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From time to time in the course of research we do for cases where we have been retained as experts and consultants; we encounter cases that may be especially enlightening to clients and friends. We post these cases here as they arise for information, education and to stimulate comment. We look for cases that are timely and involve issues of widespread applicability. We think the following are such cases and raise many issues for thought. Please check back often as we will add cases when they become available.
Credit Default Swaps: The Newest Sub prime Litigation Front Add credit default swap counterparty litigation to the growing list of sub prime-related litigation categories. Credit default swaps have, of course, already been drawn into the sub prime litigation wave to a certain extent. For example, Swiss Re has been sued in a sub prime related securities lawsuit in connection with its write-down in the valuation of certain credit default swaps. According to news reports, A bank and B bank have each been sued in separate lawsuits brought by credit default swap counterparty. A closer look at the pleadings in the lawsuits suggests we may be seeing a great deal more of this kind of litigation ahead. First, some definitions. A credit default swap is an agreement between two parties under which one party (the seller) agrees, in exchange for a periodic payment, to provide the buyer with protection in the event of a default or other credit event involving an underlying instrument. A credit default swap is like insurance, except that there is no requirement that the buyer actually hold the underlying instrument, so credit default swaps are often used as a means so speculate on interest spreads. Both A bank and B bank entered credit default swaps with a hedge fund incorporated in the Isle of Jersey (one of the Channel Islands). The hedge fund, previously known as Xxx Master Fund Ltd., is now known as Xxx Special Opportunities Master Fund Limited. During 2007, the hedge fund entered two credit default swaps, one with A bank and one with B bank, that are now the subject of litigation. According to the hedge fund’s January 12, 2008 Amended Complaint against B bank, on May 21, 2007, the hedge fund entered a $10 million credit default swap with B bank in connection with a Class B tranche of a collateralized debt obligation. The hedge fund was to be paid a 2.75% per annum fee for the swap, to be secured by a deposit of $750,000. According to the hedge fund’s allegations, during the course of 2007, B bank demanded that increasing amounts of collateral, which by November 2007 cumulated to an amount in excess of the swap’s notional $10 million face value. The hedge fund kept pace with the demands for additional collateral until the demands exceeded $8,920,000, at which point the hedge fund initiated the dispute resolution mechanisms in the agreement, and ultimately initiated litigation in New York Supreme Court, which B bank removed to federal court. The hedge fund contests that there has been an event of default or any other event that would trigger their payment obligation under the swap. B bank for its part submitted a notice of termination, foreclosed on the collateral, and counterclaimed against the hedge fund for the “deficiency.” B bank bases its justification for the increased collateral on the absence of any commercial market for the CDO. The hedge fund’s lawsuit seeks to rescind the swap, on the grounds of fraud and mistake; and also seeks damages for fraud, breach of contract and breach of the covenant of good faith and fair dealing; and unjust enrichment. B bank’s counterclaim alleges breach of contract. The hedge fund’s lawsuit with A bank is based on more or less the same dispute, albeit in connection with a different credit default swap. According to the hedge fund’s February 14, 2008 complaint, the notional value of the A bank default swap was also $10 million, and A bank ultimately “extracted” (according to the complaint) collateral of $9,960,000 from the hedge fund. There are a number of interesting things about these circumstances. Perhaps the most interesting is that according to the complaints, the hedge fund has approximately $50 million of capital under management. In other words, the notional amount of just these two swap contracts alone represented 40% of the hedge fund’s capital. I am going to go out on a limb and guess that the hedge fund had other contracts too. Whether or not the hedge fund had other contracts, it is hardly surprising that, given its limited capital, the hedge fund reached a point where litigation seemed like a better option than any further collateral advances; the fund’s managers may have decided they had nothing to lose by fighting. Even more interesting than the hedge fund’s huge vulnerability to just these two transactions is the fact that a couple of major financial