Table of Contents
Implied Covenant of Good Faith: The Silent Term in Every Contract
From Kirke La Shelle v. Armstrong to Employment Terminations
I. Introduction: The Unspoken Promise in Contractual Relationships
In the architecture of contract law, much attention is devoted to express terms—those commitments clearly articulated and mutually assented to by the parties. Yet, nestled silently within nearly every contract is an unexpressed but potent obligation: the implied covenant of good faith and fair dealing. This principle ensures that neither party will do anything to destroy or injure the other’s right to receive the benefits of the agreement. Though invisible in wording, this covenant exerts formidable influence, restraining opportunistic behavior and imbuing contractual interpretation with a sense of justice.
From its judicial formulation in early 20th-century cases such as Kirke La Shelle v. Armstrong, the implied covenant has evolved to become a vital component of American contract law. Its reach extends across diverse contexts, including the often-contentious domain of employment terminations. This essay explores the origins, doctrinal development, and modern applications of this silent term, illuminating its indispensable function in upholding the ethical infrastructure of private agreements.
II. Historical Origins: Kirke La Shelle v. Armstrong and the Formal Recognition of Good Faith
The modern doctrine of the implied covenant of good faith and fair dealing gained early prominence in the New York Court of Appeals case Kirke La Shelle Co. v. Armstrong, 263 N.Y. 79 (1933). There, the plaintiff held the exclusive right to produce a dramatic play. The defendant, by intentionally rendering the contract worthless through a separately orchestrated deal, effectively deprived the plaintiff of the benefit of its bargain. While no express term was violated, the court held that such conduct breached the implied covenant of good faith.
Judge Pound, writing for the court, famously declared that “[i]n every contract there is an implied covenant that neither party shall do anything which will have the effect of destroying or injuring the right of the other party to receive the fruits of the contract.” This statement crystallized the doctrine’s rationale: contracts are not merely bundles of explicit promises; they are also relational understandings that must be preserved from manipulation or subversion.
III. Conceptual Foundations: Good Faith as a Tool of Justice and Efficiency
The implied covenant of good faith and fair dealing operates at the intersection of moral integrity and legal pragmatism. Though often treated as a doctrinal mechanism for redressing contract breaches, it is more properly understood as an enduring normative standard—an ethical compass embedded in the jurisprudence of private obligation. Its theoretical underpinnings lie not only in the formal requirements of contract law, but in deeper philosophical commitments to justice, reciprocity, and trust as necessary conditions for human cooperation.
A. Ethical Imperative: Pacta Sunt Servanda and the Moral Dimension of Contracts
At its ethical core, the implied covenant of good faith revives and reinterprets the ancient legal maxim pacta sunt servanda—“agreements must be kept.” But unlike a rigid, formalist reading that emphasizes strict performance of express terms, the covenant insists on a richer, more holistic fidelity to the substance of the agreement. The obligation it imposes is not merely to avoid technical breach, but to refrain from actions that sabotage the mutual expectations upon which the contract was founded.
This distinction becomes crucial in contexts where one party technically complies with the contract’s wording while rendering the other party’s benefits illusory or inaccessible. Such “bad faith opportunism” might manifest in withholding necessary cooperation, exploiting ambiguities for unilateral advantage, or engaging in strategic delay to frustrate performance. While these tactics may not violate any explicit term, they are antithetical to the relational foundation of contract law—a foundation predicated on trust, reciprocity, and the moral duty not to act deceptively or destructively toward one’s counterparty.
Moreover, the covenant reflects an ethical ideal of fairness in exchange. It reminds contracting parties—and courts—that contracts are not mere tools for maximizing self-interest, but instruments for cooperative problem-solving, often between parties of unequal bargaining power. The implied covenant thus tempers the individualistic ethos of classical contract theory with the communitarian insight that obligations must be fulfilled not only formally, but honorably.
