Franchisee Prevails Early on Covenant of Good Faith and Fair Dealing Claim

One of the few tasks more daunting than trying to get Kant, Nietzsche and Plato to agree on a definition of ‘the good life’ is that of struggling to get two courts to agree on the legal meaning of the covenant of good faith and fair dealing. Indeed, some courts vociferously object to using the phraseology itself, arguing that the word ‘covenant’ must be replaced by the word ‘duty.’ Other courts refuse to allow such a claim to be prosecuted unless the claimant also pleads a concomitant and redundant breach of an explicit provision in the contract. And, a few other courts adamantly deny the existence of the covenant of good faith and fair dealing.

This energetic jurisprudential fracas among courts regrettably has not been quelled by the scores of scholarly articles that have been written on the subject; indeed, the prolific academic commentaries have done little more than throw gasoline on the intense intellectual blaze.  Not surprisingly, this existential inferno has scorched, and continues to char, many franchisees and dealers.  However, despite the terrible historical track record of franchisees that have tried to use the covenant of good faith and fair dealing in litigation against their franchisors, from time to time a franchisee does have success using the theory. One such franchisee is the auto dealer plaintiff in a case now pending before the United States District Court for the Eastern District of New York. Valley Stream Foreign Cars, Inc. v. Honda Motor Co., Inc., United States District Court for the Eastern District of New York (September 22, 2016).

Summary of Valley Stream Foreign Cars

In Valley Stream, a Honda dealer operating in Valley Stream, New York (“South Shore Honda”) sued its auto distributor, Honda (“Honda”), for allegedly breaching the covenant of good faith and fair dealing by refusing to enforce the franchisor’s wholesaling policy against the system’s non-complying dealers. In refusing to grant Honda’s motion to dismiss the dealer’s claims, the New York federal Court recognized that the dealer had pled a cognizable breach of the covenant of good faith and fair dealing based on the dealer’s allegations that the franchisor’s failure to enforce the wholesaling policy prevented the dealer from exercising its right to earn profits from the sale of vehicles.

In 2003, Honda and South Shore Honda entered into a Honda Automobile Dealer Sales and Service Agreement (the “Dealer Agreement”), which granted the plaintiff the right to sell and service Honda products as a Honda dealer. The primary conduct attacked by the franchisee in the litigation is known as “wholesaling”, which was governed by Honda’s Wholesaling Policy (the “Wholesaling Policy”), a document separate from the main Dealer Agreement. The Wholesaling Policy defined wholesaling as the sale or lease and delivery of new Honda Vehicles to persons other than (1) the ultimate end user of such vehicles, (2) a leasing company or (3) another authorized Honda Dealer. Notably, the preamble to the Wholesaling Policy stated that Honda “believes that such wholesaling is inconsistent with the Honda Automobile Dealer Sales and Service Agreement” which limits “authorized Honda Dealers to retail sales and retail leases from the authorized Honda Dealers’ premises and prohibits the creation of additional dealership locations.” The Wholesaling Policy also stated that Honda “will strictly enforce the Dealer Agreement and require that Honda Dealers not engage in Wholesaling of Honda Vehicles.”

The Wholesaling Policy also included a section entitled “Enforcement of Wholesaling Policy,” which described the processes that were to be followed for cases in which wholesaling has occurred or is alleged to have occurred. It also included procedures for the submission of reports by dealers to Honda and for Honda to conduct periodic audits of dealers, as well as the methods for Honda to make findings and for dealers to respond to such findings. Further, a related section described Honda’s “Remedies in the Event of a Violation,” which included adjusting a dealer’s allocation of vehicles, charging back incentives and marketing assistance, and not considering the dealer for any additional dealership locations for five years. Last, the Wholesaling Policy also contained a clause stating that Honda “considers any Wholesaling to be inconsistent with the Dealer Agreement” and thus, “reserves its rights to take appropriate action to prevent such Wholesaling.”