players like B bank and A bank were accepting what amounts to insurance from a thinly capitalized pocket portfolio incorporated in the Bailiwick of Jersey. Certainly if they had been placing insurance as such they would never have transacted with an offshore insurer whose total capital was so small. Whatever may have led two of the world’s largest banks to accept guarantees from a small, thinly capitalized hedge fund, these circumstances at a minimum demonstrate something that I suspect we will be reading about a lot more in the coming days – that is, “counterparty risk.” The litigation will be bad. The financial consequences could be worse. (Excerpted with permission from D & O Diary at http://www.dandodiary.com) Plaintiff is a physician, who has practiced medicine since 1996. Her husband is an electrical engineer. In August 1999, the Plaintiffs bought a lot on which they planned to build a custom home. They then hired an architect. When the architect completed the blueprints, Plaintiffs gave them to seven or eight Contractors. One Contractor provided the Plaintiffs with an estimate of $415,000. Even though he had never built a custom home, the Plaintiffs entered into a contract with him on March 13, 2000. The construction contract provided in relevant part: "The architect will visit the site at intervals appropriate to the stage of construction to become generally familiar with the progress and quality of the completed work and to determine in general if the work is being performed in a manner indicating that the work, when completed, will be in accordance with the contract documents. On the basis of on-site observations of the Architect, the Architect will keep the Owner informed of progress of the work and will endeavor to guard the Owner against defects and deficiencies in the work. However, the Owners never asked the architect to conduct inspections of the construction while the Contractor was working on the job. In order to obtain a construction loan, the Plaintiffs sought the assistance of their real estate broker. He presented them with proposals from several lenders. The Owners selected Bank's proposal based on the interest rate and other terms. On April 7, 2000, they entered into a construction loan agreement with Bank to finance the project. The loan was in the amount of $650,000 to pay for the construction of the home as well as the purchase of the lot. Bank required that some items that had originally been excluded from the construction contract, such as the landscaping, sidewalks, counter tops, and final flooring, also be included. Thus, the price to construct the home was increased to $453,262. The agreement provided Bank with the right to perform inspections prior to making loan disbursements. Pursuant to the contract, Bank hired an outside Inspector doing the business of appraisal & review, to perform inspections to determine the progress of the construction of the home. After Bank disbursed payments to the Contractor, who failed to apply the loan proceeds to the cost of construction, the Owners brought an action for breach of contract, negligence, and constructive trust. The construction loan agreement provided: "Inspections will be made by an inspector acceptable to lender prior to any disbursements to verify work and place.” The agreement between Bank and the Inspector relating to the inspections was oral. There was nothing in their agreement that specified that the inspections were for the benefit of the Plaintiffs. The construction loan agreement also stated: "ANY INSPECTIONS BY LENDER OF THE PREMISES WILL BE SOLELY FOR THE LENDER'S BENEFIT. BORROWER UNDERSTANDS AND AGREES THAT IT IS NOT RELYING ON LENDER TO SUPERVISE OR INSPECT THE CONSTRUCTION OF THE BUILDING IMPROVEMENTS OR THE SEARCH OF TITLE OR THE OBTAINING OF LIEN WAIVERS FOR BORROWER'S BENEFIT AND THAT LENDER IS NOT LIABLE IN ANY MANNER TO BORROWER EVEN IF THE IMPROVEMENTS ARE NOT CONSTRUCTED IN ACCORDANCE WITH PLANS AND SPECIFICATIONS OR THE CONSTRUCTION CONTRACT OR IN THE EVENT OF ANY LIENS ON THE PREMISES. Borrower understands and acknowledges that the disbursement system has been selected by lender for its sole protection in disbursing each advance of loan funds, and that lender neither acts as an agent or fiduciary for the borrower nor warrants the legal validity or corrections of any lien waivers or other documents provided by the provisions hereof, which lien waivers and other documents are for the sole benefit of the lender." The Plaintiffs promised in the construction loan agreement that they would: "Cause the improvements to be constructed and erected entirely within the boundaries of the Real Estate in strict compliance with all laws and ordinances and all plats, restrictions or matters of record, in a good and workmanlike manner and free of mechanic's liens, with materials and workmanship of the highest quality, and in strict accordance with the plans and specifications