B. Functional Utility: Reducing Transaction Costs and Ensuring Cooperative Performance
Beyond its moral significance, the implied covenant also plays a vital functional role in making contract law workable and efficient. In an idealized world, parties could foresee every contingency and specify in minute detail how each should be handled. In reality, contracts are necessarily incomplete. The world is too complex, human relationships too fluid, and language too imprecise to anticipate and articulate every possible form of behavior that might threaten the contract’s aims.
Absent the implied covenant, parties would be forced to draft exhaustively, enumerating prohibitions against every imaginable form of exploitation. This would raise transaction costs to an unsustainable level and deter productive agreements. The covenant, by contrast, operates as a “default term” supplied by law—an interpretive backstop that fills gaps, constrains discretion, and ensures that both parties act in ways consistent with the contract’s reasonable expectations.
In economic terms, the covenant helps prevent opportunism—behavior that extracts private gains at the expense of collective surplus. Oliver Williamson, the Nobel Prize-winning economist, emphasized the importance of such legal constraints in preserving the integrity of long-term cooperative arrangements. The implied covenant promotes relational stability by signaling that the legal system will not reward strategic bad faith or manipulation of formal loopholes.
This function is especially salient in contracts involving discretion, dependency, or long-term performance—such as franchise agreements, joint ventures, employment contracts, and licensing arrangements. In these cases, the parties rely not merely on written terms but on ongoing cooperation and mutual trust. The implied covenant safeguards this trust by ensuring that the exercise of discretion—whether in terminating, modifying, or enforcing the contract—is not arbitrary, retaliatory, or self-serving to the point of destruction.
C. Codification and Acceptance: From Common Law to UCC and the Restatement
The normative and practical force of the implied covenant is reflected in its codification and wide acceptance. Section 1-304 of the Uniform Commercial Code (UCC) declares: “Every contract or duty within this Act imposes an obligation of good faith in its performance and enforcement.” Though modest in appearance, this provision has profound consequences: it institutionalizes the principle that good faith is not optional but inherent in all commercial dealings covered by the UCC.
Similarly, Section 205 of the Restatement (Second) of Contracts provides: “Every contract imposes upon each party a duty of good faith and fair dealing in its performance and enforcement.” The commentary to this section further clarifies that good faith excludes a variety of disloyal acts—such as evasion, subterfuge, and abuse of power—that undermine the agreed-upon structure of cooperation.
Notably, these codifications do not treat the covenant as an ornamental principle or vague aspiration. Rather, they integrate it into the core of modern contract theory, treating it as an essential condition for market function and judicial fairness. Courts across jurisdictions have cited these provisions in interpreting ambiguous terms, policing abuses of discretion, and remedying concealed sabotage.
In sum, the implied covenant of good faith and fair dealing is both a moral commitment to cooperative honesty and a functional tool that preserves the efficiency and viability of contractual relations. By ensuring that the letter of the contract does not become a weapon against its spirit, the covenant sustains a legal order in which promises are not just formal obligations but expressions of mutual reliance, trust, and justice.
IV. Application in Commercial Contexts: From License Agreements to Supply Chains
In the world of commercial contracts, where transactions often involve high stakes, ongoing relationships, and significant asymmetries of power, the implied covenant of good faith and fair dealing emerges not only as a legal doctrine but as a stabilizing force. It acts as a restraint on opportunism, especially where one party enjoys discretion—explicit or implicit—over key aspects of performance, enforcement, or termination. Courts have repeatedly invoked this covenant to prevent abuses of such discretion, thereby protecting the integrity of commercial arrangements from being hollowed out by self-interested exploitation.
A. Discretion as a Point of Vulnerability
The touchstone for many good faith disputes is discretionary power. When one party to a contract is granted unilateral discretion—whether to terminate, modify, approve, allocate resources, or perform obligations—the opportunity for opportunism inevitably arises. The implied covenant functions to cabin that discretion within the bounds of fairness and reasonableness. The underlying logic is that discretion must be exercised in a manner that does not deprive the other party of the expected benefits of the agreement.
