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The obligation of good faith and the doctrine of "necessary implication": does this have relevance to the contracts entered into by sureties?

This article originally appeared in the March 2012 Fidelity and Surety Committee Newsletter.

About 35 years ago, I tried a case in "blizzard conditions" in Evansville, Indiana for eleven weeks. It was a multi-party case with an owner, contractor, surety (my client), subcontractors, suppliers and design professionals as parties. After eleven weeks, the case for the owner and most of the case for the contractor had been completed. At that point, perhaps as much from exhaustion as anything else, the case was settled pretty much for a wash.

One interesting issue was that the owner (a private owner) concluded, after the contracts had been entered into, that it did not want to pay the design professional to review changes in the work, inspect the work, and review progress to approve payouts. All of this had been set forth in the construction contract as being part of what would occur. Unlike many situations, the surety had received and read the contract before issuing the bond. Not surprisingly, two of the principal issues in the case involved changes proposed by the contractor and approved by the owner without design professional review, which were the subject of a significant dispute. Also would certain portions of the work have been disapproved if, in fact, periodic inspections had occurred? And, as one might guess, the alleged dollar amounts involved in these two problems were considerable.

My surety's claim that it should not be held responsible to the owner for these problems arose out of the argument that the owner had violated a duty to disclose these changes in the contract. The problem here, as in many such contracts, is that the documents allowed for contract changes and no surety's approval was specifically required. At that time, most issues surrounding this particular problem were issues relating to improper approval of payments to the contractor. There was ample case law regarding the surety's right to have credit against the owner's claims for payments which should not have been made. However, that was not the issue in this particular case.

There was a motion for summary judgment filed by the owner and by the design professional (against whom there were a number of claims, including claims by the surety arising out of these events). The motions were denied. The issue was in the case. There was evidence on it. But, of course, no result.

All of this was in the dim mists of my memory. But this year, I handled an arbitration involving contract relations between a company which entered into contracts with individuals. These were not called "franchises", but, in fact, the form of the contract was essentially a franchise arrangement. The franchisee had the ownership of the subject matter of the franchise (specifically a given territory within which to operate and specific customers) and had the right to sell that arrangement. However, if the franchisee was terminated for cause, the franchise was terminated and the contract stated that, after termination, no money was due for the value of the franchise. And, that is what happened.

Under the doctrine of good faith and fair dealing or under the doctrine of "necessary implication," did the owner have an obligation to advise the franchisee that termination was being considered (for an event which was clearly a violation of the franchisee's obligations)? The franchisee then would have had an opportunity to sell his franchise during the roughly one year period while the franchisor was making up its mind whether or not to terminate the franchisee (the franchisee being completely unaware that this was under consideration). This seems like a lot of talk before we get to the subject matter, but it does lay some groundwork.

In the surety context, there are a number of important contracts to which either the duty of good faith and fair dealing or the doctrine of "necessary implication" might apply. In general, what gives rise to a duty of good faith and fair dealing in contracts is not always clear. In this article, we are talking about construction contracts, contracts of employment in which a bond is given for faithful performance or the obligation to account for monies, contracts of indemnity between the surety and its principal, the surety bond itself and, in some cases, contracts are imposed by statutory language in the case of statutorily required surety instruments.

The first question: "Does an obligation of good faith and fair dealing apply?" In the case of sales of goods by suppliers there clearly is an obligation of good faith imposed by Article II of the Uniform Commercial Code. Some jurisdictions hold that every contract has an obligation of good faith and fair dealing, others hold that an obligation of good faith and fair dealing arises when there is a "special relationship" created between the parties to the contract. In the Restatement (Second) of Contracts, there is language suggesting that "every contract imposes on each party a duty of good faith and fair dealing in its performance and enforcement." (1)

However, it is obvious from reading the cases (including those in Pennsylvania), that there are a number of limitations to such a universal application of the doctrine of good faith. And, the application to the doctrine of good faith of the ancillary doctrine of "necessary implication" is even more limited. From the cases in Pennsylvania and elsewhere, it is fairly clear that some sort of special relationship is required for an obligation of good faith to arise. Certain contracts, by their nature, are excluded from the application of these doctrines. It is also clear that there is such a special relationship in most construction contracts, in contracts of indemnity and there is certainly such a special relationship in the bonds to support an obligation of faithful performance or to account for monies. So, the basic obligation of good faith and fair dealing would apply to each of the types of contracts which have been mentioned above.

