Court recognizes implied duty of good faith and fair dealing.

Arthur Andersen was faced with a claim that it had breached a duty of care implied in the contract with its client. The problem started in 1992 when Farragut Mortgage Co. and another residential mortgage banking company began negotiations to merge. Farragut retained the firm--its auditor--to provide an opinion on whether the merger would qualify for pooling-of-assets treatment in conformity with generally accepted accounting principles.

In May 1993, the firm allegedly orally informed Farragut and some of its stockholders that the Securities and Exchange Commission would permit this accounting treatment. Farragut alleged (1) it then incurred substantial expenses to prepare for the merger, (2) in an October 14, 1993, letter the SEC questioned whether the transaction qualified for a pooling of assets and (3) the firm advised Farragut the merger could not be accounted for as a pooling. Farragut said the firm knew or should have known the SEC would not permit this treatment. The company and stockholder plaintiffs claimed considerable loss of stock value.

Farragut alleged a breach of the covenant of good faith and fair dealing in its professional services contract with the firm. The court said initially that every contract in Massachusetts contains such an implied warranty or covenant, which provides that neither party can do anything that would have the effect of destroying or injuring the right of the other party to receive the fruits of the contract.

The firm sought dismissal of the claim by contending the plaintiffs were required to allege an improper or "bad faith" exercise of a discretionary right under the contract and that the complaint--which alleged only negligence on the firm's part--therefore had failed to state a claim. The plaintiffs replied that Massachusetts recognizes that bad faith may arise even in the absence of proof of intentional wrongdoing.

In considering these contentions, the court observed that (1) the Massachusetts Supreme Judicial Court consistently has recognized that bad faith requires more than mere negligence and (2) the Massachusetts Appeals Court has found that lack of good faith carries an implication of a dishonest purpose, conscious wrongdoing or breach of duty through a motive of self-interest or ill will.

Farragut alleged that the firm had known the proposed merger would not qualify for pooling-of-assets treatment but nonetheless provided an opinion to the contrary. Plaintiffs conceded that the complaint did not allege intentional conduct but argued that a lack of diligence may be sufficiently egregious to Constitute bad faith. The court found that although there was no question that in Massachusetts bad faith required a showing of more than simple negligence, courts in other jurisdictions have recognized that--at least in the context of insurance contracts--a showing that the conduct was "highly unreasonable" or in deliberate disregard of a threatened harm could constitute a breach of the implied covenant of good faith and fair dealing. Thus, because the state supreme court had not directly addressed this question, the court felt constrained to deny the firm's motion to dismiss the claim for breach of the implied good faith and fair dealing.

The plaintiffs also brought a claim alleging that the firm had violated the Massachusetts Unfair Business Practices Act (chapter 93A). The court wrote that this statute makes unlawful any unfair act or practice in the conduct of any trade or commerce. The firm sought dismissal of this claim by arguing that more than a breach of contract or simple negligence was required to establish an unfair act or practice. The plaintiffs responded to the firm's motion by asserting that the firm had made representations as to the availability of pooling-of-assets treatment when it knew or should have known that those representations were false. Plaintiffs conceded that the firm's conduct was negligent, not intentional, but argued that a chapter 93A violation could be based on gross negligence.

The court concluded that there was authority for finding a chapter 93A violation based solely on gross negligence in the provision of professional services. Its finding, however, was based solely on a decision by another Massachusetts Superior Court judge in a case involving an environmental assessment.

This case is problematic for the accounting profession. It recognizes potential liability under Massachusetts business practice statute if gross negligence is proven. (This statute allows for three times actual damages, plus the attorney's fees.) The court's willingness to recognize an implied duty of good faith and fair dealing is particularly troublesome because this implied duty appears to consider what a client might expect the accountant to have done and not what accounting professional standards require. (Farragut Mortgage Co. v. Arthur Andersen LLP, Mass. Superior Court, November 15, 1996)

Editor's note: Thanks to John Hughes of Hutchins, Wheeler & Dittmar for this case. --Edited by Wayne Baliga, CPA, JD, CPCU, CFE, president of Aon Technical Insurance Services.