What is Bad Faith in Contract Law?
Bad faith can be defined as a party’s deliberate intent to deprive the other party of the benefits expected under the contract. It is typically considered a breach of the duty to cooperate between contractual parties. When parties cannot agree on a course of action, simply failing to negotiate over the dispute is not enough to constitute bad faith. They must fully inform the other party of their position and why they adhere to it. Then there must be meaningful communication among the parties. However , in many jurisdictions including the United States Supreme Court, mere silence by one party will not necessarily rise to the level of bad faith.
The standard for what constitutes a bad faith refusal to settle a case is objective. A subjective standard would require a showing that the Defendant either knew or should have known that its position was flawed; it is not enough to simply show that the Plaintiff benefitted by being able to renegotiate a settlement.
Typical Bad Faith Situations
One of the most straightforward examples of a party engaging in bad faith is refusing to negotiate in a timely manner. Whether you are a buyer or seller of services, products or property, your offer being left open and unanswered for too long creates problems. Perhaps you do not desire to enter a contract until 3 months from now, for legitimate business reasons. Those reasons may be completely reasonable; however it can be assumed that your counterparty does not have the same interests and will look as far as 3 months ahead in evaluating other options.
Another example of bad faith is engaging in acts that are meant to encourage loss or damage to the other party to the agreement. A company which terminates an employee, then dissolves the local division the employee worked in, with the goal of preventing future suits arrayed against the company would also be acting in bad faith. This is because the party is acting in a way that encourages the loss of a potential future benefit of the contract, while also hiding behind an important principle of corporate integrity: the right to terminate an employee.
It is important to note that bad faith actions are taken to destroy the gains of the agreement for one of the parties involved, or create a deadlock thereon. Bad faith actions are usually hidden behind other actions in the contract.
Legal Implications of Bad Faith
Consequences for bad faith can include funds being returned after the fact, dismissals for cause, imposition of alleged damages and disallowance of claims on the basis of a partner’s or employee’s bad faith actions.
A consequence for failure to act in good faith is that a party can be ordered to return funds that it has received. For example, if a corporation purchases a property with knowledge of a market value having been fraudulently inflated, a court may allow the seller to recover the difference between the stated price (and paid) and the fair market value, even if the seller was not aware of the fraud, because the seller dealt with the defendant in bad faith.
If an employer commits a fraud on the Crown, by tax evasion, the employees may also be dismissed for cause. In other words, in such circumstances, the employee will not be entitled to any damages related to wrongful dismissal, and the employer will be liable for damages arising from the employee’s fraud. Such damages could include legal damages. Where it can be shown that an employee was complicit with the employer in committing the fraud, such as by assisting the employer in tax evasion measures, the employees would likely be liable to be dismissed for just cause, without reasonable notice or pay in lieu of notice.
Recent jurisprudence regarding the duty to act in good faith related to contractual relationships has suggested that the cause of action is founded in tort law, specifically intentional tort. In order to succeed, courts are likely to require a showing of misconduct amounting to dishonesty that has harmed the plaintiff. A tort of intentional infliction of mental distress may be composed of a number of elements. Some of these elements include the following:
(a) the conduct complained of was outrageous (a high threshold, conduct must be beyond the bounds of decency in the community);
(b) the conduct was flagrant and malicious (the use of the Tort is to punish those who would do a public wrong without regard to its consequences);
(c) the target of the conduct was a person of average sensibilities, not particularly susceptible or unusually offended;
(d) the person who is the target of the conduct must have suffered actual harm or distress to recover damages.
Establishing Bad Faith in Court
Burden of Proof for Bad Faith
The burden of proof for establishing bad faith in contract actions is generally on the party claiming that the other breached the contract in bad faith. In such an action, a party must prove that the breach caused substantial damage to them and that the breach was drawn out over a period of time. The plaintiff may be required to submit evidence such as depositions from both parties, discovery responses, and invoices to prove the extent of the damage .
Additionally, as a matter of trial strategy, a party accused of bad faith in a contract dispute may seek to undermine the credibility of the person who claims that he was harmed by the breach. One way a party can seek to do this is to try to place the potential damages in dispute—an act that not only calls into question the accuracy of the plaintiff’s version of events, but also shifts the discussion in the litigation from the circumstances surrounding the bad faith conduct to a dispute regarding the scope of damage.
Arguments Against Bad Faith Claims
There are a myriad of defenses that may provide a basis for defeating or reducing liability for alleged bad faith in a contractual relationship. Liability will only attach if it has been established that the plaintiff suffered actual damage as a result of the defendant’s breach of the covenant of good faith and fair dealing. With respect to a claim of bad faith denial of benefits, the denial must be unreasonable under the circumstances. Where there are multiple reasons or bases for denial of a claim, and any one or more of them is legally supportable, the refusal to pay will not constitute a violation of the covenant.
Additionally, there may be instances in which there can be no violation of the covenant. For example, purely arbitrary and capricious decisions or conduct will not violate the covenant. Additionally, a contracting party will not be liable for its conduct or decision as to the performance of the contract if it had a legitimate business reason for its decision or conduct, and that decision or conduct was reflected in the contract. Where a decision as to performance was a product of misconduct amounting to a breach of fiduciary duty, liability for damages may attach even though there was no violation of the covenant.
Therefore, as to the covenant of good faith, the focus is on performance and performance issues or issues involving the handling of an insurance claim, and not dictum or incidental matters. Moreover, as long as a legitimate reason for a decision can be shown, then failure to perform, or to pay a claim, will not violate the covenant.
Especially in the litigative arena, where fees are generally recoverable as damages, the wrongful bringing of a claim for bad faith may give rise to liability for fees. This is most common in the insurance. For example, the Texas legislature has determined that a party that falsely denies liability for an insurance claim may have to pay the attorney’s fees incurred by the opposing party in litigating its claim.
In cases in which a party is being accused of having acted in bad faith, and the claims against that party are weak or unfounded, a counterclaim may be filed, or a request for attorney’s fees may be made, thus potentially opening the door to liability for the other party’s attorney’s fees. Additionally, sanctions can be sought in federal court, though such sanctions can be difficult to obtain.
Avoiding Bad Faith in Contracts
It is vital that contract provisions avoid overly relying on limited good faith, and instead, provide express conditions. For example, the phrase "in good faith" or "using best efforts," or other similarly vague terms will be examined in light of recent Delaware and Texas law. If a contract contains a "reasonable efforts" or "best efforts" clause, the contract must contain precise definitions. A clear definition of "good faith" will also help to protect a transaction.
The purpose of an enforceable "good faith" provision is to create objective measures or standards that are clearly explained in the contract. Moreover, an imprecise clause that is not explained will, in the eyes of the Court, expose one party to an unreasonable level of risk. For example, a "good faith" clause to use "best efforts" is not satisfactory unless there are express requirements. As a result , a contract must avoid a good faith clause that leaves room for too much subjectivity. Imposing a rigorous standard on the obligor is sufficient to create an enforceable contract.
Contract terms must be chronicled in order to prevent confusion. As currently drafted, contracts generally fail to mention the consequences for failing to perform obligations. Failure to fulfill contractual obligations would be grounds for liability. For example, if a sale does not receive the required equity and cash necessary to close, the failure to fulfill that requirement should set out the specific implications. The seller would be able to use the down payment (e.g. earnest money) by the buyer as a source of handing over the forfeited funds. The contract resolution provision results from the deliberative drafting and the intent of the parties while avoiding that vague term of good faith.