Claims for Breach of the Implied Covenant of Good Faith and Fair Dealing

Arizona law implies a covenant of good faith and fair dealing in every contract. Wells Fargo Bank v. Arizona Laborers, Teamsters & Cement Masons Local No. 395 Pension Tr. Fund, 201 Ariz. 474, 490, ¶ 59, 38 P.3d 12, 28 (2002), as corrected (Apr. 9, 2002) (citing Enyart v. Transamerica Ins. Co., 195 Ariz. 71, 985 P.2d 556, ¶ 14 (1998); Rawlings v. Apodaca, 151 Ariz. 149, 726 P.2d 565 (1986)). The implied covenant prohibits a party from doing anything to prevent other parties to the contract from receiving the benefits and entitlements of the agreement. Id. The duty arises by operation of law but exists by virtue of a contractual relationship. Id.

Whether a breach of the implied covenant occurred is a question of fact, usually left for the jury. Cnty. of La Paz v. Yakima Compost Co., Inc., 224 Ariz. 590, 604, ¶ 38, 233 P.3d 1169, 1183 (App. 2010). A party who evades the spirit of the contract, willfully renders imperfect performance, or interferes with the performance by the other party may be liable for breach of the implied covenant. Williston on Contracts § 63:22 (4th ed.).

To establish a claim for breach of implied covenant of good faith and fair dealing, the plaintiff must prove: (1) express discretion was exercised in a way inconsistent with a party’s reasonable expectations; and (2) the act was not expressly excluded by the contract’s terms but nonetheless bear adversely on the party’s reasonable expected benefits of the bargain. Keg Restaurants Arizona, Inc. v. Jones, 240 Ariz. 64, 77, ¶ 45, 375 P.3d 1173, 1186 (App. 2016) (citing Bike Fashion Corp. v. Kramer, 202 Ariz. 420, 424 ¶ 14, 46 P.3d 431, 435 (App. 2002)). These two elements will be further described below.

Express Discretion was Exercised in a Way Inconsistent with a Party’s Reasonable Expectations. The first element is whether a party exercised express discretion in a way inconsistent with another party’s reasonable expectations. A party enjoys discretion in the relevant sense when the express terms of the contract do not specify how a party is to behave in all circumstances. Bike Fashion Corp. v. Kramer, 202 Ariz. 420, 424, 46 P.3d 431, 435 (App. 2002). The express terms of a contract are the best indicator of a party’s reasonable expectation. Id. at 435.

For example, a painting contract may call for painting a house red, but not specify the tint of red to use. If the painter chooses to use leftover bright pink (a tint of red) paint when the customer’s reasonable expectation was red, a claim for a breach of the implied covenant might arise. In this scenario, the painter had express discretion to choose the type of red paint, because the contract did not specify the color beyond “red.” This painter’s decision to use bright pink would violate the customer’s reasonable expectations and satisfy the first element.

The Act Was Not Expressly Excluded by Contract but Nonetheless Bore Adversely on a Party’s Reasonable Expected Benefits of the Bargain. An act that breaches the implied covenant need not be expressly excluded by the contract. Otherwise, the claim would become a breach of contract claim. The act, however, must bear adversely on another party’s reasonable expected benefits of the bargain.

For example, in Wells Fargo Bank v. Arizona Laborers, Teamsters & Cement Masons Local No. 395 Pension Tr. Fund, a bank entered into a tri-party loan contract with a real estate developer and various pension funds. 201 Ariz. at 480. In the tri-party loan agreement, the bank agreed to provide interim financing until the pension funds provided permanent financing. Id. Eventually, the real estate developer had financial problems that prevented it from repaying the loans, and the bank did not disclose this to the pension funds before the pension funds provided permanent financing. Id. The bank argued that the tri-party loan contract did not require it to provide financial information about the real estate developer to the pension funds. Id. The court found that although the bank was not required by the express contract to inform the pension funds, a jury could find that it was reasonable for the bank to disclose the information and reasonable for the pension funds to expect the information. Id. at 493. If the bank actively covered up the real estate developer’s financial situation, that act could have damaged the pension fund’s expected benefits of providing permanent financing to the real estate developer. Id. at 498.

Alternatively, even if a contract expressly allows an alleged bad faith action, that action may still be found to breach the implied covenant. In Sw. Sav. & Loan Ass'n v. SunAmp Sys., Inc., a creditor expressly reserved powers to freeze a credit line. 172 Ariz. 553, 557, 838 P.2d 1314, 1318 (App. 1992). However, a court still had to determine whether a jury might reasonably have found that the creditor exercised this power “for a reason beyond the risk” the borrower assumed or for reasons inconsistent with the borrower’s “justified expectations.” Id.

