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

• Author: Reynolds, Hugh E., Jr.

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...