submitted to and approved by Lender." The addendum to the construction loan agreement provided that "all general Contractors are to be approved by" Bank. However, it also provided that Bank's "approval of each builder should not be construed in any manner as endorsement, credit worthiness or confirmation in the selection of your builder." The agreement specified: "PROPERTY INSPECTIONS ARE FOR BANK'S USE ONLY. In determining the stage of completion of the construction, do not rely on these inspections as evidence that the work is being performed in a workmanlike manner, to plans and specifications, or to building codes." The Plaintiffs also gave Bank a copy of their construction contract that included the provision relating to inspections by the architect. After the parties' agreement was signed, the Plaintiffs waited a month and a half before the Contractor completed the foundation. They would visit the construction site daily. Plaintiff had one conversation with the Inspector while the Contractor was working on the project. She asked him whether she could change the specifications for some doors and draw more funds than originally contemplated. The inspector told her that she could not do that. Between May 2000 and September 2000, the inspector sent Bank reports that detailed the following percentages of completion: May 2, 2000: 7.3% May 19, 2000: 16.5% June 1, 2000: 24% June 15, 2000: 32.5% July 14, 2000: 48% September 7, 2000: 63.5% September 26, 2000: 72%"
In April 2000, initial draws of $196,738 and $2,540 were made to pay for the lot and the loan fees. The construction draws were as follows: Date Amount Cumulative Total May 8, 2000 $33,000 $33,000 May 22, 2000 $30,000 $63,000 June 2, 2000 $38, 500 $101,500 June 19, 2000 $45,500 $147,000 June 30, 2000 $50,000 $197,000 July 14, 2000 $51,108 $248,108 July 31, 2000 $22,670 $270,778 August 11, 2000 $38,793 $309,571 August 29, 2000 $16,000 $325,571 September 18, 2000 $7,576 $333,147 October 2, 2000 $10,941 $344,088" Each of the requests for a construction draw stated that the Contractor's company was “entitled to payment" in the amount requested, and was signed by one of the Plaintiffs. Plaintiff signed some of the requests even though they did not specify an amount. In early August, construction at the site stopped. On August 24, 2000, the Plaintiffs sent a letter to the Contractor, in which they detailed their numerous concerns about the project, including deviations from the plans, substandard work, and lack of progress. The Plaintiffs did not send a copy of this letter to either the inspector or Bank, or orally communicate this information to them. After writing the letter, the Plaintiffs approved three more construction draws without communicating their concerns to Bank. In early October 2000, the Plaintiffs fired the Contractor. Plaintiff never saw the Inspector's inspection reports prior to firing the Contractor in October 2000. On October 12, 2000, the Architect inspected the project. In his opinion, the construction was 45 percent complete, and Bank had disbursed $140,121.57 more than the progress of the work justified. The Architect and his associate identified numerous construction defects and estimated that it would cost more than $50,000 to correct them. The Plaintiffs then acted as their own general Contractor to complete their home. The cost to complete the project was $690,000. In May 2001, Plaintiffs signed the certificate of completion. On November 16, 2000, the Plaintiffs filed a complaint against Bank in which they alleged causes of action for breach of contract, negligence, and constructive trust based on allegations that Bank disbursed funds in excess of the value of the work performed by the Contractor, who was now bankrupt and judgment proof. The complaint also alleged a cause of action for breach of contract between the Inspector and Bank to review construction of the home and monitor disbursements of the funds. The Plaintiffs alleged that they were third party beneficiaries of this contract. The complaint further alleged a cause of action for negligence against the Inspector in the inspection of the construction and the approval of the disbursement of funds to the Contractor. On October 28, 2002, Bank filed a motion for summary judgment, or alternatively, for summary adjudication. Bank argued: the cause of action for breach of contract was barred by the terms of the construction loan agreement, which imposed on the Plaintiffs the duties relating to inspection and disbursement, and by the Plaintiffs' breach of contract by failing to perform those duties; the cause of action for negligence was barred by the risk allocation provisions in the construction loan agreement and by the rule announced in Aas v. Superior Court (2000) 24 Cal.4th 627 that prevents recovery from a Contractor unless there is property damage; the claim for constructive trust was invalid, because the loan