Plaintiff alleged that authorized Honda dealers located outside of plaintiff’s Area of Statistical Analysis (“ASA”) wrongfully engaged in wholesaling by “utilizing intermediaries to sell their Honda vehicles to customers who reside within plaintiff’s ASA” and that, despite receiving information about this wholesaling, Honda refused to initiate audits of the offending dealers or otherwise take any steps to curtail the wholesaling. Plaintiff also alleged that that Honda had “failed to strictly enforce its Dealer Agreement” and that this has “negatively skewed” Honda’s “evaluation of plaintiff’s retail sales performance” and caused plaintiff to lose “numerous sales of Honda vehicles in its ASA and the profits generated from those sales,” totaling at least $12 million.

Court’s Ruling in Valley Stream Foreign Cars

The Court addressed, as a threshold issue, whether the Wholesaling Agreement was incorporated by reference into the Dealer Agreement. In this regard, the Court pointed out that whether an extrinsic document is deemed to be incorporated by reference is a matter of law, and under New York law, “the doctrine of incorporation by reference requires that the paper to be incorporated into the written instrument by reference must be so described in the instrument that the paper may be identified beyond all reasonable doubt.” Applying this standard, the Court quickly concluded that “Here, the Wholesaling Policy is not identified or described in the Dealer Agreement beyond all reasonable doubt.”

Relying upon the franchisee’s awkward position that if the Court were to find the Wholesaling Policy not to be incorporated by reference into the Dealer Agreement, the franchisee would then pursue only its claim for breach of the implied covenant of good faith and fair dealing, the Court dismissed the plaintiff’s straight contract claim and considered only the breach of the implied covenant of good faith and fair dealing claim. After disposing of the incorporation issue, the Court turned to Honda’s main argument that it had no legal obligation to enforce the Wholesaling Policy.

The Court began its legal analysis by setting out the common proposition that “Under New York law, a covenant of good faith and fair dealing is implicit in all contracts during the course of contract performance.” The Court further explained that the covenant “embraces a pledge that neither party shall do anything which will have the effect of destroying or injuring the right of the other party to receive the fruits of the contract.” Interestingly, the Court viewed the covenant as including a controversial component, stating: “in some cases, the covenant may even require affirmative steps to cooperate in achieving the contract’s objective.” Concluding its definitional framework, the Court adopted a rather traditional limitation on the scope of the doctrine, warning that “the implied covenant can only impose an obligation consistent with other mutually agreed upon terms in the contract. It does not add to the contract a substantive provision not included by the parties.”

In turn, the Court identified the framework for deciding breaches of the covenant of good faith and fair dealing by again adopting a somewhat off-center principle: “In determining whether a party has breached the obligation or covenant of good faith and fair dealing, a Court must examine not only the express language of the parties’ contract, but also any course of performance or course of dealing that may exist between the parties.” As it completed its discussion of the abstract elements of a breach of the covenant of good faith and fair dealing, the Court seemed to authorize a broad-sweeping analysis: “Thus, whether particular conduct violates or is consistent with the duty of good faith and fair dealing necessarily depends upon the facts of the particular case, and is ordinarily a question of fact to be determined by the jury or other finder of fact.”

Applying this legal structure, the Court found that the plaintiff had in fact stated a plausible claim for breach of the implied covenant of good faith and fair dealing when it alleged that Honda’s refusal to enforce the Wholesaling Policy had prevented plaintiff from exercising its right to earn profits from the sale of Honda vehicles. In so ruling, the Court relied heavily on the description of the potential harm of wholesaling set forth in the Wholesaling Policy itself: “Honda explicitly acknowledges the potential harm wholesaling can inflict on Honda and its dealers, stating that ‘wholesaling is inconsistent with the Honda Dealer Sales and Service Agreement’ and that ‘transfers to intermediaries are detrimental to the best interest of Honda since they undermine Honda’s authorized Honda Dealer network, impair the ability of Honda to provide the highest level of customer satisfaction, create situations that tarnish the reputation of the Honda Division and Honda’s authorized Dealers for quality automobiles and service, and lead to lost sales.’”  Based on this, the Court was comfortable drawing the factual conclusion that “Honda has received reports of wholesaling, but has chosen to abandon its stated intention to enforce the Wholesaling Policy in order to prevent acknowledged economic and reputational harm.” And, in turn, the Court held that this was sufficient to support a plausible claim that the defendant is acting ‘arbitrarily or irrationally’ in violation of the implicit covenant of good faith and fair dealing in the Dealer Agreement. Although the Court had not identified this standard earlier, it stated here that “the implied obligation of each promisor to exercise good faith includes a promise not to act arbitrarily or irrationally”.

