Good Faith in Contract Law: Meaning, Effects, and Integration, Exams of Law

Download Good Faith in Contract Law: Meaning, Effects, and Integration and more Exams Law in PDF only on Docsity! Good Faith, Unconscionability and Reasonable Expectations S M Waddams* The expression 'good faith' makes frequent appearances in contract law. The concept is firmly established in American jurisdictions because of its inclusion in the Uniform Commercial Code,1 and the Restatement of Contracts.2 It is in the new Quebec Civil Code.3 It forms an important part of many other civil law systems, and appears in a number of international documents applicable in common law jurisdictions.4 Several cases in Commonwealth jurisdictions have adopted it in various contexts.5 There has been much academic writing on good faith. English and Commonwealth writers have been divided in their opinions on whether the adoption of a general concept of good faith would be desirable.6 American writers, however, rarely discuss this question: the concept is sufficiently firmly fixed now for this to be of theoretical interest only.7 The focus of American writing is on what meaning should be given to the expression, and how it applies in different contexts. On a question of this sort, where the law is in many jurisdictions apparently in the process of change, two levels of analysis are necessary. It is of interest to examine the probable effect and utility of adopting, in English and Commonwealth law, a general doctrine of good faith. This process involves the identification of problems likely to be caused by the doctrine. It is of theoretical as well as of practical interest, and might well tend to suggest caution on the part of law reformers, legislative, judicial, and academic. But since the concept of good faith has found favour in several jurisdictions where it is unlikely to be decisively rejected, an equally important function of analysis is to suggest ways in which the problems of integrating good faith with other contractual concepts can be minimised. The perspectives of this * Albert Abel Professor of Law, University of Toronto. 1 UCC s 1-203. 2 American Law Institute, Restatement of Contracts Second, (1961), s 205. 3 Article 1375. 4 Convention on the International Sale of Goods, art 7(1), Principles of International Commercial Contract, UNIDROIT, International Institute for the Unification of Private Law, Rome, 1994, art 1.7, European Council Directive on Unfair Terms in Consumer Contracts, art 3(1). 5 See Renard Constructions (ME) Pty Ltd v Minister of Public Works (1992) 26 NSWLR 234, 263-71 (per Priestley JA). 6 See, for example, M Bridge, 'Does Anglo-Canadian Law need a Doctrine of Good Faith?', (1984) 9 CBLJ 385, R Brownsword. 'Two Concepts of Good Faith' (1994) 7 JCL 197. The present writer has counted himself with the sceptics in respect of precontractual duties of disclosure: S M Waddams, 'Pre-contractual duties of disclosure', in P Cane and J Stapleton (eds), Essays for Patrick Atiyah, (Oxford, 1991). 7 See E A Farnsworth, 'Good faith in contract performance' in J Beatson and D Friedmann, eds, Good Faith and Fault in Contract Law, ch 6, Oxford, 1995: "but then if one could start afresh, 1 would abandon the term 'good faith' entirely in connection with performance and use it only in connection with purchase. For me, 'fairness' says all that needs to be said in connection with performance. But, alas, it is too late in the day to start afresh". 55 56 (1995) 9 Journal of Contract Law essay, therefore, will be twofold: insofar as good faith has not yet been accepted, to suggest caution, and insofar as it has, to ask how the concept relates to other concepts of contract law, and how confusion of thought, where that seems to be a danger, can be avoided. The first point to be noted is that the expression 'good faith' is used in a number of different contexts, with very different meanings in each. The best established use of the expression is in reference to the state of mind of a buyer of property, or of the holder of bill of exchange, as in such expressions as 'good faith purchaser without notice of defects in title'. Here 'good faith' means ignorance of the interest or claim of another person. Secondly, the expression is used to describe the high level of duty owed by agents to their principals, and, more generally, by fiduciaries. Here it means a duty to prefer another's interest to one's own, and not to permit a conflict of duty and self-interest. A third use of the expression is in the context of pre-contractual negotiation, where there may be a duty to bargain in good faith. In this context the meaning of good faith is not so clear. It does not, for example, exclude the frank and open pursuit of self-interest, because it is clear that a prospective seller may usually break off negotiations on the ground that the price offered is inadequate. Also in the field of pre-contractual negotiations, but capable alternatively as being viewed as a contractual defence, is the duty of pre-contractual disclosure, which is often described also as a duty of good faith. Here 'good faith' means a positive obligation to reveal to the opposite party facts adverse to one's own interest In their important task of implying terms into contracts, courts often make reference to the parties' duties of good faith. There are, I think, two meanings here of 'good faith', not always clearly distinguished from each other: sometimes the phrase is used to assist the courts in determining what the parties probably in fact intended; at other times it is used to determine what terms are, in the opinion of the court, fair and reasonable in the circumstances. The expressions 'good faith performance' and 'good faith enforcement' suggest that contractual rights, in some circumstances, may not be exercised for motives of self-interest, or for reasons that may be called extraneous or opportunistic.8 To these usages may be added the concept of 'bad faith breach' of contract, which has been used in several cases to support the punishment of contract breakers by an award of exemplary damages.9 Sir Frederick Pollock, in the preface to his Principles of Contract, wrote that: The law of Contract may be described as the endeavour of the State, a more or less imperfect one by the nature of the case, to establish a positive sanction for the expectation of good faith which has grown up in the mutual dealings of men of average right-mindedness.10 8 See E G Anderson, 'Good Faith in the Enforcement of Contracts', 73 Iowa LR 299 (1988) distinguishing between good faith in performance (as part of the definition of contractual rights) and good faith in enforcement (as restraining the exercise of the rights). 9 Adams v Confederation Life Insurance Co [1994] 6 WWR 662 (Alta QB). 10 Quoted from preface to fourth edition, 1885. Good Faith, Unconscionability and Reasonable Expectations 59 concepts mentioned. None of the three concepts is precise, but reasonable expectations and fairness, as basic concepts, have an understandable content. It is more difficult to say the same of good faith. The reasonable expectations of the promisee are commonly taken to define the scope of contractual obligation. Good faith, as understood, for example, by Pollock and by Lord St Leonards in the passages mentioned above, would tend to favour protection of the promisee's reasonable expectations, and enforcement of the obligations of the promisor accordingly. It is, certainly, inherent in the expression 'reasonable expectations' that expectations should be protected only so far as reasonable, but this has nothing to do with the motives of the promisee. An unreasonable expectation is not protected however much the promisee honestly and in good faith believes that she is entitled to it. Noone has proposed that we should substitute for the reasonable expectation test, one based on the subjective expectation or motives of the promisee. Here it is of interest to consider the cases on written documents and the admission of extrinsic evidence. In a variety of cases the courts have admitted evidence to prevent a party from relying on the terms of a written document The clearest example is rectification, or reformation, which (in the simplest case) prevents a party from taking advantage of a clerical error in a document. It might perhaps seem attractive to explain such a result as an instance of application of a doctrine of good faith. However, the right to rectification does not depend on the bad faith of the promisee. A promisee wholly ignorant of the error, and therefore, morally speaking, wholly innocent, still cannot enforce the document. In Paget v Marshall17 the court declined 'in charity and justice to the defendant . . . to impute to him the intention of taking advantage of any incorrect expression' in the document. Nevertheless the defendant was not permitted to enforce the document, and the result, though it has been doubted,18 may be defended on the ground that the court found that the defendant had no reasonable expectation that the document embodied the true intent of the promisor. In other cases, signed documents have been avoided by use of the doctrine of equitable fraud, in order to prevent a party from using a document contrary to the parties' understanding.19 Again, no proof is required that the party seeking to rely on the document was in any way fraudulent, or lacking in good faith, at the time of the contract. The objection to enforcement is the same, whether the promisee intended all along to deceive the promisor, or whether the promisee decided only after the document had been executed to attempt to enforce it according to its terms. The fraud, insofar as there is any actual fraud, may be said to be a fraud on the court in seeking the aid of the court to enforce a document that must now be conceded not to represent the promisor's true intention. In this sense, the concept of equitable fraud tends to merge with the concept of equity itself, or justice. 17 (1884) 28 Ch D 255. 18 See Riverlate Properties Ltd v Paul [1975] Ch 133 (CA). 19 Farah v Barki [1955] SCR 107, Long v Smith (1911) 23 OLR 121 (Div Ct) . 