proceeds had been disbursed; and the third party beneficiary claim was barred, because the terms of the construction loan agreement negated any basis for finding that the contract between Bank and the Inspector entitled the Plaintiffs to rely on the Inspector's inspections or that the contract was made for the benefit of the Plaintiffs. The Plaintiffs filed opposition to Bank's motion, which included a memorandum in opposition, declarations and a separate statement of disputed facts. One declaration stated that he (Expert) was a construction lending consultant. After reviewing the deposition testimony of the Inspector and an officer of Bank, he concluded that Bank's conduct in the instant case fell below the commercially reasonable standard for a construction lender. According to the Expert, Bank failed to research the qualifications of the Contractor; did not have a list of approved appraisers; required lien waivers only from the Contractor, not from material men and subcontractors; paid the draw requests prior to receiving photographs; failed to compare photographs to draw requests; reimbursed the Contractor for deposits on materials without verification; and failed to take standard security measures before advancing funds for deposits or materials that were not installed or controlled on site. An Appraisal Expert's declaration stated that he was an appraiser and real property consultant. After reviewing the Inspector's deposition, he concluded that the Inspector lacked the appropriate training and experience in construction cost estimation; the Inspector did not disclose his lack of qualifications to Bank or Plaintiffs; and he did not undertake to obtain the necessary training. This expert also concluded that Bank failed to ascertain the Inspector's lack of qualifications, did not supervise the Inspector, and subcontracted payment to plaintiffs. The Plaintiffs contended: the cause of action for breach of contract should be sustained, because the breach was predicated on active negligence; the clauses shifting responsibility to them were invalid exculpatory clauses; and Bank breached an implied condition of the contract that it would do nothing to harm the other party. They argued: the cause of action for negligence was sustainable, because Bank was chargeable with the Inspector's negligence as well as its own; the decision in Aas v. Superior Court, supra, 24 Cal.4th 627, did not protect a construction lender; and the cause of action for constructive trust was sustainable. They also contended that the cause of action for breach of a third party beneficiary contract was valid, because the Plaintiffs were the intended beneficiaries of the oral contract between Bank and the inspector. On November 26, 2002, the trial court granted the Bank’s motion for summary adjudication of the causes of action for breach of contract, negligence, and third party beneficiary contract, and denied the motion as to the cause of action for constructive trust. On December 16, 2002, Bank filed a second motion for summary judgment as to the cause of action for constructive trust. On December 20, 2002, the Inspector filed a motion for summary judgment, or alternatively, for summary adjudication based in large part on Bank's moving papers. The Plaintiffs filed opposition to the motions. Following a hearing, the trial court denied the motion for reconsideration, granted Bank's motion for summary judgment, and granted the Inspector's motion for summary judgment. On March 12, 2003, judgment was entered in favor of Bank and the Inspector. Plaintiffs appealed. Analysis Breach of Contract In their first cause of action, the Plaintiffs contended that Bank breached the construction loan agreement by its negligent supervision of the Contractor and by disbursing more funds than were justified. The appeal court concluded, however, that the terms of the construction loan agreement barred the breach of contract claim. Here the terms of the construction loan agreement clearly barred the breach of contract claim. Paragraph 8 specifically stated that the Plaintiffs agreed that they were "not relying on Lender to supervise or inspect the construction of the building improvements." Paragraph 7 stated that Bank's inspections and disbursement system were "for its sole protection in disbursing each advance of Loan funds, and that Lender neither acts as an agent or fiduciary for the Borrower...." The agreement further stated that Bank would not be "LIABLE IN ANY MANNER TO BORROWER EVEN IF THE IMPROVEMENTS ARE NOT CONSTRUCTED IN ACCORDANCE WITH THE PLANS AND SPECIFICATIONS OR THE CONSTRUCTION CONTRACT, OR IN THE EVENT OF ANY LIENS...." The addendum provided: "PROPERTY INSPECTIONS ARE FOR [BANK'S] USE ONLY." Moreover, the Plaintiffs promised that they would be responsible for constructing their home "in strict compliance with all laws and ordinances ... in a good and workmanlike manner and free of mechanic's