In Fortune v. National Cash Register Co., 373 Mass. 96 (1977), the Massachusetts Supreme Judicial Court confronted this exact problem. The plaintiff, a long-serving salesman, had secured a significant deal that would have entitled him to a substantial commission. Before the commission was paid, the employer terminated his contract under its at-will clause. Although technically permissible under the letter of the agreement, the court concluded that the termination, motivated by a desire to avoid compensating the employee, violated the implied covenant of good faith and fair dealing. The decision reinforced the idea that discretion—especially when used to evade payment or subvert reliance interests—must be exercised in good faith.
This principle has rippled through employment, agency, and sales agreements, discouraging the use of termination or other discretionary clauses as tools of unjust enrichment or avoidance of accrued obligations. Courts have not prohibited employers or principals from exercising discretion, but they have required that such exercises be anchored in legitimate business purposes rather than in malice, retaliation, or economic predation.
B. Franchise and Licensing Agreements: The Struggle Against Cannibalization
The implied covenant finds particularly fertile ground in franchise and licensing relationships, which are typically characterized by long-term collaboration, ongoing performance, and unequal bargaining power. These contracts often give the franchisor or licensor broad control over pricing, geographic expansion, marketing, and product development. When this discretion is exercised in ways that harm the franchisee or licensee, courts increasingly look to the implied covenant as a judicial compass.
One common form of bad faith is territorial cannibalization, where a franchisor opens a competing, company-owned store near an existing franchise, thereby drawing away customers and diluting the franchisee’s investment. Even where the contract permits such openings, courts have sometimes found violations of good faith when the franchisor’s actions are so economically destructive as to eviscerate the franchisee’s reasonable expectations under the agreement.
In Burger King Corp. v. Weaver, 169 F.3d 1310 (11th Cir. 1999), the court held that the franchisor did not breach the implied covenant by opening a new location, but it acknowledged that such conduct could raise concerns if done arbitrarily or with clear intent to damage an existing franchisee. By contrast, in Atlantic City Coin & Slot Serv. Co. v. IGT, 14 F. Supp. 2d 644 (D.N.J. 1998), the court found that the licensor had breached the covenant by refusing to supply necessary parts and support to a licensee, thus rendering the licensee’s business operations unviable.
These cases reflect a growing judicial awareness that contract law must accommodate relational dependencies in complex commercial environments. The implied covenant thus functions as a kind of “relational justice clause,” demanding that dominant parties exercise power in a way that sustains, rather than undermines, the mutual benefit at the heart of the agreement.
C. Supply Chains and Procurement: Faith in the Flow of Commerce
The globalized supply chain offers another realm where good faith plays a critical—if often underappreciated—role. Manufacturers, distributors, and retailers often operate through multi-tiered contracts in which the timing, quality, and volume of deliveries are left to one party’s discretion. For instance, a buyer may reserve the right to reject goods for nonconformity, or to demand “just-in-time” delivery based on shifting needs.
When this discretion is exercised abusively—such as through excessive delay, arbitrary rejection, or manufactured “nonconformance” to escape obligations—courts have occasionally stepped in to enforce the implied covenant. In Net2Globe International, Inc. v. Time Warner Telecom of New York, 273 F. Supp. 2d 436 (S.D.N.Y. 2003), the court found that the defendant’s unreasonable delay in provisioning a telecommunications service, though not a literal breach of a deadline, constituted a breach of the covenant due to the deliberate frustration of the contract’s core purpose.
These rulings reinforce that in the delicate and interdependent world of modern commerce, trust in the fair execution of contracts is indispensable. The implied covenant ensures that commercial players do not engage in post-contractual behavior designed to extract surplus or shift risk unfairly, particularly where one party’s discretion governs vital logistical or economic functions.
