Volume 4, Issue 2
2
The Contract Term You Agreed To and Didn’t Even Know It
By: Andrew F. Halaby
Did you know that every time you enter into a
contract in Arizona, you agree to a term you
did not bargain for? The Arizona courts call
this term the “implied covenant of good faith
and fair dealing.” It means that once you enter into your contract, you may not do anything to prevent the other party from receiving
“the benefits and entitlements of the agreement.” If you do, you may be held liable for
breaching the contract. If the other party engages in such conduct, you may be able to
charge that party with breach.
“How do I know what ‘benefits
and entitlements’ the other party
has under the contract?”
Once you start thinking this “implied covenant” through, your first question may be,
“How do I know what ‘benefits and entitlements’ the other party has under the contract?” A logical answer is, “It depends what
the contract says.” And at least superficially,
that’s the law. The Arizona Supreme Court
held nearly twenty years ago in Wagenseller
v. Scottsdale Memorial Hospital that “the relevant inquiry always will focus on the contract
itself” and “what the parties did agree to.”
The Arizona Court of Appeals recently observed in Bike Fashion v. Kramer that the
“general rule” is that the implied covenant
“cannot directly contradict an express contract
term.”
any explicit term of the agreement. Thus, in a
case arising out of former governor Fife Symington’s financial difficulties relating to the
Mercado development in downtown Phoenix,
the Supreme Court held that his interim construction lender may have had an implied obligation to inform the permanent lender of those
difficulties even though the express terms of
the parties’ contract did not require the interim
lender to volunteer any information to the permanent lender. And despite the “general
rule,” the Court of Appeals in the Bike Fashion case said that the implied covenant
“preserves the spirit of the bargain rather than
the letter.” Thus, it held that a party can
breach the implied covenant simply by exercising discretion explicitly given to it under
the contract in a way inconsistent with the
other party’s “reasonable expectations.” It
also held that a party can breach the implied
covenant by acting in ways not expressly excluded by the contract’s terms, but which adversely impact the other party’s “reasonably
expected” benefits of the bargain.
You may then think, “Well, I’ll just negotiate
the implied covenant out of my contract.”
Again, you would need sufficient bargaining
power to accomplish that objective. In any
event, the Arizona Court of Appeals suggested
“That’s easy,” you may say. “All I have to do in Bike Fashion that it would not recognize a
is carefully negotiate the terms of my contract party’s attempt to disclaim the implied covein the first place, and I’ll always know what nant.
‘benefits and entitlements’ the other party expects.” Of course, that’s only a solution if you If you’re the sort of person who believes peocan think of every possible contingency in ple ought to be free to negotiate and enter into
advance and have enough bargaining power to contracts, and then be bound by their terms,
extract favorable terms dealing with them. these rulings may be troubling. You may ask,
But even if you have enough foresight and “If I am following the contract I negotiated to
enough bargaining power to get all the explicit the letter, why should I have to pay any attenterms you want, you still can’t entirely control tion to what the other party expects to receive
the obligations the implied covenant will im- from the contract?” That’s a good question,
pose. According to the Arizona Supreme but like it or not, you must—in Arizona and
Court in Wells Fargo Bank v. Arizona Labor- most other places. You may also ask, “Why is
ers, Teamsters and Cement Masons Local No. this thing called the implied covenant of good
395 Pension Trust Fund, the obligation im- faith and fair dealing anyway? If I’m simply
posed by the implied covenant “extends be- doing what the contract says I can do, how can
yond the written words of the contract,” and a anyone say I’m acting in bad faith or dealing
party may breach it without actually breaching unfairly?” That too is a good question, not
Continued on page 3
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3
March, 2003
Continued from page 2
only because the Arizona courts have long
held that your intent really has nothing to do
with whether your conduct comprises a
breach of contract, but because the very
definition of the implied covenant—doing
something which prevents the other party
from receiving “the benefits and entitlements of the agreement”—has nothing to do
with your intent. Put another way, even if
you really, really believe you are doing what
the contract requires, you can still breach the
implied covenant.
For all those well-reasoned criticisms, the
implied covenant probably does some good
in some cases. For example, in Diagnostic
Laboratory, Inc. v. PBL Consultants, a laboratory doing work for Tucson Medical Center entered into an agreement with some
consultants who were physicians at the hospital. The agreement provided that the physicians would not compete for services provided by the laboratory, but that “nothing”
in the contract would apply to the consultants’ work for the hospital. Arguing that
“nothing means nothing,” the consultants
then expanded Tucson Medical Center’s
services to compete with the laboratory’s!
The Court of Appeals ruled that the implied
covenant might bar the consultants’ actions.
That ruling certainly seems fair, even if you
are inclined to wonder why the laboratory
didn’t negotiate an explicit provision to deal
with such a contingency.
The bottom line is that you should always
take the implied covenant into account,
whether you’re negotiating a contract before
the fact or trying to figure out what your
contract requires after the fact. Negotiating
a contract involves trying to get a deal done
on terms that yield the greatest aggregate
benefit at the least cost. Sometimes you
accept less favorable terms on some issues
in order to obtain more favorable terms on
others. Sometimes you know of an issue but
don’t provide for it in the contract at all,
hoping that it never arises or planning to
deal with it only when it does. If you have
more bargaining power than the other party,
then the implied covenant probably means
there’s only so far you can go in converting
your bargaining power into favorable con-
tract terms. If you have less bargaining
power than the other party, and something
later goes wrong, the implied covenant may
give you arguments that the contract means
something other than what it says. In either
case, your lawyer can help you determine
the role of the implied covenant in the calculus of your particular negotiations.
Take particular care to take the implied
covenant into account whenever you’re performing, or considering stopping performing, under a contract. The implied covenant
means that if the other party complains that
your performance is deficient because
you’re acting in a particular way, responding, “The contract doesn’t say I can’t,”
probably isn’t enough, and may subject you
to substantial breach of contract risks. Since
the implied covenant is a contract term like
any other, its breach may be so significant
that under certain circumstances, it may justify the other party in suspending or terminating its performance under the contract.
Your lawyer can help you figure out when.
...even if you have enough
foresight and enough bargaining power to get all the explicit terms you want, you
still can’t entirely control the
obligations the implied covenant will impose.
The bottom line is that you
should always take the implied covenant into account,
whether you’re negotiating a
contract before the fact or
trying to figure out what your
contract requires after the
fact.
Andy Halaby is a partner at Snell &
Wilmer in Phoenix. You can reach him
at (602) 382-6277 or
ahalaby@swlaw.com.
2398 E. Camelback Rd. · Suite 620 · Phoenix, AZ 85016 · 602-224-6670
www.yoursourcefinancial.com