liens ... and in strict accordance with the plans and specifications...." Since the construction loan agreement provided that the Plaintiffs, not Bank, would bear the risk of the Contractor's failure to apply the loan proceeds to the cost of construction, the trial court granted the motion for summary judgment as to this cause of action. The Plaintiffs' construction contract also specified that the Architect that they selected, not Bank, would ensure that their home was built according to plans. The Plaintiffs assert that Bank breached the construction loan agreement by failing to make disbursements only to defray costs "actually incurred" and "directly connected with the Building." Plaintiffs certified in writing to Bank with each request for a draw on the construction loan that the draw was for expenses properly incurred for the construction of their home. Moreover, the agreement explicitly stated that the Plaintiffs were not to rely on inspections by Bank. Thus, under the terms of the agreement, the responsibility for determining whether costs were "actually incurred" and "directly connected with the Building" rested with the Plaintiffs. The Plaintiffs contended, however, that the provisions in the construction loan agreement that shifted the responsibility for inspection and progress payments to them were not enforceable. They claimed these provisions were part of a contract of adhesion, and that the provisions were unconscionable and violated public policy. The court then recognized that "a contract of adhesion is fully enforceable according to its terms unless certain other factors are present which ... operate to render it otherwise." The court stated that "there are two judicially imposed limitations on the enforcement of adhesion contracts or provisions thereof. The first is that such a contract or provision which does not fall within the reasonable expectations of the weaker or 'adhering' party will not be enforced against him. The second--a principle of equity applicable to all contracts generally-- is that a contract or provision, even if consistent with the reasonable expectations of the parties, will be denied enforcement if, considered in its context, it is unduly oppressive or unconscionable. The Plaintiffs argued that the construction loan agreement fell outside their reasonable expectations. They claimed that they could have reasonably expected that Bank would inspect the progress of the construction, since this was the industry standard, and it retained discretion and control over these functions. Here the provisions notified the Plaintiffs in "plain and clear" language that Bank inspections were for the benefit of Bank, not the Plaintiffs. Plaintiff also admitted in her declaration that she was aware that the contract stated that it was their responsibility to ensure that the house was built properly and that there were not liens on it. Moreover, the Plaintiffs had previously acknowledged this responsibility in their contract with the Contractor in which they agreed to appoint their own architect to ensure that the Contractor followed the construction plans. In addition, Plaintiff conceded that she never saw Bank's inspection reports, and thus did not rely on them prior to signing the requests for construction draws. Thus, the notice provided to the Plaintiffs and their own conduct established that the challenged provisions did not fall outside the Plaintiffs' reasonable expectations. The Plaintiffs next contend that even if the duty-shifting provisions of the construction loan agreement fell within their reasonable expectations, they were unconscionable. In this case, the construction loan agreement was neither procedurally nor substantively unconscionable. Bank was not in the position of superior bargaining power or in control over the transaction. The Plaintiffs had their own broker representing them and there were other lenders who would have entered into a construction loan agreement with them. The Plaintiffs selected Bank's proposal based on the interest rate and other terms. In addition, the challenged provisions were not hidden in a lengthy agreement. They were conspicuously displayed in the agreement, since they were in much larger type and in capital letters. Moreover, the provisions that the property inspections by the Bank’s Inspector were for Bank's benefit do not “‘shock the conscience.” First, the Bank lent money at interest to the Plaintiffs on the security of their property. Thus, it was reasonable for the parties to agree that Bank's periodic inspections would protect its interest, not the Plaintiffs' interest in the property. Second, the Plaintiffs were in a better position to monitor the progress of the construction of their home, thereby protecting their interest in ensuring that the Contractor met his obligations to them. Not only were they at the construction site daily, but they also informed Bank that their