Performance, breach, and discharge - Obligations of good faith and fair dealing

Learning Outcomes

This article examines the implied duty of good faith and fair dealing essential to contract performance and enforcement. It clarifies the scope of this duty under both the Uniform Commercial Code (UCC) and common law, identifies common scenarios where the duty is invoked, particularly regarding discretionary powers and conditions, and explains the consequences of breaching this obligation. After studying this material, you will be equipped to analyze how the duty of good faith and fair dealing impacts contractual obligations and assess its relevance in MBE fact patterns.

MBE Syllabus

For the MBE, understanding the implied obligations parties owe each other during contract performance is essential. This includes the duty of good faith and fair dealing. You should be prepared to:

  • Recognize that the duty of good faith and fair dealing is implied in virtually all contracts.
  • Understand the meaning of "good faith" (honesty in fact and reasonable commercial standards for merchants) and "fair dealing" (cooperation, not hindering performance).
  • Differentiate the application and standards under the UCC (Article 1 and Article 2) and the common law.
  • Analyze how the duty limits the exercise of discretion conferred by a contract (e.g., satisfaction clauses, requirements/output contracts).
  • Determine when conduct constitutes a breach of the implied covenant.
  • Identify the remedies available for such a breach.

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

  1. The implied covenant of good faith and fair dealing applies to:
    1. Only contracts for the sale of goods under the UCC.
    2. Only common law service contracts.
    3. Virtually all contracts, whether governed by the UCC or common law.
    4. Only contracts where the parties explicitly include such a term.
  2. Under UCC Article 2, "good faith" for a merchant requires:
    1. Honesty in fact only.
    2. Honesty in fact and the observance of reasonable commercial standards of fair dealing.
    3. Strict adherence to the contract's express terms, regardless of commercial standards.
    4. Subjective belief that one's actions are fair.
  3. A party with discretionary power under a contract (e.g., a "satisfaction" clause) generally breaches the duty of good faith and fair dealing if they exercise that discretion:
    1. In any way that disadvantages the other party.
    2. To recapture opportunities forgone when entering the contract.
    3. Based on personal taste, even if honestly held.
    4. Reasonably and consistent with the contract's purpose.
  4. Which of the following actions is most likely to constitute a breach of the implied covenant of good faith and fair dealing?
    1. Refusing to modify a contract term when the other party encounters unexpected difficulty.
    2. Insisting on strict performance of an express condition.
    3. Terminating an at-will employment contract for a stated, non-discriminatory reason.
    4. Deliberately hindering the other party's ability to perform their contractual duties.

Introduction

Beyond the express terms written into an agreement, contract law imposes certain implied obligations on the parties. One of the most significant is the implied covenant of good faith and fair dealing. This covenant is implied in nearly every contract and imposes a duty on each party not to act in a way that undermines or destroys the other party's right to receive the benefits reasonably expected under the agreement. It requires cooperation and prohibits evasion of the spirit of the bargain.

This duty applies during the performance and enforcement phases of a contract, not generally during negotiation (though related doctrines like promissory estoppel might apply there). Both the UCC and the common law recognize this duty, although its specific contours, particularly the definition of "good faith," can differ slightly. Breach of this implied covenant constitutes a breach of contract, entitling the non-breaching party to standard contract remedies.

Key Term: Good Faith and Fair Dealing An implied duty in every contract requiring each party to act honestly and fairly, observe reasonable commercial standards (if a merchant under the UCC), and cooperate so as not to frustrate the other party's ability to receive the benefits of the contract.

Scope and Meaning

The covenant encompasses two related concepts: good faith and fair dealing.

Good Faith

  • Common Law: Generally means honesty in fact—acting without deceit or ulterior motive. It prohibits dishonest conduct designed to undermine the contract's basis.
  • UCC: Defines good faith as "honesty in fact and the observance of reasonable commercial standards of fair dealing." [UCC § 1-304, § 1-201(b)(20)]. For merchants involved in the sale of goods (Article 2), there's an even higher standard: "honesty in fact and the observance of reasonable commercial standards of fair dealing in the trade." [UCC § 2-103(1)(b)].

Fair Dealing

This aspect relates more to the manner of performance and requires cooperation between the parties. It prevents one party from acting in a way that hinders or prevents the other party's performance or deprives them of the reasonably expected fruits of the contract.

Application of the Duty

The duty of good faith and fair dealing is particularly important in situations where one party retains discretion or where cooperation is necessary for performance.

Discretionary Contracts

When a contract grants one party discretion in performing or enforcing a term, that discretion must be exercised in good faith. This prevents the party with discretion from acting arbitrarily, capriciously, or in a way inconsistent with the other party's reasonable expectations. Common examples include:

  1. Requirements and Output Contracts (UCC § 2-306): In a requirements contract, the buyer agrees to buy all needed goods from the seller. In an output contract, the seller agrees to sell all goods produced to the buyer. Good faith limits demands or tenders to quantities that are not "unreasonably disproportionate" to any stated estimate or prior requirements/output. A party cannot drastically alter their requirements or output in bad faith simply to take advantage of market fluctuations.

Key Term: Requirements Contract An agreement where a buyer promises to buy all the goods they require for a certain period from a particular seller, who agrees to sell that amount. Quantity is measured by the buyer's good faith needs.

