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Every contract includes an implied covenant of good faith and fair dealing. Starr v. Fordham, 420 Mass. 178, 184 (1995); Anthony’s Pier Four, Inc. v. HBC Assoc., 411 Mass. 451, 473 (1991). “The implied covenant … provides ‘that neither party shall do anything that will have the effect of destroying or injuring the right of the other party to receive the fruits of the contract.’” Owen v. Kessler, 56 Mass. App. Ct. 466, 471 (2002). But what if a contractual provision gives one party unbridled discretion to act as he or she pleases? Is that discretion limited by the implied covenant of good faith and fair dealing?
Consider, for example, an employment contract which requires the employer to review the employee’s performance annually and to award the employee a raise which the employer’s board of directors deems appropriate. While the employer must conduct the performance review, the contract appears to vest the employer’s board of directors with unlimited discretion as to what factors should be considered in the performance review and what, if any, salary increase the employee should be given based upon that review. Can the employer exercise its contractual discretion by selecting performance criteria which it knows will produce a poor performance review? Can the employer, in its discretion, decline to give the employee a raise despite an excellent performance review? The covenant of good faith applies in both situations.
Where a contract grants discretion to a party, the covenant of good faith and fair dealing limits the exercise of that discretion. McAdams v. Massachusetts Mutual Life Ins. Co., 391 F.3d 287, 301 (1st Cir. 2004) (“The contract, read in light of the covenant of good faith and fair dealing, constrains MassMutual’s contractual discretion somewhat”); Allan Farnsworth, Farnsworth on Contracts, §7.17 at 365 (3d ed. 2004) (the covenant is often used to limit discretion where the terms of the contract give one side discretion over another).
The exercise of discretion as a pretext to improve one’s position is a breach of the covenant of good faith and fair dealing. Anthony’s, 411 Mass. at 473 (“Anthony’s use of a discretionary right under the agreements as a pretext justifies the judge’s ruling that Anthony’s breached the covenant…”); Concourse Ticket Agency v. Kraft, 1995 WL 809935, *2 (Mass. Super. 4/3/95) (“One party’s use of a discretionary right under an agreement as a pretext constitutes a breach of the covenant of good faith and fair dealing”). Stated another way, “where one party has the right to exercise discretion under the contract, it is bad faith to use that discretion to ‘recapture opportunities foregone on contracting as determined by the other party’s reasonable expectations.’” Piantes v. Pepperidge Farm Inc., 875 F.Supp. 929, 938 (D. Mass. 1995), quoting Anthony’s, 411 Mass. at 473. See also Farnsworth on Contracts, §7.17(a) at 329 (1990).
Thus, the covenant of good faith prevents the employer from exercising its discretion to deny the employee a raise despite a very favorable performance review. Doing so would defeat the employee’s reasonable expectations and entirely deprive the employee of the benefit of the contractual provision requiring annual performance reviews and appropriate salary increases.
An employer also violates the implied covenant by using its discretion to select performance criteria calculated to generate a poor performance review. The Supreme Judicial Court has held that the covenant is breached where a contracting party with discretion over the other party’s compensation intentionally selects performance criteria to minimize that compensation and fabricates negative factors which are used to lower the other party’s compensation. In Starr, a withdrawing partner sued a partnership, claiming that he had not been allocated his fair share of profits for his last year with the firm. Agreeing that the firm had acted in breach of the covenant of good faith and fair dealing, the court stated:
[A]n unfair determination of a partner’s respective share of a partnership’s earnings is a breach not only of one’s fiduciary duty, … but also of the implied covenant of good faith and fair dealing…. The judge found that the plaintiff had produced billable hour and billable dollar amounts that constituted 16.4% and 15%, respectively, of the total billable hour and billable dollar amounts for all of the partners as a group. The judge noted, however, that the founding partners distributed only 6.3% of the firm’s 1986 profits to the plaintiff. Meanwhile, the other partners received substantially greater shares of the profits. The judge concluded, therefore, that the founding partners had decided to exclude billable hour and billable dollar totals as a factor in determining compensation. The judge determined that this decision to exclude billable hour figures was unfair to the plaintiff and indicated that the founding partners had selected performance criteria in order to justify the lowest possible payment to the plaintiff. The judge also noted that Fordham had fabricated a list of negative factors that the founding partners had used in determining the plaintiff’s share of the firm’s profits. As a result, the judge concluded that the founding partners had violated their respective fiduciary duties to the plaintiff as well as the implied covenant of good faith and fair dealing….
420 Mass. at 184-85. (Emphasis added).
Even where a contract appears to grant unlimited discretion, the party exercising that discretion cannot act in a manner calculated to deprive the other party of the bargained for benefits of the contract. In short, there is no such thing, under Massachusetts law, as unlimited contractual discretion.
