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Drafting Around Good Faith

BY ALLEN B. GRODSKY Court has explained, the covenant discretion? Courts have addressed cannot be read “to prohibit a party this issue in a number of cases. from doing that which is expressly permitted by an agreement.” (Carma CASE LAW Developers, 2 Cal. 4th at 374.) How- Plaintiffs in three particular disputes ever, the courts are very particular tried unsuccessfully to invoke the about the specificity required for a implied covenant to impose a good contract to avoid the implied cov- faith limitation on conduct specifi- n California, every contract enant of good faith and fair dealing. cally described and expressly permit- Icontains an implied covenant of good faith ted by the contract. In one instance, and fair dealing, which prevents one party TWO-PRONGED TEST an employment contract provided from unfairly frustrating the other party’s In general, California courts will that when a Lockheed employee right to receive contractual benefits. The interpret a contract to allow a party created an invention during his implied covenant is particularly important to use its sole discretion—unlimited or her employment, the inven- in situations where an agreement invests one by the covenant of good faith and fair tion belonged to the company; the party with a discretionary power affecting the dealing—if two conditions are met. employee, however, could request rights of the other party; under the implied l The express purpose of the con- from Lockheed a “special invention covenant, such power must be exercised in tract is to grant unfettered discre- award” of up to $20,000. The con- good faith. (See Carma Developers (Califor- tion, and tract expressly stated that Lockheed nia), Inc. v. Marathon Development California, l The contract is otherwise sup- “may, but is not obligated to, grant” a Inc., 2 Cal. 4th 342, 372 (1992).) ported by adequate consideration. special invention award and that all MCLE But what if the parties intend to allow one (See Wolf v. Walt Disney Pictures & decisions “shall be final and conclu- party to exercise discretionary power with- Television, 162 Cal. App. 4th 1107, sive.” (Brandt v. Lockheed Missiles & out any good faith restriction? This is not an 1121 (2008).) Space Co., 154 Cal. App. 3d 1124, unusual situation. For example, record com- In such cases, one party’s ability 1128 (1984) (emphasis added).) panies often bargain for unlimited discretion as to use sole unfettered discretion is, The employee who brought the suit to whether and how to distribute albums that by definition, within the reasonable argued that the implied covenant of a musician records. Similarly, employers want expectation of the parties, and there- good faith and fair dealing required unlimited discretion to decide whether or not fore the exercise of discretion is not that Lockheed’s decision whether to award a bonus. In each of these cases, com- limited by the implied covenant. to grant a special award be made petent parties intend to “contract around” the In this context, how does one in good faith. The court of appeal implied covenant. But legally, can they do this? determine that the express purpose disagreed, finding that the language The answer is yes. As the California Supreme of a contract is to provide unfettered of the contract “could not be more clear and explicit.” (Brandt, 154 Cal. MCLE CREDIT CERTIFICATION App. 3d at 1130.) In other words, CLE CENTER Earn one hour of MCLE credit by The Daily Journal Corp., because the contract specified that You can now earn MCLE credit reading the article and answer- publisher of California Lawyer, ing the questions that follow. has been approved by the without leaving your computer. Go to Lockheed was not obligated to grant Mail your answers with a check State Bar of California as a www.callawyer.com and click on CLE for $35 to the address on the continuing legal education an award, the implied covenant Center for access to dozens of articles answer form. You will receive provider. This self-study could not impose a restriction on and tests on a range of topics. the correct answers with activity qualifies for Minimum EARN MCLE CREDIT explanations and a certificate Continuing Legal Education Lockheed to make such decisions within six weeks. Price subject credit in the amount of one only in good faith. GENERAL CREDIT to change without notice. hour of general credit. In another case, a commercial

