New York’s Implied Good Faith Covenant: What Companies (and Practitioners) Need to Know

Contracts say what the parties must do. But what about what they can’t do? For nearly a century since the landmark Kirke La Shelle v. Armstrong ruling (263 N.Y. 79 (1933)), New York has relied on the implied covenant of good faith and fair dealing to say what is prohibited by implication. The covenant says that a party can’t unfairly take away the benefit the other party was supposed to receive under the contract. Since 1933, the covenant has been implied in every contract under New York law.

1. What does good faith mean in practice?

An implied covenant sounds a bit like motherhood or apple pie: easy to see as positive and hard to find objectionable. Defining its requirements is trickier. New York courts have given a bit of guidance, explaining that the covenant protects a party’s right to receive the “fruits” of a contract. Id. at 87. This can matter if a contract does not explicitly prohibit the conduct at issue.

The classic application of the good-faith requirement is in consumer contracts. Such contracts are generally ‘contracts of adhesion’—legalese for “take-it-or-leave it.” One party has limited bargaining power, limited time or capacity to review, limited competence in the industry, and limited access to counsel. To paraphrase Uncle Ben in Spiderman, the powerful party to such contracts must exercise its power responsibly and in good faith.

2. When does the covenant actually matter?

While always present, the covenant is not operative in every contracting situation. Parties generally negotiate terms that they find important. If a brand wants an exclusive relationship with its spokesperson, the brand (or its lawyers) make sure that the word “exclusivity” appears in the contract and that the prohibited act is clearly spelled out. In most straightforward contracts, simply performing is enough—one doesn’t need to do so with the most beneficent of intentions.

The covenant matters, however, when there is asymmetric power. The New York Court of Appeals addressed this issue in Dalton v. Educational Testing Service, 87 N.Y.2d 384, 389 (1995). In Dalton, the Court considered a contract that gave Educational Testing Service (ETS) substantial discretion over cancelling a student’s SAT score. The Court recognized that the party with more power had a duty to exercise that power reasonably and not arbitrarily or capriciously. However, citing the earlier Murphy v. American Home Products case, the Court noted that the implied covenant can’t be used to imply obligations that are inconsistent with the rest of the contractual relationship. Id.

3. Where does the covenant find its limits?

The covenant can’t rewrite a deal. One doesn’t automatically get a lower interest rate on one’s mortgage just because interest rates have dropped. One doesn’t get a partial refund for a car purchase when the vehicle turns out to be a lemon (warranty issues excepted). One generally doesn’t have a claim against a broker if a stock performs poorly.

There is a fairly large corpus of New York case law setting out these limitations. In Rowe v. Great Atlantic & Pac. Tea Co., Inc., 46 N.Y.2d 62 (1978), the Court of Appeals declined to apply the covenant, noting that “courts should be extremely reluctant to interpret an agreement as impliedly stating something which the parties have neglected to specifically include.” Id. at 72. This position was reaffirmed in Reiss v. Fin. Performance Corp., 97 N.Y.2d 195 (2001) and Vt. Teddy Bear v. 538 Madison, 1 N.Y.3d 470 (2004). The key thread running through all of these cases was a hesitance to substitute the court’s judgment for that of the parties to a contract.

4. What does this all mean to practitioners?

The key takeaway is not that the implied covenant does not matter. The covenant has existed for over a century. Eminent jurists such as Benjamin Cardozo have opined on its inherent merit, stating that “[w]e are not to suppose that one party was to be placed at the mercy of the other.” Wood v. Lucy, Lady Duff-Gordon, 222 N.Y. 88 (1917).

Rather, the take-home message is that parties should understand how the covenant applies to their situation. A few tips for getting implied covenant right:

1. Don’t assume courts will bail you out. If you want a contractual protection, put it in the contract. If an arrangement should be exclusive, make sure the contract has an exclusivity clause. If you want the seller to pay for shipping, make sure to have DDP or DAP shipping terms. While UCC gap-filling does exist in some cases, New York courts will generally not add terms that parties choose not to add themselves.
2. Don’t exercise power capriciously. If you think that you can hide behind fine print on your terms of service, think again. Dating to the Kirke La Shelle case, New York courts have been reluctant to enforce contracts that deprive a party of the “fruits” of its bargain. A cancellation term that terminates services but doesn’t refund fees paid for those services is a classic fruits-deprivation example. Contract terms that deprive another party of a fair bargain are likely to be struck down.
3. Understand nuances. A few factors may change how the implied covenant gets applied:
   1. Entire agreement clauses. An integration or “entire agreement” clause can put limits on the implied covenant—preventing the use of extrinsic evidence for unambiguous terms—but it doesn’t waive the requirement.
   2. Mixed sophistication contracts. There is no bright-line rule that sophistication alone determines a heightened covenant requirement. Many contract situations fall in the murky middle. Contracts that are B2B and reviewed by counsel could still violate the implied covenant if there is no meaningful opportunity for negotiation and one side deprives the other of the fruits of the contract.
   3. Identifying violations. The implied covenant doesn’t create a general obligation to be nice, but neither does one have to seek to harm to the other party to violate it. For parties seeking to defend a breach-of-implied-covenant claim, this is an important distinction.

In Wood v. Lucy, Lady Duff-Gordon, Justice Cardozo wrote that, “[a] promise may be lacking, and yet the whole writing may be ‘instinct with an obligation,’ imperfectly expressed.” The implied covenant can put teeth on that imperfectly-expressed obligation—but only in certain circumstances. Successful navigation of the implied covenant involves understanding when.

Disclaimer: This blog is for informational purposes only and does not constitute legal advice. Reading or interacting with this content does not create an attorney–client relationship. You should consult a qualified attorney for advice regarding your specific situation. Mehaffy, PLLC disclaims all liability for actions taken or not taken based on this blog.