60 (1995) 9 Journal of Contract Law In many cases it has been held that a promisee may not effectively accept an offer known to be mistaken in its terms.20 Again, it might seem tempting to explain these cases as instances of a principle of good faith, and indeed the legal rule does, incidentally, tend to prevent bad faith. But the principle is wider. The test is not whether the promisee acted in bad faith, but whether the promisee had a reasonable expectation. However honest and pure the motives of the promisee, she cannot enforce terms that were not reasonably to be attributed to the promisor. All the cases of mistake in contractual terms, including the cases on written documents, are cases in which good faith might be said to be enforced, but it is enforced incidentally, by means of the wider, more stable, and more predictable principle of protecting only reasonable expectations. Unconscionability, or unfairness, in jurisdictions where it is recognised as a general defence, supplies a defence to contractual obligation. The explanation of such a defence can only be found in the notion that there are values that have to be weighed against the values that favour enforcement of contracts. Even though the promisee has a reasonable expectation, the promisor may yet escape liability for sufficient countervailing reason. This countervailing reason is widely taken to be the avoidance of unjust enrichment. Our concept of freedom of contract tolerates enrichment, by the enforcement of profitable bargains, to a considerable extent, but when the enrichment is very great, and when bargaining power is very unequal, the values that favour contract enforcement eventually face a serious challenge. This view of unconscionability is not universally held,21 but if it is accepted it will be seen that a principle of good faith is no substitute. If a contract, to use a well known definition of unconscionability, causes the promisee to derive an immoderate gain from an inequality of bargaining power, it ought to be set aside, whether or not the promisee can be said to have acted in good faith. The enrichment is the same whether the promisee cynically calculated the gain, or whether he naively thought he was paying full value, and it is the same whether or not the promisee knew of the weakness in the promisor's bargaining power. The substitution of good faith as a criterion would tend to weaken the protection given to weaker parties. This consideration points to a possible difficulty in the terms of the European Council Directive on Unfair Terms in Consumer Contracts: 3(1) A contractual term which has not been individually negotiated shall be regarded as unfair if, contrary to the requirement of good faith, it causes a significant imbalance in the parties' rights and obligations arising under the contract, to the detriment of the consumer. There is much to be said, where there is inequality of bargaining power, for giving the courts power to set aside a contractual term that 'causes a significant imbalance in the parties' rights and obligations, to the detriment' of the weaker party. But, if these conditions are satisfied, it should not be 20 Smith v Hughes (1871) LR 6 QB 597, Taylor v Johnson (1983) 151 CLR 422. 21 Some modem cases and commentators have used the word 'unconscionable' with reference to conduct. The older usage, however, and that of the Uniform Commercial Code (s 2-302), applies the word unconscionable to the contract itself, or a clause of it, not to the conduct of the party seeking enforcement. Good Faith, Unconscionability and Reasonable Expectations 61 necessary, in my view, for the weaker party to establish what was the stronger party's state of mind, or what were her motives. The phrase 'contrary to the requirement of good faith', therefore, seems superfluous, and potentially damaging to the interests of the consumer. How damaging in practice will depend, of course, on the interpretation given to the phrase and in a jurisdiction where the Directive is binding, the arguments just made would necessarily be recast in the form of arguments in favour of an objective interpretation of the phrase, to mean something like 'commercial standards of fair dealing'.22 But, it may be observed, this is very far from the ordinary meaning suggested by 'good faith'. In Interfoto Library Ltd v Stilletto Ltd23 the question was of the notice necessary for the incorporation into a contract of an onerous clause in an unsigned document. The English Court of Appeal held that the clause was not incorporated because insufficient notice of it had been given. Bingham LJ suggested that this problem would in other jurisdictions, and might with advantage in English law, be resolved by a principle of good faith. He added: The well-known cases on sufficiency of notice are in my view properly to be read in this context. At one level they are concerned with a question of pure contractual analysis, whether one party has done enough to give the other notice of the incorporation of a term in the contract. At another level they are concerned with a somewhat different question, whether it would in all the circumstances be fair (or reasonable) to hold a party bound by any conditions or by a particular condition of an unusual and stringent nature.24 Good faith, however, is something different from a test either of reasonable notice, or one of fairness. The clause in the Interfoto case would have been equally unfair, and the notice of it would have been equally insufficient, if the plaintiff had acted throughout in the honest (but erroneous) belief that the clause was perfectly fair and reasonable, and that ample notice of it had been given. If the court recognises that reasonable notice of the clause must be given, and that the clause must be fair and reasonable, a principle of good faith is not needed, and to rest the result on good faith might suggest the additional need for the defendant to establish misconduct or bad motive on the plaintiff's part Perhaps the longest established use of concepts of good faith is in the implication of contractual terms. As I have already suggested, an attempt to determine what the parties