38 JULY 2013 CALLAWYER.COM CONTRACTS

lease provided that the landlord, within contract. But what if the contract is not prior dealings. The mortgage agreement 30 days of receiving notice that the ten- so precise? What if it provides broad dis- did not expressly state that the lender ant intended to sublet or assign the lease, cretion to one party but does not specifi- could absolutely refuse to grant exten- could terminate the rental agreement, cally address the conduct that another sions (unlike the language in the Brandt enter into its own lease with the intended party claims is restricted by principles of or Third Story Music cases). Nevertheless, sublessee or assignee, and keep all the good faith and fair dealing? Courts have the district court held that the contract’s profits realized on account of the termi- split dramatically on this issue. broad language provided unfettered dis- nation and reletting. (Carma Developers, On one side of this split is a case cretion inconsistent with the implied 2 Cal. 4th at 351–352.) The landlord did involving a contract that gave defendant covenant of good faith and fair dealing. exactly what the lease said it could, ter- Walt Disney Pictures & Television the (Symbolic Aviation, Inc. v. PNCEF, LLC, minating the lease after receiving notice discretion to assign or license rights to 2010 WL 3584509 (S.D. Cal).) of the intent to sublease and then nego- the plaintiff’s Roger Rabbit franchise as Also instructive is a franchise dispute tiating directly with the intended subles- Disney “saw fit.” The plaintiff argued in which the governing contract pro- see. The tenant argued that the implied that Disney breached the implied cove- vided that a franchisee could not change covenant of good faith and fair dealing nant by entering into licenses with third location without the franchisor’s written prevented the landlord from ending the parties in exchange for promotional consent. When the franchisor refused to lease unless its objection to the transfer considerations, without monetary allow the franchisee to move, the fran- was in good faith. The court of appeal compensation; this meant the plaintiff chisee sued, arguing that the implied agreed, concluding that as a matter of received no royalties. The court rejected covenant obligated the franchisor to act law the landlord’s termination of the the claim, holding that “recognizing only in good faith. Though the contract lease “solely to realize a profit” breached an implied term that would limit the did not specify that the franchisor could the implied covenant. But the Califor- unfettered discretion given to Disney to refrain from approving a move, the dis- nia Supreme Court reversed, holding license the characters as [Disney] saw trict court nevertheless held that because that the landlord’s “termination of the fit would be at odds with the express the agreement provided unfettered lease in order to claim for itself appre- terms of the agreement.” (Wolf, 162 discretion on the issue of relocation, ciated rental value of the premises was Cal. App. 4th at 599.) It did not mat- the court could not imply a covenant expressly permitted by the lease and was clearly within the parties’ reasonable MCLE expectations.” (Carma Developers, 2 The covenant of good faith and fair dealing Cal. 4th at 376 (emphasis added).) does not limit a party’s right to engage in Finally, an agreement with an enter- tainment production company gave conduct specifically permitted by a contract. Warner Communications the right to manufacture and distribute musician Tom Waits’s recordings—or to refrain ter that the contract failed to expressly of good faith and fair dealing. (Dos from these activities. The production state Disney could license the franchise Beaches, LLC v. Mail Boxes Etc., Inc., company wanted to release a new com- in exchange for only promotional con- 2012 WL 1903905 at *6 (S.D. Cal.).) pilation of the artist’s works, but Warner siderations. The court concluded that refused to distribute it because Waits— broad contractual language—as Disney ALTERNATE VIEW who had no legal right to object—was saw fit, to paraphrase the court—was But there is another side to the story. Two opposed to releasing the new compi- sufficient to establish the parties’ intent other courts have held that when a broad lation. The court sided with Warner to grant Disney unfettered discretion. discretionary clause does not specifically because the covenant of good faith and Two federal courts applying Cali- allow the challenged conduct, a party’s fair dealing would be directly at odds fornia law have reached the same con- conduct is restricted by the implied cov- with the express contractual grant of dis- clusion. One case involved a mortgage enant of good faith and fear dealing. cretionary power. (Third Story Music, Inc. agreement providing that a lender had The primary case for this proposi- v. Waits, 41 Cal. App. 4th 798 (1995).) “sole and absolute discretion” to extend tion involves a classic instance of bad the maturity date. After agreeing to one facts making bad law. (Locke v. War- VAGUE LANGUAGE extension, the lender balked and refused ner Bros., Inc., 57 Cal. App. 4th 354 The foregoing cases make clear that the to further extend the loan’s due date (1997).) The plaintiff, Sondra Locke, covenant of good faith and fair dealing without new payments. The plaintiff entered into a movie-development deal does not limit a party’s right to engage alleged that the shift in the lender’s posi- with Warner Bros., by which she was in conduct specifically permitted by the tion was inconsistent with the parties’ paid $250,000 a year for three years and