D. Financial Instruments and Commercial Leases: Duty Within Formality
Even in highly formalized instruments such as commercial leases and financial agreements, where parties often attempt to contract around uncertainty through precision, the implied covenant retains force. Courts have used it to protect tenants from landlords who impose arbitrary obstacles to renewal or refuse to make reasonable accommodations, and to prevent lenders from calling in loans or triggering default clauses in a manner calculated to seize collateral or restructure relationships on more favorable terms.
In Wilshire Westwood Associates v. Atlantic Richfield Co., 20 Cal. App. 4th 732 (1993), a California court ruled that a lessor’s refusal to approve a tenant’s proposed assignee—despite a contractual “reasonableness” standard—was a breach of good faith, as the denial was not based on legitimate business concerns but on speculative or pretextual grounds.
Similarly, courts have reviewed decisions made under “sole discretion” clauses in financing contracts to ensure they are not exercised in a capricious or abusive manner. While absolute discretion clauses are often upheld, the implied covenant can still serve as a backstop against fraud, manipulation, and conduct that is plainly inconsistent with commercial norms.
In conclusion, the implied covenant of good faith and fair dealing serves as an essential check on discretionary power in commercial settings. It fortifies the cooperative premises of complex transactions, deters strategic manipulation, and reaffirms the moral foundation upon which commercial law is built. By restraining opportunism and encouraging consistency with the contract’s spirit, the covenant helps ensure that private law remains not only a mechanism of enforcement but also a vessel for fairness, trust, and shared enterprise.
V. The Implied Covenant in Employment: From At-Will Doctrine to Fair Dealing
Perhaps the most controversial and dynamic arena for the implied covenant is employment law. In the United States, the employment-at-will doctrine permits employers to terminate employees for any reason not specifically prohibited by law. Yet courts in some jurisdictions have softened this harsh rule by invoking the implied covenant of good faith.
In Cleary v. American Airlines, 111 Cal. App. 3d 443 (1980), the court held that a long-time employee could not be dismissed in bad faith, particularly when the termination was motivated by retaliation or a desire to deprive him of earned benefits. The reasoning echoed that of Kirke La Shelle: a party should not evade contractual obligations through tactical terminations.
Still, the application of the covenant in employment remains inconsistent across states. Some courts, such as in New York, continue to maintain a strict interpretation of at-will employment and reject good faith limitations unless explicitly contracted. Others, such as California and Massachusetts, allow employees to invoke the implied covenant when employers act with malice, fraud, or an intent to frustrate reasonable expectations.
Critics argue that these judicial incursions blur the lines between contract and tort, introducing subjective standards into otherwise clear contractual relationships. Yet proponents counter that the implied covenant is a necessary brake on corporate abuse, and a means of aligning legal doctrine with evolving notions of workplace fairness.
VI. Limits and Controversies: Judicial Balancing and the Risk of Overreach
While the implied covenant is powerful, it is not without limits. Courts generally refuse to use it to create new obligations not contemplated by the parties or to override clear and unambiguous terms. As the Restatement cautions, good faith is a principle of interpretation, not an independent source of duties. For example, in Brooke Group Ltd. v. JCH Syndicate 488, 87 N.Y.2d 530 (1996), the court reiterated that the implied covenant cannot be used to impose substantive terms absent from the agreement.
Moreover, judicial application of the covenant must walk a fine line: too little enforcement invites contractual sabotage; too much creates legal uncertainty and chills legitimate discretion. The virtue of good faith lies in its adaptability—but this is also its vice, depending on how liberally it is interpreted by courts.
VII. Conclusion: The Enduring Relevance of a Silent Covenant
The implied covenant of good faith and fair dealing remains one of the most intellectually and morally intriguing doctrines in contract law. It reflects a legal system’s effort to balance formalism with fairness, precision with equity. From the theatrical intrigue of Kirke La Shelle to the painful realities of wrongful termination, the covenant stands as a testament to the enduring need for trust and cooperation in private ordering.
In an age increasingly dominated by complex transactions and impersonal relations, this silent term continues to speak—quietly but authoritatively—reminding parties that the law, like any good faith agreement, is not merely a matter of form, but of principle.
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