The implied contractual duty of good faith and fair dealing is well enshrined in the common law, including in New York and every jurisdiction in the U.S. Since, by its nature, however, the duty is not susceptible of precise definition, its application is more art, than science. Thus, it is sometimes difficult for lawyers to counsel their clients when a client wishes to exercise his or her contractual rights, particularly where the conduct is not prohibited but could result in disproportionate harm to the counterparty. Generally speaking, most lawyers probably counsel their clients that they may exercise contractual rights consistent with the contract's express provisions provided that they are not acting maliciously, or with an intent to cause harm.

Background

In Good Hill v. Deutsche Bank, the N.Y. Appellate Division arguably went a step further. Good Hill purchased certain securitized notes (Series B6 to B12) from Bank of America. Later, Good Hill entered into a credit default swap (CDS) on the B6 notes with Deutsche Bank. Under the CDS, Good Hill was required to pay Deutsche Bank a floating amount upon reduction in the principal amount of the B6 notes. The ISDA agreement between Good Hill and Deutsche Bank provided explicitly (section 9(b)(iii)) that each party may act “as if the Credit Derivative Transaction did not exist, regardless of whether any such action might have an adverse effect on” the other party.

As a result of adverse market conditions, Bank of America decided to unwind the transaction and sought to repurchase Good Hill’s notes. Bank of America and Good Hill initially negotiated a purchase price of US$0.29 on the dollar for the entire “stack” of B6 through B12 notes. Realizing that this would trigger a large floating amount payment to Deutsche Bank, Good Hill asked Bank of America to allocate the consideration such that the B6 notes would be paid at par and ultimately convinced Bank of America to allocate the purchase price such that 83% of the B6 notes were paid, resulting in only a 17% write off. That allocation resulted in a significantly smaller floating payment obligation to Deutsche Bank. Deutsche Bank refused to accept the allocation, asserting that it was made in bad faith, and litigation ensued.

The Ruling

The trial court ruled in favor of Good Hill. The Appellate Division, without much elaboration, affirmed, holding that (i) Good Hill did act in good faith and in a commercially reasonable manner, and (ii) section 9(b)(iii) allowed Good Hill to act as if the CDS “did not exist” and did not prohibit the allocation. Based on the facts as set forth in the Appellate Division’s opinion, it is hard to see how Good Hill could be viewed as having acted appropriately. The trial court’s opinion, however, provides additional factual background.

The trial court explained that the B6 notes were of a higher quality than the other tranches since they were the most secure of the seven tranches held by Good Hill. Further, Bank of America and Good Hill negotiated different repurchase price allocation to each series of notes based on independent analyses conducted by each of the Bank and Good Hill. These independent analyses provided an alternative explanation for what otherwise would appear to be an arbitrary and transparent attempt to artificially increase the value of the B6 notes and a reallocation of value from the other tranches.

Focusing on the import of section 9(b)(iii), the trial court observed that the implied duty of good faith and fair dealing cannot create obligations in conflict with the express terms of the contract. Thus, section 9(b)(iii) allowed Good Hill to act in its own self-interest, and that bargained-for freedom could not be overruled by judicial application of the implied duty of good faith and fair dealing. The courts did not address whether there was any limit to Good Hill’s freedom of price allocation and thus it is not clear whether repurchase of the B6 notes at par, completely eliminating the value of the CDS to Deutsche Bank, would have passed judicial muster.

Implications

While section 9(b)(iii) seems to have been born as a creature of derivative transactions, its usefulness may not be limited to these transactions. Such a provision could be utilized in many other contexts, with the goal of limiting the scope of the implied duty of good faith. Contractual parties should be aware that such provisions may be strictly enforced, at least under New York law.

Read the Appellate Division opinion »

Read the Trial Court opinion »