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agreed to submit all motion picture proj- how the court could conclude there was requires for sufficient consideration is ects first to the film studio. Warner Bros. no evidence that the parties intended to the proverbial ‘peppercorn.’ ” (San Diego then had 30 days to accept or reject a give Warner Bros. unfettered discretion. City Firefighters, Local 145, AFL-CIO v. submission. The studio rejected every The Locke case was followed by a Bd. of Admin. of San Diego City Emps.’ project Locke brought it. But Locke dispute over a nonexclusive distribu- Ret. Sys., 206 Cal. App. 4th 594, 619 obtained evidence that Warner Bros. tion agreement between Gap, a retailer, (2012).) Indeed, “[a]ny valid though never intended to make any films with and Gabana, a clothing distributor. slight consideration will support the Locke; it had entered into the agreement (Gabana Gulf Distribution, Ltd. v. Gap most onerous obligation.” (Taylor v. Tay- only to accommodate actor Clint East- Int’l Sales, Inc. (2008 WL 111223 (N.D. lor, 66 Cal. App. 2d 390, 398 (1944).) wood, who was divorcing Locke at the Cal.).) The agreement provided that The Third Story Music case cited time and agreed to reimburse the studio Gabana had to obtain Gap’s approval above is instructive. The court found for the cost of her contract so long as before selling clothes to any particular that the recording contracts at issue Locke’s projects were never produced. retailer, and that Gap “shall have the gave unfettered discretion to Warner Locke alleged the obvious cause of right in its sole discretion to approve, Communications to decide whether to action (fraud), but she also asserted a disapprove, or cancel at any time any release a Tom Waits album. However, claim for breach of the implied cov- Distribution customer.” Gabana argued the contracts required Warner to make enant of good faith and fair dealing. that Gap had breached the implied various annual and per-album pay- Warner Bros. argued that the implied covenant by instituting a freeze on all ments to Third Story; and although the covenant could not be imposed in this new retail customers, regardless of the money paled in comparison to what case because it was inconsistent with merits of the proposal. could have been earned by a success- the language of the contract. The court repeated the Locke court’s ful recording artist, the court found the Relying on Third Story Music, the distinction between a contract that pro- consideration adequate, and it com- court held that the agreement “did not vides a party with the power to exercise mented that judges “cannot make bet- give Warner the express right to refrain discretion, and one that provides the ter agreements for the parties than they from working with Locke” but rather power to refrain from exercising dis- themselves have been satisfied to enter only gave “discretion with respect to cretion. Thus, “because Gap merely into, or rewrite contracts because they developing Locke’s projects.” (57 Cal. bargained for the right to exercise ‘dis- operate harshly or inequitably.” (Third App. 4th at 367.) Thus, reasoned the cretion’ over proposals made by Gab- Story, 41 Cal. App. 4th at 809.) court, the implied covenant obligated ana, Gap did not bargain for the right With this split in authority, what Warner Bros. to act in good faith. to refrain from approving all proposals is the best approach for a drafter who There are multiple problems with altogether.” (Gabana, 2008 WL 111223 intends to provide unfettered discre- this analysis. The facts of the case clearly at *8.) Note that the courts that decided tion? Here are some suggestions. MCLE state a fraud claim, and the court held Symbolic Aviation and Dos Beaches sim- l Use broad language in the agree- that there was a triable issue of fact on ply ignored the earlier Gabana ruling. ment that makes it as clear as possible fraudulent concealment. The claim for that the parties intended for the discre- breach of the implied covenant, then, CONSIDERATION tion conferred to be unfettered. Phrases was the proverbial tail wagging the dog. When dealing with these issues, it is like “sole and exclusive discretion,” or Moreover, the court’s focus on the important to bear in mind the second “as the party sees fit” are essential. absence of contractual language permit- element of the two-pronged analytical l Always specify that the party enti- ting Warner Bros. to “refrain” from mak- framework. Even if a contract provides tled to exercise the discretion may ing any of Locke’s projects is not useful unfettered discretion, a promise to use refrain from doing so. because it is impossible to discern from good faith will be implied unless there l If possible, give examples of ways in the opinion itself precisely what the con- is other consideration. (Third Story which the party may exercise discretion. tract says. (The court did not quote the Music, 41 Cal. App. 4th at 808.) Very Parties can indeed contract for the exact language.) For example, readers of few cases address this specific require- right to exercise unfettered discretion; the opinion do not know if the contract ment because most contracts, espe- the key is to include the right language. contains broad language that gave War- cially those in writing, are supported by Using the verbal incantations that have ner Bros. “absolute and sole discretion” other consideration. influenced the case law will help assure regarding Locke’s projects—or whether, The legal code provides some help that the drafter’s intent prevails in the as the court seems to suggest, the con- here. California’s statutes declare that event a dispute arises. CL tract says merely that the studio had 30 “[a] written instrument is presumptive Allen B. Grodsky, a partner at Grodsky & days to approve or reject a submission. evidence of consideration.” (Cal Civ. Olecki in Santa Monica, specializes in business, In the latter case, it would be easier to see Code § 1614.) Furthermore, “all the law entertainment, and intellectual property litigation.