Going back to my Evansville case, still buried in the mists of time, applying an obligation of good faith and fair dealing would suggest that the owner had an obligation to the surety to advise it if the controls imposed by the contract and to be exercised by the design professional were not going to occur. The test suggested by the case law might be: "Did the party in the position of the surety reasonably expect that it receive word if, in fact, in a contract that called for this type of involvement by the design professional had been altered to remove the design professional's participation?" The lack of such participation leading, in the case I have described, to substantial claims of damages against the surety on its bond.

The arbitration case in which I was involved recently was to be decided under Pennsylvania law. Pennsylvania (along with Delaware) is a state which has more or less clearly adopted the doctrine of "necessary implication." An advantage of the doctrine of "necessary implication," if it were to be applied, is that it provides much more useful tests of what the obligation of good faith requires than are laid out in the general case law involving good faith issues.

It would appear that the doctrine of "necessary implication" has been adopted in Pennsylvania although there is no Pennsylvania Supreme Court case directly on point. The doctrine can be stated as follows:
   In the absence of an express
   provision, the law will imply an
   agreement by the parties to a
   contract to do and perform those
   things that according to reason and
   justice they should do in order to
   carry out the purpose for which the
   contract was made and to refrain
   from doing anything that would
   destroy or injure the other party's
   right to receive the fruits of the
   contract. Accordingly, a promise
   to do an act necessary to carry out
   contract must be implied. (2)

Pennsylvania case law holds that the court may apply this doctrine of "necessary implication" to imply a missing term only when it is abundantly clear that the parties intended to be bound by such a term. Thus unequivocal contract terms hold a position superior to any terms to be implied by courts, leaving the implied covenants to serve as a gap killer.

The doctrine "cannot imply a term not explicitly contemplated by the contract." (3) "Both the implied covenant of good faith and the doctrine of "necessary implication" are principles for courts to harmonize the reasonable expectations of the parties with the intent of the contractors and the terms of their contract." (4)

If one wished to review the Pennsylvania case law which progressed over time and outline a number of the potential limitations, the principal cases, in chronological order, are Daniel Van Campen Corp. v. Bldg. and Constr. Trades Council of Philadelphia and Vicinity, (5) Slater v. Pearle Vision Ctr., Inc., (6) Sommers v. Sommers, (7) Cornelius F. Murphy, Jr. v. Duquesne Univ. of the Holy Ghost, (8) Agrecycle, Inc. v. City of Pittsburgh (9) and, Kamco Indus. Sales, Inc. v. Lovejoy, Inc. (10)

Lovejoy (11) is particularly appropriate in considering the potential use of good faith and fair dealing or the doctrine of "necessary implication" in a context similar to those that might arise involving instruments in which a surety is a party or otherwise responsible. There, a company purportedly following its right under the contract, transferred all of a sale's representative's accounts to "house accounts" thus depriving the sales' representative of its commissions. The background here is that Kamco attempted to force the salesmen into a certain financial situation and it refused to agree. So, Kamco used its contractual right to designate "house accounts" as a method of obtaining actually more than what it previously wanted by the use of express language of the contract.

In this case, the court refused to allow this, applying the doctrine of good faith and fair dealing to the point that, to give proper place to the rights of the sales organization such a use of the sections relating to "house accounts" would violate the reasonable expectations of the parties if the matter had been considered at the time the contract had been signed. The court held that the duty of good faith and fair dealing and the doctrine of "necessary implication" could be used to harmonize the reasonable expectation to the parties even though it is to be applied only under limited circumstances and cannot trump the express provisions in the contract. However, you will see in many instances this construction works out to vitiate a term of the contract.

In Conomos, (12) in which the doctrine was applied, there was to be a duty of good faith in the inspection of a construction contractor's surface preparation. However, although the basic claim of Conomos was approved, it held the obligation of good faith and "necessary implication" could not be used to overturn a limited liability provision protecting the refiner. Thus, the amount of recovery was contractually limited.