own architect would determine whether construction was proceeding according to the plans. Based on this record, the appeals court concluded that the construction loan agreement must be enforced. Negligence - Contractor In their second cause of action for negligence, the Plaintiffs alleged that Bank was negligent in approving the Contractor as the Contractor and in supervising Inspector's inspections. The construction loan agreement barred the negligence claim. Though the agreement provided that the general Contractor was to be approved by Bank, it also stated that Bank's "approval of each builder should not be construed in any manner as [Bank's] endorsement, credit worthiness, or confirmation in the selection of your builder." Thus, the construction loan agreement allocated the duty to supervise the Contractor and to assume the risk of his nonperformance to the Plaintiffs. Regarding the negligent supervision of Inspector, the construction loan agreement provided that the Plaintiffs were not to rely "ON LENDER TO SUPERVISE OR INSPECT THE CONSTRUCTION OF THE BUILDING IMPROVEMENTS" and that Bank's inspections were "SOLELY FOR LENDER'S BENEFIT." Moreover, the construction contract between The Contractor and the Plaintiffs provided that the Plaintiffs' architect would supervise and inspect the construction of their home. Since Bank owed no duty to the Plaintiffs where the parties' agreement allocated the duty to the Plaintiffs, the court granted the motion for summary judgment on the cause of action for negligence. Constructive Trust In their third cause of action, the Plaintiffs alleged that Bank held the construction funds and excess funds paid to the Contractor as constructive trustee for their benefit. "A constructive trust is an involuntary equitable trust created by operation of law as a remedy to compel the transfer of property from the person wrongfully holding it to the rightful owner.” Here the requirements for imposition of a constructive trust were not met. The loan proceeds were Bank's property until they were disbursed. Thus, Bank did not gain the proceeds by a wrongful act. Nor did Bank detain the proceeds. However, to support imposition of a constructive trust, the Plaintiffs claim that they suffered an unjust loss, because Bank disbursed more funds to the Contractor than he was entitled to receive. As previously discussed, Bank did not breach the construction loan agreement. Where a defendant has not breached a contract, the plaintiff does not have a claim for constructive trust on any alleged breach. Accordingly, the court granted the motion for summary judgment on the cause of action for constructive trust. Breach of Third Party Beneficiary Contract In the fourth cause of action, the Plaintiffs alleged that the Bank’s Inspector breached the contract by recommending a greater percentage of the loan proceeds be paid to the Contractor than the percentage of completion of the project, and that Bank breached the contract by paying this amount. They further alleged that they were the third party beneficiaries of this contract, since they would have benefited from the proper performance of the contract. Here the Plaintiffs did not dispute that "there was nothing in the oral arrangements between Bank and Inspector to the effect that the inspections were for the benefit of the Plaintiffs." They argue, however, that Defendants' intent to benefit them can be inferred from the circumstances, that is, that properly conducted inspections would have ultimately benefited them. This argument ignores the terms of the construction loan agreement, which provided that Bank's inspections were solely for Bank's benefit, that the Plaintiffs were not relying on Bank to inspect the construction, and that the property inspections were only for use by Bank. Thus, the court granted the motion for summary judgment as to this cause of action. Negligence - Inspector In the fifth cause of action, the Plaintiffs alleged that the Inspector breached his duty to them "to insure that they would not recommend to defendant Bank that a greater percentage of said loan proceeds be paid to Contractor than the percentage of completion of said Project. "An action in negligence requires a showing that the defendant owed the plaintiff a legal duty, that the defendant breached the duty, and that the breach was a proximate or legal cause of injuries suffered by the plaintiff.” Here the Inspector owed no duty of care to the Plaintiffs. Pursuant to the loan agreement, the Plaintiffs agreed that Bank's inspections were intended solely for Bank's benefit and that they would not rely on these inspections. The Plaintiffs also agreed that they would be responsible for assuring the progress and quality of the Contractor's construction. Moreover, the Plaintiffs approved each construction draw in writing. Thus, the court granted the motion for summary judgment on this cause of action for negligence.
