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The Implied Covenant of Good Faith and Fair Dealing

Every business contract — indeed, every contract — contains an implied covenant of good faith and fair dealing. Breaching this implied covenant can subject your business to litigation and to damages. A good business lawyer can help.

What is the Implied Covenant?

The basic idea of the implied covenant is that none of the parties to a contract should do anything that will prevent the other parties from receiving the benefits of the agreement. Courts use the good faith covenant to protect the reasonable expectations of the parties to the contract.

Why is the Covenant “Implied?”

The covenant is “implied” because, by operation of law, the covenant is inserted into every contract. It is like an invisible ghostly provision that attaches itself to every contract. The implied covenant attaches to written contracts, oral contracts, and to contracts formed by course-of-conduct.

The Implied Covenant is Separate and Independent of Other Contract Obligations

Under California judge-made law, the implied covenant is not, in any way, connected or contingent upon the type of contract or other provisions in the contract. The covenant is applicable to sales contracts, employment contracts, service contracts, etc.

If Contract Allows Discretion, the Covenant Will be Strongly Invoked

Some contracts give exclusive discretion to one party. For example, a contract might allow one party to set certain terms or make certain decisions as to, say, quantity, price, grace periods, forgiveness, waivers and other aspects of a contract. When a party is vested with discretion under a contract, courts have held that such discretion must be exercised reasonably and with proper motives. The implied covenant will be invoked to ensure that the discretion is used in good faith and in a manner that is consistent with the reasonable expectations of the other party.

Courts Will Enforce the Implied Covenant

The implied covenant will be enforced by courts as a contractual provision. Because the covenant is contractual, damages for its breach are limited to contract remedies. Contract remedies are:

  • Money damages
  • Prejudgment where applicable and allowed
  • Specific performance
  • Rescission and/or reformation of the contract

Damages that are typically considered tort damages are not available for breach of the implied covenant including these categories of damages:

  • Punitive damages
  • Pain and suffering
  • Loss of consortium, loss of society, etc.
  • Emotional distress

One Exception: Insurance Contracts

There is one exception to the general rule that only contract damages are available for breach of the implied covenant – insurance contracts. The underlying idea is that a person buying insurance is not seeking to obtain a product or service in the normal commercial manner. Rather, someone buying insurance is attempting to obtain protection against calamity. Moreover, the insurance company is, according to the courts, providing a “vital service” that is “quasi-public in nature.” For this and related reasons, the courts have held that, when an insurance company unreasonably and in bad faith withholds payment of claims, the insurance company breaches the implied covenant and is subject to liability in contract AND in tort.

What to do? Have Written Contracts and Seek Legal Counsel

A good business attorney can provide you and your business with guidance as to how not to violate the implied covenant. For example, a review of your various contracts will show where your business is vested with discretion. That is the starting point for ensuring that any decisions being made pursuant to any discretion are being made in good faith. In addition, a review of company policies and procedures may be in order. This highlights the importance of having written contracts and of having a skilled business attorney working to help your business succeed.

Contact San Diego Corporation Law Today

If you would like more information on the implied covenant and/or business contracts in general, contact attorney Michael Leonard, Esq., of San Diego Corporate Law. Mr. Leonard can be reached at (858) 483-9200 or via email.

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