Duty of Good Faith - Not Always a Reliable Safety Net

Anyone who has bought or sold a business has experienced the back and forth nature inherent in a typical transaction. Parties exchange documents back and forth with minor language tweaks, decision makers hold phone conferences to tie up loose ends—the seemingly endless negotiation can make even the most veteran business owner feel overwhelmed. Historically, a safeguard quelled many enduring this process. The duty of good faith and fair dealing, a long-recognized legal construct compelling parties to deal with one another fairly, acts as a baseline operating procedure to help ensure negotiating parties contract with a sense of honesty. The Uniform Commercial Code defines “good faith” as “honesty in fact and the observance of reasonable commercial standards of fair dealing.” This seems pretty straightforward. Unfortunately, the 7th Circuit recently narrowed good faith’s protections.

In Betco Corp. Ltd. v. Peacock, the Seller of a bioaugmentation company provided customers analyses of bacteria levels found in waste breakdown mechanisms. Buyer, through its due diligence process, determined that some customers required certificates of analysis to better guarantee bacteria levels. After the deal closed, Buyer further discovered that some products contained bacteria levels inconsistent with the certificates, and that some employees were deliberately falsifying records to rectify the difference. Fortunately for Buyer, it had withheld 10% of the purchase price ($500,000) to offset any problems encountered within the first two years after closing. Unfortunately for Buyer, it had paid out that escrowed money at a discount before the two-year window ended but after Buyer had discovered the aforementioned issues (which Buyer failed to formally investigate before paying out the escrowed funds). When the issues started to pile up, Buyer filed suit, including a claim for breach of the duty of good faith and fair dealing in the Purchase Agreement.

The 7th Circuit rejected Buyer’s claim, stating that Seller had not breached the duty of good faith and fair dealing. The Court’s analysis began by reaffirming the principle that every contract implies good faith and fair dealing between the parties to a contract. However, the crux of the opinion focused on relative expectations of parties and how expectations drive the duty of good faith and fair dealing.

In its opinion, the Court reasoned that, while there may have been some issues on Seller’s side, Seller satisfied a substantial portion of Buyer’s expectations. Buyer was aware of the issues before closing. In fact, Buyer discovered most of what it complained about during the due diligence period, long before either party made substantial strides towards closing. Importantly, the Court noted that a party can follow the letter of an agreement, but breach that party’s duties by violating the spirit of the agreement. In the eyes of the 7th Circuit, the inverse is also true: the spirit of an agreement can be followed, even if the letter is not. It all comes down to relative expectations. The Court went so far as to state, “A party can act in bad faith without injuring or destroying the other party’s ability to receive the benefits of the contract.”

Here, the Court determined Buyer expected to acquire a company free of customer complaints and had provided advance notice of certain defects within the products and the company. The company Buyer received checked both of those boxes, even if those factors were not helpful to Buyer. Functionally, Buyer received exactly what it bargained for when it closed the deal because, to the Court, Seller met all bargained-for expectations.

While this case seems like a lesson against paying out escrowed money too soon, there are important issues to consider if you are contemplating a merger or acquisition. The takeaway is this: clearly define your expectations via contract and make certain you address any issues discovered in due diligence before closing. Be certain that any issues you find in due diligence are properly vetted and rectified before closing. Your knowledge of important issues, especially those fundamental to the business, as was the case in Betco, should mandate a formal cure from the other side. Further, do not rely on the other side’s verbal assurance of cure. Having a dependable attorney on your side work through these issues before closing can mean the difference between a positive business transaction experience and a negative one. Your attorney can also ensure that you are not forced to rely on a legal principle as a safety net.

Written By:
Law Firm of Conway, Olejniczak & Jerry, S.C.