Court Rejects Franchisor’s Argument in Valley Stream Foreign Cars

In opposing this view, Honda had argued that the Wholesaling Policy did “not impose upon it an enforcement obligation” and that choosing not to ‘strictly enforce’ the Wholesaling Policy was an “exercise of discretion.” Honda also argued that the implied covenant of good faith and fair dealing cannot create new contractual rights and “imposing an obligation on a franchisor to ‘strictly enforce’ its contractual rights against all franchises would obviously add a new, substantive, and burdensome contractual provision.”

In rejecting Honda’s argument, and concluding that plaintiff had sufficiently stated a claim for breach of the implied covenant of good faith and fair dealing, the Court explained that Honda had misinterpreted the Court’s analysis – it did not find that the dealer necessarily had a right to the ‘strict enforcement’ of the Wholesaling Policy. Instead, according to the Court, it found that the plaintiff had adequately alleged that Honda had ‘arbitrarily acted’ counter to its stated interest and the interest of its dealers by “taking no steps to enforce its Wholesaling Policy” and, despite being made aware of wholesaling, “continuing to turn a blind eye to the Wholesaling.” In this regard, according to the Court, the complaint did not merely allege a lack of strict enforcement, but rather the complete abandonment of any enforcement by the franchisor. As the Court explained, “If the practice of wholesaling is known and widespread, and Honda is not taking any steps to curtail it, a plausible claim for breach of the covenant of good faith and fair dealing exists given the devastating economic and reputational impact that this practice is alleged to have on Honda and its dealers.”

The Court then completed its analysis by setting out a hybrid catch-all legal sub-tenet of the covenant of good faith and fair dealing that it believed fit the facts of the case: “Where a contract contemplates the exercise of discretion, ‘courts have equated the covenant of good faith and fair dealing with an obligation to exercise that discretion reasonably and with proper motive, not arbitrarily, capriciously, or in a manner inconsistent with the reasonable expectations of the parties.’” 

Notably, in a footnote appended to the decision, the Court also discussed, and rejected, Honda’s additional argument against recognizing a breach of the good faith based on a line of cases in which courts had declined to find that franchisors were obligated to enforce franchise standards against other franchisees. The Court did not find these cases persuasive, however, since, according to the Court, the manuals in the other cases, unlike the Wholesaling Policy in the Honda case, did not describe the specific economic and reputational harm a particular practice would cause the franchise system and the franchisees in the absence of enforced standards. Further, the Court noted that the franchisors in the other cases had not undertaken to “strictly enforce” those standards to prevent the acknowledged harm.

The Future of the Covenant of Good Faith and Fair Dealing in Franchising

As a franchise lawyer representing only franchisees and dealers, given the wide-ranging inadequacy of more traditional franchisee legal claims, I try to make use of the covenant of good faith and fair dealing in litigation on a regular basis. Regrettably, at best, the doctrine is rudderless, allowing piddling guidance to determine ahead of time whether the claim will be a hit or a miss; at worst, it is an ineffectual ersatz concept, consisting of  little more than traditional contract interpretation. Making matters worse for franchisees is that courts have almost universally and vociferously refused to allow franchisees in particular to use alternative legal doctrines that arguably could have served as functional substitutes for a breach of the covenant of good faith and fair dealing, including negligence, breach of a fiduciary duty, or unconscionability.  

Given the lethargic pace of franchise legislation, as well as the dearth of state statutes that create a duty based on the covenant of good faith and fair dealing, it will be up to franchisees and their lawyers to create, flesh out and animate claims based on the covenant of good faith and fair dealing on a case by case basis. Although this process necessarily will be anemic, convoluted and lingering, there are no other practical alternatives.

By: Jeffrey M. Goldstein, Esquire

(202) 293-3947

Washington, DC

*/ Thanks to Noah Adam Goldstein for Proof Reading Review on this Article

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