actually intended tends to merge with the implication of terms that are fair and reasonable in the view of the court. It is inevitable that such a merger should occur. The curious ambiguity in the word 'construction', derived alternatively from the verbs 'construe' and 'construct' is significant. No words, even those that we call express, have meanings that are perfectly clear: construction in the sense of interpretation will always involve a certain amount of construction, in the sense of new building. Many 22 See UCC s 2-103 (1)(b)- This is similar to the interpretation of the Directive suggested by S A Smith, 'Contract' [1994] CLP 5, 8. Substantially different views of the meaning of the phrase are taken by H Collins, 'Good Faith in European Contract Law' (1994) 14 Ox JLS 229, 253-4, and by E McDonald [1994] JBL 441, 157. 23 [1989] 1 QB 433 (CA). 24 Id at 439. 64 (1995) 9 Journal of Contract Law Insurance contracts are contracts where good faith is undoubtedly required for purposes of disclosure of relevant facts. Indeed, they are said, rather colourfully, to be contracts of the very richest good faith (uberrimae fidei). But no-one doubts that an insurer (with proper notice, and after expiration of grace periods) can terminate an insurance contract for non-payment of premiums, even if, as is usually the case, the insurer's motive is that the risk has become uninsurable, or undesirable at the premium previously agreed. Even in cases where contracts are terminated for bad motives in the sense that the party terminating gives a wholly improper reason that does not entitle her to terminate, the termination is valid if there was in fact some other ground justifying termination. Conversely, if termination is not, by the terms of the contract, justified, a purported termination is invalid, however benign the motives of the party purporting to terminate. Good faith, therefore, seems an unsatisfactory basis for this branch of the law. The decision of the English Court of Appeal in Cehave NV v Bremer Handelgesellschafi mbH27 may offer an illustration. Here goods were delivered that, though damaged, could still be used for their intended commercial purpose. The buyer purported to reject the goods, which it then repurchased through judicially ordered proceedings at about one-third of the contract price. The court held that the buyer's purported rejection was ineffective, on the ground that rejection was only permitted in case of serious breach, and the seriousness of the breach was to be judged by its commercial consequences. It may seem attractive to explain this case as depending on a principle of good faith, but the reasoning of the court did not depend on the buyer's state of mind. The buyer would not have been entitled to reject even if the buyer had honestly, but mistakenly, thought that the damaged goods were worth only a third of the contract price. Some business persons, or their legal advisers, might support the old rule on this point (any defect justifies rejection); others might favour the new rule (it depends on the commercial consequences of the breach); few would, I think, be inclined to favour a rule that the right to reject should depend on the actual motives of the buyer, a rule that would involve costly enquiries and create incentives to assemble unreliable and self-serving evidence of good motive. An option must be exercised according to its terms, and so it would usually be held that a purported exercise of an option after the time limit had expired was ineffective, and that the option granter could deny liability. As with termination, the motive of the option granter in such cases is usually that she now regrets the terms of the option. She is entitled to act from motives of self-interest in rejecting the late exercise of the option, just as she would be entitled to refuse, for reasons of self-interest, to enter into a new contract with anyone else. Few would say that such a motive constituted bad faith. The exercise of a right of termination, it may be suggested, is similar in principle. 27 [1976] QB 44. Good Faith, Unconscionability and Reasonable Expectations 65 A right to renew a contract is indeed often expressed in the form of an option, and an option in one party to renew on certain conditions may be precisely equivalent to a right in the other party to terminate in the absence of those conditions. At this point we come to the question of a duty to negotiate in good faith. It was said in Walford v Miles28 that 'a duty to negotiate in good faith is as unworkable in practice as it is inherently inconsistent with the position of a negotiating party'. A duty to negotiate in good faith is, however, recognised in some contexts, for example in labour law, where an employer and a union may have a statutory duty to negotiate in good faith. Good faith in this context does not exclude self-interest, and it is generally accepted that employers and unions, while bound to listen to proposals, may refuse those that they consider unsatisfactory. This would seem to be a necessary feature of a duty to negotiate in good faith. Entering into negotiations would be a very dangerous step if it carried with it an inability to withdraw. The cases on contract modification, where one party demands a higher price for a performance already promised, would be affected by a duty to negotiate, or renegotiate in good faith. Several recent cases have held that where a contract is