Daily Development for Monday: March 20, 1995           

 

By: Patrick A. Randolph, Jr.
Elmer F. Pierson Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin
Kansas City, Missouri
prandolph@cctr.umkc.edu

 

LANDLORD/TENANT; DUTY OF GOOD FAITH AND FAIR DEALING:  Seventh Circuit rules that one party to a lease must warn the other party when the other party is about to take an action that might lead to an adverse result under the terms of the lease.  Market Street Assoc. v. Frey, 21 F.34d 782 (7th Cir. 1994). 

 

Two parties agreed to establish a sale/leaseback arrangement whereby the buyer/landlord (the "Landlord") would acquire vacant land and lease it back to the seller/tenant (the "Tenant") for a twenty five year term under circumstances in which the Tenant was expected later to develop the property. Landlord was a major real estate lender, and the lease agreement provided that when Tenant was ready to develop, it would inquire for a loan from Landlord and Landlord and Tenant would negotiate in good faith over the terms of that loan.  If, following such negotiation, Landlord did not make the loan to Tenant, Tenant had the right to buy the property back from Landlord at a price set by a schedule set forth in the lease.  Tenant did not elect to develop the property right away, and, twenty years later, transferred the property to an assignee third party  (the "Assignee").  (Although not particularly relevant to the case, the Assignee was PharMor.) 

 

Assignee contacted Landlord informally and asked about buying the property, and Landlord's property manager quoted a selling price that Assignee was unwilling to pay.  Assignee then inquired about borrowing to develop the property.  It sought financing for $2 million.  Landlord's manager told Assignee that Landlord typically only made loans for $10 million or more.  Nevertheless, Assignee sent a formal financing proposal asking for financing "pursuant to the Lease," but Assignee did not mention that Landlord's failure to agree to financing would give Assignee a right to buy the property at the price set forth in the lease, which was by this time a bargain price.  

Landlord responded with a form letter refusing to make the loan because of its size.  Following one more letter, Tenant went ahead and arranged financing with third parties and, thereafter, tendered the "bargain price" to the Landlord.  For the first time, Landlord became aware of the situation created by its failure to read the lease and bargain for financing.  It offered at this point to finance, but Tenant refused, and demanded specific performance of the sale agreement.

 

Held:  If Tenant believed that Landlord was unaware of the risk of refusing to extend financing terms, Tenant had a duty of good faith and fair dealing to warn Landlord before it took advantage of the sale clause.  Here, on an earlier remand, the trial court had found that Tenant had intended to take advantage of Landlord's carelessness.  This was a breach of Tenant's duty.  Specific performance denied.

 

Note:  The court specifically was not relying on the language of the lease requiring that the parties negotiate for financing terms in good faith. Instead, it was relying on the general duty of good faith and fair dealing implied into every contract as a matter of the common law of Wisconsin.

 

Comment:  It is true that the court made a specific finding that the Tenant here intended to take advantage of Landlord's carelessness, but the impact of the rule in practice will go far beyond punishing devious bargaining strategies.  The court fails to take into account the impact of its ruling on the conduct of the parties in future negotiations.  Parties operating under a lease will always be compelled to anticipate that a court might rule that they acted in bad faith, and consequently will regularly have to call the other side's attention to particular aspects of the leasing documents.  In effect, each side to what has traditionally been an adversarial relationship becomes the other's fiduciary.  We should keep in  mind that the issue eventually will reach a court typically when there is something at stake:  a loss to be allocated or a business advantage to be gained.   The court's view of the reasonableness of a party's conduct will be influenced by the outcome of its ruling on the court's view of the "fairness" of the result in the abstract -

rather than as the contract allocates the result.. 

 

It is unclear whether the rule of this case would extend to negotiations, when the parties are not already in a contract relationship, but there is certainly the chance that it will so extend.  There have already been a few cases declaring that there is a duty of good faith and fair dealing even in bargaining.  The upshot, if parties really abide by the admonition of the case, will be exhaustive disclosures and warning documents - the equivalent of a registration statement, accompanying every contract initiative or negotiation offer. 

 

The fact is, parties to commercial contracts cannot live with this kind of burden on their negotiating freedom.  Likely, they will ignore it and suffer the unfortunate consequence when a creative lawyer comes up with the "Market Street" doctrine.  An ironic name - since the rule of this case changes  real estate negotiations from a "marketplace" to a support group.

 

Note that there is no reason that the case should be limited to leases.  Logically, it should apply as well to financing arrangements and purchase agreements - both of which are in any event implicitly involved in this case.

Note also that we are not dealing with "widows and orphans" here.  The Landlord in the case was the General Electric Employee's Pension Trust.  The original Tenant was Penny's.  Do such players really need the court's help in setting aside the consequences of their contracting acts?  Do they even want that help?

 

Practice Tip:  There is authority that the implied duty of good faith and fair dealing can be waived if done knowingly and particularly.  Good drafting practice might focus on those areas of the contract in which absolute rights are intended, and insertion of waivers in those places.  That practice probably would not have resulted in waivers in this clause, of course

 

Readers are urged to respond, comment, and argue with the daily development or the editor's comments about it.

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