Have you ever wondered why contracts do not have a clause that states the parties cannot commit fraud against the other? Contracts often try to contemplate every possible scenario, but a “No Fraud” clause usually is not one of them. Does that mean that one party can commit fraud against the other? Logic says, “No, of course not! It wouldn’t make sense to allow one party to defraud or cheat the other?” But how does the law enforce a provision that is not in the contract?
Every contract under Delaware law carries with it an implied covenant of good faith and fair dealing. In a colloquial context, people understand what it means for something to be “fair” or to be treated “fairly”, but what about in a legal context? What is the standard and at what point do you measure whether a particular act falls within the bounds of “fair”?
In a recent Delaware case, the Delaware Court of Chancery explains the implied covenant of good faith and fair dealing. In its decision, the court distinguishes it from colloquial senses of fairness and develops a model to assist in explaining what it means to act within the bounds of the implied covenant.
The facts in this case, while interesting and a cautionary tale for legal drafters, are not significantly important for the purposes of this discussion. In short, ASB and Scion entered into four joint ventures to invest in several real estate opportunities. Unfortunately, due to a typographical error, a provision of the first joint venture agreement was drafted incorrectly and gave Scion substantially more return than was intended, and this mistake was repeated three other times before ASB caught the error. Scion claimed that the error reflected the parties’ intentions, which forced ASB to file suit. Ultimately, the judge corrected the error in favor of ASB.
Part of the court’s decision involved whether Scion breached an implied covenant of good faith and fair dealing. The key questions were: what is the standard and how to determine if someone has breached this standard. As the court noted, the concept of good faith and fair dealing is measured against whether a party’s actions are consistent with the terms of the agreement and its purpose. In other words, the question is not whether one party was loyal or fair to the other party, but rather, whether the parties were faithful to the purposes of the underlying contract. The court looks to the time of the contract was formed and asks what agreement the parties would have made if they considered the issue at the time the contract was formed. Therefore, a result may appear unfair in the present, but not constitute a breach of the implied covenant of good faith and fair dealing because the parties agreed to such a possible result in the past.
For example, proving fraud is one way of establishing a breach of the implied covenant of good faith and fair dealing, because, presumably, no party to a contract would ever agree to be defrauded by the other party; and therefore, the parties would have agreed that the parties could not commit fraud had they considered it at the time the contract was formed. Thus, it is not necessary to explicitly state that the parties cannot commit fraud against the other.