John L. Diamond et al., Understanding Torts ' 19.03 (2000)

Good Faith

In each contract, there is an implied covenant of good faith and fair dealing.¹ The purpose of the implied covenant is to allow for the terms of contracts to be interpreted fairly.² Consequently, what constitutes a breach of the covenant depends on the particular terms of the contract. If A contracts with B to perform when the clock strikes at noon, the implied covenant of good faith would impose liability if A destroyed the clock to avoid having to meet the precise terms of the contract.

While the covenant is in essence an implied contract term, occasionally courts have held that the breach of the implied covenant of good faith and fair dealing can also constitute a tort.³ This allows for tort damages as well as contract damages. Tort damages can include, in addition to consequential economic loss, mental distress and punitive damages, where malice is proven. Such tort damages can far exceed ordinary contract damages. While contract remedies recognize that a breach may in fact be economically efficient and are therefore not intended to be punitive, the extensive potential tort damages are a response to what is viewed, at the least, as a serious private wrong.

The tortious breach of the covenant of good faith and fair dealing is generally limited to breaches by insurance companies in particular contexts. An insurance company's bad faith refusal to pay the insured can exist when an insured has suffered a loss and the insurer, as a result, has greater leverage over its claimant. In these situations, the tort of breach of the covenant of good faith and fair dealing provides an appropriate countermeasure against intentional efforts to deny or wrongfully reduce indemnification for a legitimate claim.⁴ Without the threat of mental distress and punitive damages available in the tort action, an insurance company could potentially intentionally stonewall a valid claim from its client, recognizing that litigation, if pursued by the claimant, could at worse compel the company to pay only what it had refused to pay initially under the insurance contract.⁵ However, there are concerns that the tort will subsume contract law's delicate effort to enforce contract expectations ⁶ by excessively punishing defendants, deterring economically efficient contract breakers, or recklessly creating high stakes litigation.

As noted above, courts ordinarily apply tortious breach of the covenant of good faith and fair dealing only in the context of insurance contracts.⁷ For example, in Foley v. Interactive Data Corp.⁸ the California Supreme Court refused to extend the tortious breach of the covenant of good faith and fair dealing to employment contracts by concluding that employers have economic incentives to treat employees fairly. Therefore, any bargaining disparity is not comparable to the insurance context.⁹

Prior to its decision in Foley, the California Supreme Court in Seaman's Direct Buying Service, Inc. v. Standard Oil Co.,¹⁰ held that a bad faith denial of the existence of a commercial contract could constitute a tort. The decision received national prominence for its implications for the ultimate expansion of the bad faith tort to all contracts. Seaman=s was generally criticized and rarely followed.¹¹ In 1995, the California Supreme Court overruled Seaman=s and joined with other states in limiting the bad faith tort to the insurance context.¹²

1 "Every contract imposes upon each party a duty of good faith and fair dealing in its performance and enforcement." Restatement (Second) of Contracts ' 205.

2 See generally Alfred Hill, Breach of Contract as a Tort, 74 Colum. L. Rev. 40 (1974).

3 One of the earliest cases is Crisci v. Security Ins. Co., 426 P.2d 173 (Cal. 1967), where the court allowed an insured to recover for emotional damages suffered as a result of the insurer=s refusal to settle a claim. The refusal was deemed a breach of the covenant of good faith and fair dealing. See also Gruenberg v. Aetna Ins. Co., 510 P.2d 1032 (Cal. 1973); Egan v. Mutual of Omaha Ins. Co., 620 P.2d 141 (Cal. 1979). But see A.A.A. Pool Service & Supply Co. v. Aetna Casualty & Surety Co., 395 A.2d 724 (R.I. 1978), where the court did not allow a bad faith refusal to settle an insurance claim to comprise an independent tort action.

4 "The relationship of insurer and insured is inherently unbalanced: the adhesive nature of insurance contracts places the insurer in a superior bargaining position." Egan v. Mutual of Omaha Ins. Co., 620 P.2d 141, 146 (Cal. 1979).

5 See, e.g., Egan v. Mutual of Omaha Ins. Co., 620 P.2d 141, 147 (Cal. 1979), where the plaintiff "received his first payment from Mutual on the claim in issue only after a long delay and a personal visit to the claims office. Testimony was introduced that McEachen [Mutual's agent], although aware of plaintiff's good faith efforts to work, called plaintiff a fraud and told him that he sought benefits only because he did not want to return to work. When plaintiff expressed his concern regarding the need for money during the approaching Christmas season and offered to submit to examination by a physician of Mutual's choice, McEachen only laughed, reducing plaintiff to tears in the presence of his wife and child."

6 Tort application "has the potential for distorting well-established principles of contract law." Beck v. Farmers Ins. Exchange, 701 P.2d 795, 799 (Utah 1985).

7 See, e.g., Nichols v. State Farm Mutual Auto. Ins. Co., 306 S.E.2d 626 (S.C. 1983) (bad faith refusal to pay benefits of automobile policy to insured); see also Green v. State Farm Fire & Casualty Co., 667 F.2d 22 (9th Cir. 1982) (bad faith refusal to pay fire policy; the defendant maintained that the cause of the fire was arson, but did not sufficiently support this argument).

8 765 P.2d 373 (Cal. 1988).

9 See, e.g., Thompson v. St. Regis Paper Co., 685 P.2d 1081 (Wash. 1984).

10 686 P.2d 1158 (Cal. 1984). See also Eileen A. Scallen, Comment, Sailing the Unchartered Seas of Bad Faith: Seaman's Direct Buying Service Inc. v. Standard Oil Co., 69 Minn. L. Rev. 1161 (1985); Steven B. Katz, Note, The California Tort of Bad Faith Breach, the Dissent in Seaman's v. Standard Oil, and the Role of Punitive Damages in Contract Doctrine, 60 S. Cal. L. Rev. 509 (1987); James H. Cook, Comment, Seaman's Direct Buying Service Inc. v. Standard Oil Co.: Tortious Breach of the Covenant of Good Faith and Fair Dealing in a Noninsurance Commercial Contract Case, 71 Iowa L. Rev. 893 (1986).

11 The subtle distinction between disputing the existence of a contract in good faith and denying it in bad faith has concerned courts. Witness Judge Kozinski's concurring opinion in Oki America, Inc. v. Microtech Int'l Inc., 872 F.2d 312, 314-315 (9th Cir. 1989):

Nowhere but in the Cloud Cuckooland of modern tort theory could a case like this have been concocted. One large corporation is complaining that another obstinately refused to acknowledge they had a contract. For this shocking misconduct it is demanding millions of dollars in punitive damages. I suppose we will next be seeing lawsuits seeking punitive damages for maliciously refusing to return telephone calls or adopting a condescending tone in interoffice memos. The intrusion of the courts into every aspect of life trivializes the law, and denies individuals and businesses the autonomy of adjusting mutual rights and responsibilities through voluntary contractual agreement.

12 See Freeman v. Mills, Inc. v. Belcher Oil Co., 900 P.2d 669 (Cal. 1995). But see Story v. Bozeman, 791 P.2d 767, 776 (Mont. 1990), extending bad faith tort to contracts where parties have special relationship.