may impose a "best efforts"
obligation as an extra-contractual
term. The Satellite Broadcastingopinion
states that a venturer can only file an
action for extra-contractual damages
for a violation of the duty of good
faith when there were pre-contractual
bad faith negotiations.
* Real estate contracts. In a condo-
minium project, the failure to disclose
a fiduciary relationship among cus-
tomers and lenders did not constitute
a breach of good faith. Flahertyv. Bay-
bank Merrimack Valley, N.A., 808 F.
Supp. 55 (D. Mass. 1992). In Flaherty
the purchasers of condominium units
alleged that the closing lawyers com-
mitted actionable fraud when they
failed to disclose the fair value of cer-
tain condominium units. The plaintiffs
claimed overvaluation during the
course of negotiations. The lenders
had no fiduciary obligations to the
purchasers other than their own arm's
length loan commitments. In not sur-
rendering appraisal information, the
court held that the banks did not vio-
late the implied duty of good faith and
fair dealing.
9 Stock purchase agreements.
Negligent misrepresentations do not
violate the duty of good faith and fair
dealing when numerous contractual
disclaimers and integration clauses
are contained in a stock purchase
agreement. Both Professional Service
Industries v. Kimbrell, 834 F. Supp. 1305
(D. Kan. 1993), and Reprosystem, B.V.
v. SCM Corp., 727 F.2d 257 (2d. Cir.),
cert. denied, 105 S. Ct. 110 (1984), arose
out of stock purchases and the level of
negotiations that the plaintiffs claimed
were fulfilled. In Kimbrell, the pur-
chaser of stock in an asbestos removal
corporation alleged a breach of the
implied covenant of good faith and fair
dealing when the seller failed to dis-
close a pending EPA action and the
contract was not fulfilled. This infor-
mation was available before the negoti-
ations started. In Reprosystem, extensive
negotiations over a stock purchase
agreement occurred, but a material
change permitted one party to termi-
nate its obligations without violating
the duty of good faith and fair dealing.
Conclusion
Both before and after contracts are
formed, the implied covenant of good
faith and fair dealing is hazy, unset-
tled and amorphous. As is evident
from the cases, the implied covenant
adheres to all enforceable contracts.
Parties to commercial agreements
should be aware that, if a letter of
intent or other preliminary agreement
is accepted, it may result in an obliga-
tion of good faith and fair dealing for
future negotiations.
If a party abuses its discretion,
makes misrepresentations or takes
unfair advantage of facts that are only
within its knowledge, a court may
rewrite, rescind or terminate the agree-
ments and impose liability or damages
on the party, especially if those actions
occur after a binding agreement has
been reached. If parties use a letter of
intent or other preliminary agreement
and they do not intend to require good
faith negotiations going forward, they
should explicitly disclaim the obliga-
tion to deal fairly and in good faith in
a manner sufficient to abrogate the
implied covenant.
Eugene A. DiPrinzio is a partner
with Young, Conaway, Stargatt &
Taylor in Wilmington, Delaware. He
is a member of the Real Property Sec-
tion's Commercial Financing (1-1) and
Loan Practices and Lender Liability
(1-3) committees.
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