Discussion
This type of case comes up much more frequently than anyone would hope or expect. While the background of the case is very common; some aspects are quite different. The opinion turned out to be like a suspense story with several unexpected twists and turns. No one knows with certainty what a Judge or Jury will decide before they actually render a verdict; but, when we started reading the factual history, we expected a quite different result from what actually happened. What were the turning points? What facts influenced the court to render the decision it did? From the point of view of standards of care and industry practices; we believe the Plaintiffs’ expert got it right. The Bank’s failure to qualify its Inspector, the Contractor, implement the usual and customary internal controls and monitor its advances against the percentage of completion of the project left it exposed to lender liability. These borrowers/plaintiffs were; however, not your typical borrowers. It is a very small minority of borrowers in similar circumstances who engage an architect to perform independent construction inspections and visit the construction site daily. The court also took note of the fact that the construction loan was negotiated by a broker and decided upon from numerous offers from other lenders. This particular fact was interesting to us, not only because of its impact on mitigating the lender’s liability on a negligence claim, but because of the effect it had on the disclaimers contained in the construction loan agreement. We believe that “Take It or Leave It Adhesion Contracts” such as contained here or for mandatory arbitration or waiver of jury trial will become the subject of increased dispute in the future. No matter where you come down on the issues, we would love to hear your opinions.
Wisconsin Supreme Court Says Arbitration Remedies Have to be Mutual Between Parties
A business cannot draft an arbitration agreement that is tilted in its favor,
according to the Wisconsin Supreme Court.
History of The Implied Contractual Duty of Good Faith and Fair Dealing Until the 20th Century, financial contracts were treated the same as any other contract, with recovery generally limited to the damages contemplated by the parties when they entered into the contract. Like any other contract, they were enforced by their explicit terms, and courts were reluctant to substitute their own judgment for the terms upon which the parties agreed absent some independent injustice. By the end of the 19th Century, however, the judiciary in the United States began to recognize a general obligation of good faith performance implied in every contract. By the 1930s, the implied covenant of good faith became a standard doctrine. This duty of good faith and fair dealing originated to resolve disputes over agreements that were not explicit on pivotal contract terms, or left discretionary power in the hands of one of the contracting parties. This concept of “good faith and fair dealing” has been applied to many different types of contracts that left performance in the discretion of one of the parties. However, the implied covenant has been applied differently across the country and has received critical scrutiny by scholarly writers. In his widely cited article, Professor Steven J. Burton discusses the implied covenant of good faith and fair dealing. He evaluated contracts by which one party was permitted to exercise discretion in performing contractual obligations. (Steven J. Burton, Breach of Contract and the Common Law Duty to Perform in Good Faith, 94 Harv. L. Rev. 369 (1980). As Professor Burton points out in various contexts, it may be in the best interests of the parties to allow one of them to exercise discretion. One party to a contract may be willing to rely on the good faith of the other because detailed planning may be ineffectual or inadvisable. Accordingly, discretion is often vested with one of the parties to the contract. The good faith performance doctrine requires this discretion to be exercised in accordance with the intentions of parties, or to protect their reasonable expectations when entering into the contract. Bad faith performance occurs when the discretion is used for the improper purpose of attempting to recapture opportunities foregone upon contracting. Good faith performance occurs when a party's discretion is exercised for any purpose within the reasonable contemplation of the parties at the time of formation. The Restatement of Contracts notes that every contract imposes on each party a duty of good faith and fair dealing in its performance and enforcement. A comment to the Restatement states that “[g]ood faith performance or enforcement of a contract emphasizes faithfulness to an agreed common purpose and consistency with the justified expectations of the other party; it excludes a variety of types of conduct characterized as involving 'bad faith' because they violate community standards of decency, fairness or reasonableness.” The implied covenant to perform on a contract in good faith is historically an element of the contractual obligation. “[A] party's good-faith cooperation is an implied condition precedent to performance of a contract; where that cooperation is unreasonably withheld, the recalcitrant party is estopped from availing himself of his own wrong doing.” Consistent with this traditional approach, Courts have held that the rights conferred by the implied covenant of good faith and fair dealing are limited to the agreed terms of the contract. Whether the implied covenant of good faith is interrelated with, or independent of, the express contract terms, the motive of the party exercising discretion is a factor to consider. “[A] party must exercise discretion reasonably and with proper motive when that party is vested with the exercise of discretion under a contract.” The Supreme Court of New Jersey, for example, has established the following test for a breach of the implied covenant of good faith and fair dealing: A party exercising its right to use discretion in setting price under a contract breaches the duty of good faith and fair dealing if that party exercises its discretionary authority arbitrarily, unreasonably, or capriciously, with the objective of preventing the other party from receiving its reasonably expected fruits under the contract. Such risks clearly would be beyond the expectations of the parties at the formation of a contract when parties reasonably intend their business relationship to be mutually beneficial.