The doctrine has also been adopted in Delaware (at least by a federal district court sitting in Delaware) in W&G Seafood Assoc. LP v. E. Shore Markets, Inc. (13) It cited a Delaware Chancery case, in which the Delaware Court of Chancery stated:
   Terms are to be implied in a
   contract not because they are
   reasonable, but because they are
   necessarily involved in the
   contractual relationship so that the
   parties must have intended them
   and have only failed to express
   them because they are too obvious
   to need expression. They are
   implied only because they are
   necessary to give the contract the
   effect which the parties--presumably
   would have agreed on,
   if, having in mind the possibilities
   of the situation which has arisen,
   they had contracted expressly in
   reference thereto. (14)

So, it is clear that there is probably an obligation of good faith and fair dealing in most of the contracts which directly affect a surety's obligation either on performance bonds, construction contracts and performance bonds on employees and positions as well as many statutorily required bonds. But the extension of that good faith doctrine (or perhaps explanation of the doctrine is a better word), by use of the doctrine of "necessary implication" has been largely limited to the states of Pennsylvania and Delaware. It is, nonetheless, an interesting concept which would seem to have considerable merit. It is obvious just from reading the few Pennsylvania cases I have cited that, to some degree, the application of either the general doctrine of good faith and fair dealing or the doctrine of "necessary implication" is not a white line and, to some extent, may be a minefield. Nonetheless, I suggest that surety lawyers should be aware of the possible use of such doctrines on their clients' behalf and to beware of the possible use of such doctrines against them as a result of a surety's action or inaction. It is reasonable to predict that in the right case on the right facts other jurisdictions will certainly apply the application of the doctrine of good faith and fair dealing and may, as an extension of that, apply the doctrine of "necessary implication".

Thus, one should consider some of the possibilities. By far the most significant possibility for the potential application of those doctrines would arise in the case of changes in a construction contract. Such changes without notifying the surety may very well have been expressly provided for in the language of the contract itself and of the bond. Does that mean, because there is express language allowing such changes without notifying the surety and with the surety continuing to be bound, that their express contract language must control? And, thus, neither the obligation of good faith and fair dealing nor the doctrine of "necessary implication" could be applied.

In the first place, we know that this is not the law in cases in which some substantial changes in the scope of the contract performance occur. This is where they are considered by the court (or the finder of fact) to be such a material change that the contract against which the owner is attempting to apply the bond is no longer the same contract. While that situation usually arises in connection with extras to the work, it would not require a leap of faith to find that, if the two doctrines apply, the circumstance described in my many years old Evansville case might be circumstances to which one could apply the doctrine. The surety should have the benefit of this doctrine to require performance by the other party to avoid materially injuring its right. A change as significant as removing the design professional from seeing that the duties that appear to be imposed on the contractor in the construction contract are properly performed should give rise to an obligation of the owner to inform the surety and obtain its permission.

The case law, in general, holds that despite the clear language of a faithful performance bond or other instruments requiring accounting for money, an obligation under the bond arises when the particular acts set out in the instrument have occurred. Assume the obligee is aware of dishonesty or lack of faithful performance and overlooks it and later seeks to recover losses occurring following its knowledge of the prior dishonest or improper performance of the principal. Any such case would be very fact sensitive.

The case law and, in many instances, the language of the bonds themselves generally hold that recovery from the surety for the later misconduct is barred. However, an argument can be made under the doctrine of good faith and fair dealing that the notice also may have given the surety an opportunity to obtain recoupment or indemnity from its principal in a situation in which the principal's financial condition would (in most cases) be significantly better than after the successive additional defalcations have occurred.

Now, again, there is a considerable body of case law which suggests this may be a basis for defense. Another example, in the context of a construction contract, would be a situation in which the work is performed in various sequences. The bonded contractor has entered into a contract to perform each of those sequences in a prescribed order. However, there are certain requirements applying to each sequence. Suppose that the owner, invoking one of those requirements in a circumstance where the contractor's work is otherwise completely satisfactory, removes one of these sequential activities from the contractor and awards it to someone else. An obvious situation where this might occur would be where the contractor has unpaid bills on that sequence (some of which, of course, may be in dispute between the contractor and its subcontractors or suppliers) and the owner, on the basis of those unpaid bills, removes that portion of the work but then insists that the contractor must proceed to perform the remaining work. In such a case, the contractor loses control of the sequence and faces the potential of serious harm to the contractor, which is a potential of serious harm to the surety. Many surety instruments actually contain language which holds that the coverage afforded by the surety bond protecting the obligee is no longer in effect once the obligee is aware of prior improper acts or omissions which would be violations of the bond. Nonetheless, in more sophisticated cases, the ability to look to the doctrines of good faith and fair dealing or the doctrine of "necessary implication," requiring notice to the surety of the discovery of these acts as a prerequisite to the continued enforcement of the obligation, would make the application of the law as applied to facts clearer.