renegotiated in such circumstances, the promise to pay the higher price is, in the absence of duress or its equivalent, enforceable.29 In considering these cases in the light of good faith, it might at first be supposed that it is the party seeking the modification who might be said to be acting in bad faith, and the terms opportunism and strategic behaviour have been used in connection with that party's behaviour.30 It has always been assumed in discussion of these cases that the party resisting modification is entitled to insist on his strict contractual rights, and to sue for damages in case the threat of breach is implemented. But if there is a duty to renegotiate in good faith, these cases will appear in an entirely new light. In the typical case of this kind there is an agreement to render a performance for a certain sum, followed by a threat of breach by the party promising performance coupled with a demand for an increase in the contract price. If there really is a duty incumbent on the paying party to renegotiate in good faith, there may be an obligation at least to give serious consideration to such proposals. It is not very easy, however, to reconcile this notion with the principle, always assumed in the modification cases, that the original contract is fully binding. Some of the difficulties here alluded to may be seen in a 1990 decision of the US Seventh Circuit Court of Appeals, Kham and Nate's Shoes, No 2 v First Bank of Whiting.31 A bank granted a $300,000 line of credit to a lender, reserving the right to terminate financing on five days' notice. After advancing $75,000, the bank gave the notice, and refused to lend any more money. The District Court held that the bank was in breach of a duty of good faith. The Court of Appeals reversed, Judge Easterbrook saying: 28 [1992] 2 AC 128. 29 See Williams v Roffey Bros and Nicholls (Contractors) Ltd [1991] 1 QB 1 (CA). 30 See V A Aivazian. M J Trebilcock, and M Penny, 'The law of contract modifications: the uncertain quest for a benchmark of enforceability', (1984) 22 Osg HLJ 173. 31 908 F 2d 1351 (CA-7, 1990). 66 (1995) 9 Journal of Contract Law Although courts often refer to the obligation of good faith that exists in every contractual relation . . . this is not an invitation to the court to decide whether one party ought to have exercised privileges expressly reserved in the document. . . . When the contract is silent, principles of good faith . . . fill the gap. They do not block use of terms that actually appear in the contract. . . . The $300,000 was the maximum loan, not a guarantee. The bank exercised its contractual privilege after loaning debtor $75,000 . . . It had the right to do this for any reason satisfactory to itself. . . . The bank was entitled to advance its own interests.32 This decision was vigorously criticised by an academic writer, Professor Patterson, on the ground that Judge Easterbrook had confined himself to too literal an interpretation of the words of the contractual document.33 It may be conceded to Professor Patterson that interpretation is not a simple task, and does not depend solely on what may be supposed to be the literal meaning of written words. As is apparent from this essay, I would concede also that a contractual clause should not be enforced if unfair (and, despite the imprecision of the concept, it is possible to imagine that such clauses might be unfair). But, if those two questions are decided in the bank's favour, surely Judge Easterbrook must be right. His conclusion may be paraphrased by saying that there is no contractual principle on which the bank can be held liable for not lending money when it had not promised to do so. This is so, whatever may be the motives of the bank. There are many cases deciding that when money is repayable 'on demand', the creditor cannot expect or require instantaneous repayment: even the most conservative courts have held that, at the very least, the debtor must be allowed the minimum time that a solvent person would require to raise the sum in question. Professor Patterson is right to this extent. Literal interpretation of the phrase 'on demand' would be impossible: the debtor is not expected to have the total amount of the debt at all times in cash in her back pocket. But this example shows that the proper interpretation of the words of the contract does not depend on the motives of the creditor, but on the parties' reasonable expectation. However honest the creditor in demanding instant repayment, the debtor's obligations will not be enlarged. On the other hand, if the creditor has not promised (on a fair interpretation of the contract) to extend further credit, there is no contractual principle on which it can be compelled to do so, any more that it could be compelled to make an initial loan in the absence of any contractual relationship at all. Here we come to the vexed question of excludability of a duty of good faith. It is common for proposals for a principle of good faith to be combined with a provision to the effect that the duty of good faith cannot be excluded.34 The 32 Id at 1357-1358. 33 D M Patterson, 'A fable from the Seventh Circuit: Frank Easterbrook on good faith', 76 Iowa LR 50 (1991). 34 See Ontario Law Reform Commission, Report on Amendment of the law of contract, (Toronto, 1987), Principles of International Commercial Contracts, (UNIDROIT, 1994), art 1.7 (2) ("The parties may not exclude or limit this duty').