Earlier this year, in a decision handed down in favor of a commercial mortgage lender, the United States District Court for Massachusetts offered a clear warning to careless borrowers. The case, Blue Hills Office Park LLC v J.P. Morgan Chase Bank (477 F.Supp 2d 366 (D.Mass. 2007), demonstrates:
This decision is particularly important, since there are relatively few cases that deal with the enforceability of "non-recourse carveouts" (also known as "bad-boy carveouts") and the lender’s ability to take advantage of overly broad terms to accelerate foreclosure and recover the full amount of a loan. An Overview of the Case In 1999, Blue Hills Office Park LLC ("Blue Hills") negotiated and closed a $33 million non-recourse mortgage loan with Credit Suisse First Boston Mortgage Capital LLC ("Credit Suisse"). The loan was guaranteed by William Langelier and Gerald Fineberg, and secured by a first trust deed on an office building; J.P. Morgan Chase Bank ("J.P. Morgan") was the trustee for the investors in the securitization trust that held the mortgage. The terms of the loan included typical carveouts from the non-recourse provisions, covering acts such as waste, fraud and other recourse triggers. Blue Hills subsequently defaulted on the loan by failing to make two monthly payments of principal and interest. It also failed to notify the lenders of, or to obtain prior consent for, the settlement of a zoning dispute involving a neighboring building. Without disclosing the transaction to the lender, Blue Hills transferred the $2 million dollar settlement payment into an account held by the guarantors’ lawyers rather than into one of its own accounts. When Blue Hills requested that the lender make the missed payments from the loan reserve, the lender refused. Without giving any notice or opportunity to cure, the lender accelerated the debt, foreclosed on the property, and commenced pursuing a deficiency claim of over $10 million. Blue Hills sued J.P. Morgan and Credit Suisse, claiming that the lenders had breached the terms of the loan, had foreclosed wrongfully and had violated the Massachusetts Consumer Protection Act, among other claims. The lenders countersued, claiming that Blue Hills and two of its principals had breached the loan contract and some of the "bad boy" carveouts, and had violated an implied covenant of good faith and fair dealing. The lenders also claimed that the guarantors had made representations that violated Massachusetts General Laws. The Decision The District Court found in favor of the lenders on all counts. Of specific interest to borrowers, the Court ruled that Blue Hills had failed several key obligations under the loan documents: the duty to have an independent director (the Blue Hills "director" was a former secretary at one of the borrower's law firms and did not participate in the business) and the duty not to commingle assets (which occurred when the borrowers deposited the $2 million settlement into the account held by the guarantors’ lawyers). The Court found that the terms of the non-recourse mortgage loan were stated broadly enough that they allowed the lender to claim immediate default without requiring notice or an opportunity to cure. The language of the agreement also enabled the lender to pursue the full amount of the debt, as opposed to limiting recourse to the significantly lesser amount of damages or losses created by the specific breach. "Non-Recourse" Does Not Mean "Without Recourse" The decision in Blue Hills makes it clear that non-recourse loans do not mean that lenders are without recourse. In fact, when loan terms are written with overly broad carveout language, the unintended consequence is often that lenders have incredible latitude in pursuing foreclosure and seeking deficiency damages associated with alleged defaults. Borrowers can attempt to mitigate these risks in several ways:
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