Key Term: Output Contract An agreement where a seller promises to sell all the goods they produce during a certain period to a particular buyer, who agrees to buy that amount. Quantity is measured by the seller's good faith output.

  1. Satisfaction Clauses: Contracts may condition performance on one party's "satisfaction."
    • Objective Satisfaction: If the contract involves mechanical fitness, utility, or commercial quality, satisfaction is measured objectively—would a reasonable person be satisfied? Dissatisfaction must be reasonable and in good faith.
    • Subjective Satisfaction: If the contract involves personal taste or judgment (e.g., portrait painting), satisfaction is measured subjectively—is the party personally satisfied? Even here, the dissatisfaction must be honest and in good faith, not a mere pretext for avoiding payment.

Key Term: Satisfaction Clause A contract provision making a party's duty to perform conditional on their approval or satisfaction with the other party's performance. The standard (objective or subjective) depends on the subject matter.

Hindrance or Failure to Cooperate

Each party impliedly promises not to hinder or prevent the occurrence of conditions to, or the performance of, the other party's duties. Deliberately preventing the other party from performing or making performance significantly more difficult breaches the covenant.

Worked Example 1.1

Bakery entered into a written agreement with Flour Mill, under which Bakery agreed to purchase "all the organic whole wheat flour Bakery requires for its operations for the next 12 months" from Flour Mill at a fixed price per pound. For the first six months, Bakery ordered an average of 1,000 pounds per month. Market prices for organic flour then dropped significantly. Bakery, wanting to buy cheaper flour elsewhere, drastically reduced its operations for the next two months, ordering only 50 pounds per month from Flour Mill, while secretly purchasing large quantities of similar flour from another supplier for its slightly altered (but substantially similar) product line. Flour Mill sued Bakery. Did Bakery breach the implied covenant of good faith and fair dealing?

Answer: Yes, likely. This is a requirements contract under the UCC. While Bakery has discretion regarding its requirements, this discretion is limited by good faith. Dramatically reducing requirements solely to take advantage of lower market prices elsewhere, especially while still having substantial operational needs fulfilled by another supplier, suggests bad faith. The reduction appears disproportionate and not based on legitimate business needs arising in good faith, thus breaching the implied covenant.

Breach and Remedies

A violation of the implied covenant of good faith and fair dealing is treated as a breach of contract.

  • Materiality: Depending on the severity, the breach may be minor or material, affecting the remedies available.
  • Remedies: The non-breaching party is entitled to standard contract remedies, including:
    • Damages: Expectation damages to compensate for the loss resulting from the breach. Consequential damages may be available if foreseeable.
    • Specific Performance/Injunction: In rare cases where damages are inadequate, equitable relief might be sought.

Worked Example 1.2

Patron commissioned Artist to paint a portrait of Patron's prize-winning poodle, Fluffy. The contract stated, "Patron's duty to pay the 5,000feeisconditioneduponPatron′scompletesatisfactionwiththefinalportrait."Artistcompletedtheportrait,whichartcriticsacclaimedasamasterpieceofcanineportraiture.Patron,however,refusedtopay,statingonly,"Ijustdon′tlikeit.Theearsaren′tquiteright."EvidenceshowsPatronrecentlysufferedmajorinvestmentlossesandtoldafriend,"Ican′taffordthatpaintingnow,soI′lljustsayIdon′tlikeFluffy′sears."CanArtistrecoverthe5,000 fee is conditioned upon Patron's complete satisfaction with the final portrait." Artist completed the portrait, which art critics acclaimed as a masterpiece of canine portraiture. Patron, however, refused to pay, stating only, "I just don't like it. The ears aren't quite right." Evidence shows Patron recently suffered major investment losses and told a friend, "I can't afford that painting now, so I'll just say I don't like Fluffy's ears." Can Artist recover the 5,000 fee?

Answer: Yes, likely. Although the contract involves personal taste (subjective satisfaction standard), Patron's dissatisfaction must be genuine and in good faith. The evidence that Patron's rejection was motivated by financial difficulty, rather than honest aesthetic dissatisfaction, suggests bad faith. If Patron's stated dissatisfaction is found to be dishonest, the condition of satisfaction is excused due to the breach of the duty of good faith, and Patron must pay.

Summary

The implied covenant of good faith and fair dealing is a fundamental principle in contract law, applicable under both common law and the UCC. It mandates honesty in fact and, for merchants under the UCC, observance of reasonable commercial standards. It requires parties to cooperate and prohibits them from hindering performance or unfairly exercising discretion granted under the contract (e.g., in requirements, output, or satisfaction clauses). A breach of this covenant gives rise to standard contract remedies.

Key Point Checklist

This article has covered the following key knowledge points:

  • The duty of good faith and fair dealing is implied in nearly all contracts.
  • The duty applies during performance and enforcement stages.
  • "Good faith" means honesty in fact (and reasonable commercial standards for UCC merchants).
  • "Fair dealing" involves cooperation and not hindering the other party.
  • The duty limits the exercise of contractual discretion (e.g., requirements, output, satisfaction clauses).
  • Hindering or preventing the other party's performance breaches the duty.
  • Breach of the covenant is a breach of contract.
  • Standard contract remedies (damages, etc.) apply to a breach.

Key Terms and Concepts

  • Good Faith and Fair Dealing
  • Requirements Contract
  • Output Contract
  • Satisfaction Clause
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