I am not suggesting how these cases or others that we could consider would work out. I am merely suggesting that it is wise to consider the application of the doctrine of good faith and fair dealing. Sometimes in the real world, the kinds of instances to which I have referred (as was true in Lovejoy), the use of a contractual provision to gain an advantage which the court finds a misuse of an otherwise proper provision in order to avoid a clearly improper result, using the doctrine of "necessary implication" or providing for a good faith interpretation of the contract, allows the court to say, if the parties had considered those circumstances, they would realize that enforcing the strict provision being misused would unfairly deprive the other party of the rights obtained from the other provisions of the contract and thus relief from the clause implied as a portion of the contract.

I would predict that if any such cases arise there is at least a reasonable possibility that courts considering what law to apply may very well consider either the employment of the general rule of good faith and fair dealing or the more specific rule of "necessary implication" in seeking to protect the contractor (and, by extension, the surety). Forewarned is forearmed!

(1) RESTATEMENT (SECOND) CONTRACTS [section] 205 (1981).

(2) Conomos Inc. v. Sun Co., Inc., 831 A.2d 696, 706 (Pa. Super. Ct. 2003) (quoting Daniel B. Van Campen Corp. v. Bldg. and Constr. Trades Council of Philadelphia and Vicinity, 195 A.2d 134, 136-137 (Pa. Super. Ct. 1963)).

(3) Conomos, 831 A.2d at 708.

(4) Id.

(5) 195 A.2d 134 (Pa. Super. Ct. 1963) (in which the comment on "necessary implication" is dicta).

(6) 546 A.2d 676 (Pa. Super. Ct. 1988) (in which the doctrine was discussed but not applied).

(7) 613 A.2d 1211 (Pa. Super. Ct. 1992) (in which an implied duty of good faith was applied).

(8) 777 A.2d 418 (Pa. 2001) (in which the discussion is in a concurring opinion).

(9) 783 A.2d 863 (Pa. Comm. Ct. 2001) (in which the doctrine was held not to be applied to the facts).

(10) 779 F. Supp.2d 419 (E.D. Pa. 2011) (in which the federal court held that the doctrine did apply).

(11) 779 F. Supp.2d 419.

(12) 831 A.2d 696.

(13) 714 F. Supp. 1336 (D. Del. 1989).

(14) Danby v. Osteopathic Hosp. Assn. of Del., 101 A.2d 308, 313-314 (Del. Ch. 1953).

Hugh E. Reynolds, Jr. is a Past Chair of the Tort and Insurance Practice Section of the American Bar Association, and one of its delegates to the ABA House of Delegates, a past chair of its Fidelity and Surety Law and Appellate Advocacy Committees. He was on the Governing Committee of the Forum on the Construction Industry of the American Bar Association (1984-90), was the Chair for one year and editor of the Construction Lawyer for two years. Mr. Reynolds is a founding fellow of the American College of Construction Lawyers and a member of the American College of Trial Lawyers. He is a member of the American Law Institute and was an advisor to the committee which revised the Restatement of the Law of Suretyship. He has received the Cornerstone Award for lifetime achievement from the Forum on the Construction Industry of the ABA, the Martin Andrew Award for lifetime achievement in fidelity and surety law from the Fidelity & Surety Committee of the Tort & Insurance Practice Section of the ABA and the Louis B. Potter Lifetime Professional Service Award from the Defense Research Institute for demonstrating a lifetime commitment to the legal profession and to the betterment o four civil justice system.
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Author:Reynolds, Hugh E., Jr.
Publication:Defense Counsel Journal
Date:Apr 1, 2012
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