Virginia courts consistently recognize an implied duty of good faith and fair dealing in common law contracts.  In a recent case in the U.S. District Court for the Eastern District of Virginia, the court held that plaintiffs had sufficiently pleaded a breach of the implied duty of good faith and fair dealing by alleging that defendant bank acted in bad faith and against usual and prudent business and banking practices.

This recent case identifies not only how important it is for businesses to carefully draft contract language, but it also adds an extra layer of caution in determining whether and how to exercise discretion in applying what may appear to be contractual rights.  If a party to a contract is given a right to do something, but this right is not dependent upon the occurrence of a definite fact, then that party has discretion on the question of whether or not he is allowed to exercise that right, which implicates the implied duty of good faith and fair dealing.  If this happens, the party must take extra caution.  He must be careful not to breach the implied duty of good faith and fair dealing by acting unfairly.

In this case, Plaintiffs owed defendant bank a debt of approximately $9 million.  The bank agreed to receive a $3 million payment settlement amount from plaintiffs in lieu of the total debt owed.  After deciding on this number, the parties executed a debt settlement agreement. During the negotiation of the agreement, one of the plaintiffs, John P. Right, gave the bank financial statements. These statements did not include property held in tenancy-by-the-entirety with his wife, because Mr. Right thought that the statements were only supposed to include property held in his individual name.

After the signing of the agreement, Mr. Right provided another financial statement which this time included the jointly-owned property, as required by the signed agreement.  The bank took notice of this additional property.

A provision in the agreement allowed the bank to terminate the agreement and obtain its rights and remedies under the agreement if it was found that a financial statement contained a material misrepresentation or omission in the form of understating assets by at least $100,000.  This gave the bank discretion on its right to terminate.  Due to Mr. Right’s omission of the jointly-owned property in the first-provided financial statement, the bank promptly terminated the agreement.

Plaintiffs alleged as part of their breach of contact claim that the bank acted in bad faith and the bank’s decision to terminate the agreement based on the financial statements was against usual and prudent banking practices.

For a claim of breach of implied covenant of good faith and fair dealing to survive, a party must prove a contractual relationship existed and a breach of the implied covenant. This second prong occurs when either (1) a party acts dishonestly where that party has a clear contract right, or (2) where a party acts arbitrarily or unfairly in the case where a party has discretion in performance.  Thus, an important question to determine is whether a party has a clear contractual right or has discretion in performance.

The district court described the applicable standard as follows:  when parties to a contract create valid and binding rights, the implied covenant of good faith and fair dealing is inapplicable to those rights.  But a party may not exercise contractual discretion in bad faith, even when such discretion is vested solely in that party.

Broadly speaking, every exercise of a contractual right involves some “discretion” in determining if a right has accrued or whether to exercise a right that has accrued.  The court drew a legal distinction between an exercise of discretion and an exercise of a contractual right.  A good example provided by the court of when a party has discretion in performance was the case of Virginia Vermiculite, Ltd. v. W.R. Grace & Co.  In that Fourth Circuit case, a family contracted with a mining company for the sale of mining rights to their land.  The family was paid in proportion to the amount the mine produced.  The contract gave the mining company the “sole discretion” whether to mine the land.  When the mining company donated the land to a trust, the court held that there was a breach of the duty of good faith because the trust forbade any mining of the land, and the purpose was to frustrate a competitor.  156 F.3d 535 (1998).

In the case at hand, Plaintiffs argued that the defendant bank was required to use “usual and prudent business and banking practices” when determining whether a financial statement had a material representation or omission in order to uphold its duty of good faith and fair dealing.  Plaintiffs did not argue that the bank’s decision to exercise its contractual right amounted to contractual discretion, but instead argued that the bank’s determination of whether a contractual right had accrued amounted to contractual discretion.  The court recognized the novelty of this question: whether the implied duty of good faith and fair dealing requires a party to be reasonable in ascertaining whether a contractual right has accrued.

The court reasoned that because the accrual of the bank’s right to terminate the agreement was not committed to the occurrence of an objective, undisputed fact, but was committed to the bank’s determination or discovery that the financial statement contained a material omission, the case was like Virginia Vermiculite.  The review of the financial documents was committed to the discretion of the bank, just as the mining of land was committed to the discretion of a mining company.  The mining company could not decide to not mine land, to get an advantage over a competitor.  “Both the deliberations there and here were committed to experts and were antecedent to the exercise by the expert of a purported right –to mine or not mine, or to consummate or not consummate a settlement.”  Op. at 12-13.

Therefore, the court held that the bank, in determining that a financial statement of plaintiff contained a misrepresentation or omission, acted in bad faith and against usual and prudent business and banking practices.