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False False False False False False False q q q q q q q CONTRACTS CALLAWYER.COM True True True True True True True please check here if this is a new address q q q q q q q It is impossible to draft a contractIt is impossible In drafting a contract intended to Token consideration is not consideration is Token obligation. than a “peppercorn.” that a contract operates harshly or generally will rewrite courts unjustly, it fair. to make the agreement it is discretion, unfettered provide wise to include examples of the type of decisions over which a will have such discretion. party granting unfettered discretion to a discretion granting unfettered or film studio. producer record a promise discretion, unfettered be implied to use good faith will is other consideration. unless there consideration.evidence of adequate onerous an to support sufficient Valid consideration requires more more requires consideration Valid When consideration is so small A written contract is presumptive presumptive A written contract is Even if a contract provides Even if a contract provides state bar number (required)

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True True True True True True date (required) q q q q q q A contract stating that one party If the contract is clear and sup If the contract is clear right to refrain from certain from right to refrain activities, the decision to do so must still be made in good faith. its rights “as it sees may exercise unfettered fit” gives that party discretion. ported by adequate consideration, by adequate ported is discretion a grant of unfettered the reason to be within considered able expectation of the parties. employee bonus, the employer is always bound by an implied covenant of good faith and fair dealing. For a contractual grant of unfet For a contractual it be effective, to discretion tered in the must be clearly expressed agreement. for Consideration is not required a clause granting unfettered discretion. When granting or denying an If a contract gives one party theIf a contract gives one party

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HOW TO RECEIVE ONE HOUR OF MCLE CREDIT False False False False False False False q q q q q q q to: True True True True True True True California Lawyer/MCLE Box 54026, Los Angeles, CA 90054-0026 P.O. q q q q q q q California Lawyer good faith. Even if conduct is specifically permitted by a contract, a party can engage in that conduct only in action that is expressly permitted action that is expressly by an agreement. The implied covenant does not taking from a party prohibit a contract so as to avoid the implied covenant of good faith and fair dealing. In California, parties cannot writeIn California, parties Rarely do contracting parties do contracting parties Rarely to exercise intend for one party discretion. unfettered party, there is never an obligation there party, to act in good faith. When an agreement invests one When an agreement power with a discretionary party the rights of the otheraffecting other party’s right to receive receive right to other party’s contractual benefits. The implied covenant of goodThe implied covenant one prevents faith and fair dealing unfairly frustrating the from party contains an implied covenant of implied covenant contains an good faith and fair dealing. In California, not everyIn California, contract law firm, company, or organization name (required) mation below. Mail this page and a check for $35 made payable Mail this page and a check for $35 made payable mation below. to Answer the test questions above, choosing the one best answer Answer the test questions above, choosing the one best answer infor- print the requested to each question. For timely processing, 7 6 5 4 3 2 Drafting Around Good Faith Around Drafting 1 SELF-ASSESSMENT TEST SELF-ASSESSMENT