It is no surprise that parties to a contract are bound by its express terms. In Virginia, as in many other jurisdictions, parties also are bound by an “implied duty of good faith and fair dealing.” The duty is “implied” because the conduct required by this principle is not set forth in the terms of the contract. The U.S. District Court for the Eastern District of Virginia recently examined the contours of this somewhat amorphous obligation in Stony Glen LLC v. Southern Bank & Trust Co.
In that case, the plaintiffs included an LLC, which took out a $9 million loan from the defendant bank, and several individuals who acted as guarantors of that loan. After the LLC had trouble repaying the loan, it, the guarantors and the bank reached an agreement whereby payment of $3 million to the bank would be made in settlement of the remaining debt. This debt settlement agreement required the individual guarantors to provide the bank with certain financial disclosure statements which would include a list of assets and liabilities. The agreement also provided that the bank had the option to terminate the agreement – and sue for the full amount of outstanding debt – if the guarantors made any material misrepresentations or omissions in their financial statements.
In preparing a required financial disclosure statement, one of the individual guarantors did not disclose property that he and his wife owned jointly. The guarantor did not disclose the property because he believed that he was only required to list assets that could be subject to the bank’s claims against him individually, which did not include the property he owned jointly with his wife. The guarantor later submitted a statement that did list the property among his assets. Shortly after that, the bank notified the LLC and the individual guarantors that it was exercising its option to terminate the debt settlement agreement because the guarantor had made a material misrepresentation or omission in failing to disclose the property in his earlier disclosure.
The LLC and the guarantors sued, claiming that the bank’s conduct in terminating the debt settlement agreement constituted a breach of the implied duty of good faith and fair dealing. The bank filed a motion to dismiss the lawsuit. The bank argued that, because the debt settlement agreement granted the bank the right to terminate the contract if the plaintiffs made a material misrepresentation, the bank could not be acting in bad faith or unfair dealing to exercise that right when the plaintiff made a material misrepresentation in failing to disclose the jointly-owned property.
The court disagreed with the bank and refused to dismiss the plaintiffs’ complaint. The court noted that claims for a breach of the duty of good faith and fair dealing commonly arise when a contract gives one party the option to take some action which may be adverse to the other party. The court found that, generally, when the contract provides that the option is triggered after the occurrence of some definitive event (e.g., the failure to make timely payment), the party with the option has absolute discretion to do whatever it wants – even “flip a coin” – in deciding whether to exercise its right. However, when a party is required to exercise its own discretion to determine whether its option has been triggered, that party is not allowed to act arbitrarily and is bound by the duty of good faith and fair dealing.
Here, the bank’s option to terminate the debt settlement agreement was triggered by one of the plaintiffs making a material misrepresentation on a financial disclosure statement. Because the bank was required to exercise some discretion in determining whether the financial disclosure statement did, in fact, contain a material misrepresentation, that exercise of discretion was subject to the implied duty of good faith and fair dealing. Accordingly, because the plaintiffs argued that the bank acted arbitrarily and failed to use prudent banking practices in making that decision, the court allowed the plaintiffs to go forward with their claim.
Contracting parties should be aware that the full extent of their obligations may not be spelled out in the contract itself. Particularly where the contract provides that one party has the option to do something that might be adverse to the other party, parties should take care to consider whether taking that action might run afoul of the implied duty of good faith and fair dealing.