Likewise, in Bike Fashion Corp., a partnership agreement between the parties prohibited sale of a property without consent of the partnership. 202 Ariz. at 423. The partner that sold the property argued that the agreement only required the managing partner to seek consent, and not the general partner. Id. The court held that even if the express terms of the agreement did not prohibit the general partner from selling the partnership’s property without consent, jurors could still conclude that there was a breach of the implied covenant. Id. at 436.

Although a well-written contract can define the parties’ reasonable expectations, the contract cannot eliminate the implied covenant. See In re Sky Harbor Hotel Prop., LLC, 246 Ariz. 531, 443 P.3d 21 (2019) (holding that an LLC may, though an operating agreement, limit or eliminate fiduciary duties but not the implied covenant of good faith and fair dealing).

Breach of the implied covenant is sometimes known as a “contort” claim, because it could sound in both tort and contract. As the implied covenant arises from contract, at the very least contractual damages can be claimed. See Wells Fargo Bank, 201 Ariz. at 491. However, breach of the implied covenant has also been found to be a tort claim that allows for tort recovery. See Rawlings v. Apodaca, 151 Ariz. 149, 158, 726 P.2d 565, 574 (1986) (finding that tort recovery for breach of the implied covenant is well established in actions brought on insurance contracts but only reluctantly extended to other relationships.)

The crucial element of determining whether a breach of the implied covenant sounds in tort or contract is whether the contract creates a special relationship in which the law implies special duties not imposed on other contractual relationships. Id. at 574; McAlister v. Citibank, 171 Ariz. 207, 829 P.2d 1253 (Ct. App. 1992). These relationships are characterized by elements of public interest, adhesion, and fiduciary responsibility. Id. For example, there are relational duties between a: (1) common-carrier and passenger; (2) innkeeper and guest; (3) physician and patient; (4) and attorney and client. There is no need to prove this special relationship if a plaintiff is only seeking contractual damages. See Wells Fargo Bank, 201 Ariz. at 491.

Once a special relationship has been proven for a tort cause of action, the plaintiff must prove an “evil hand” - the intent to do the act. Rawlings, 151 Ariz. at 577. Mere negligence or inadvertence is not sufficient - the defendant must intend the act or omission and must form that intent without reasonable or fairly debatable grounds. Id. There is, however, no need to prove an “evil mind” – that there was an intent to cause harm. Id. The defendant need only have intended its act or omission without a founded belief that its actions was permitted by policy or was reasonable. Id.

Despite the broad nature of the implied covenant, there are very important limitations to the covenant. The plaintiff has the burden of proving a breach of the implied covenant by a preponderance of the evidence. Wells Fargo Bank, 201 Ariz. at 493.

The general rule is the implied covenant cannot contradict an express contract term. Bike Fashion Corp., 202 Ariz. at 423. Clear contract terms that expressly allow/disallow an action are the best defense against a claim that the implied covenant was breached. For example, the first element the plaintiff must prove is that a party had “express discretion.” A common defense to a breach of the implied covenant claim is an argument that the alleged bad faith action was required by the contract. A potential, but less common, defense could argue the alleged bad faith action was not purposeful or caused by an external force that could not be controlled. This distinction is important because involuntary actions or actions required by the contract would not meet the element of express discretion.

Although a party may claim that it has been harmed by an alleged bad faith act, there may be no liability if the act was found to be reasonable. Returning to a previously mentioned case, SW. Sav. & Loan Ass'n v. SunAmp Sys., Inc., where a creditor expressly reserved its right to freeze a credit line, the court eventually granted relief to the creditor. 172 Ariz. at 553. The court found the creditor’s decision to freeze the credit line when it had concerns about the guarantor was objectively reasonable. Id. at 559. This decision was made notwithstanding a jury verdict that awarded damages to the contrary. Id. at 563.

In sum, a plaintiff may bring a claim against a defendant for breach of the implied covenant of fair dealing and good faith in Arizona, but must plead and prove the defendant had the express discretion for its actions and that it bore adversely on plaintiff’s expected benefits of the bargain. Although the implied covenant arises from contract, ultimately a fact finder would have to determine what the parties’ expectations were and whether those expectations were breached. The claim’s imprecise nature, despite being a claim that arises from contract, adds more limitations on parties beyond the black and white letters on the contract.