Implied Covenants
The National Law Journal, December 2000

By Michael Starr and Jordan Lippner

The California Supreme Court's recent decision in Guz v. Bechtel Nat'l, Inc., 8 P.3d 1089 (Cal. 2000), represents a dramatic shift that will change the face of employment law for years to come. For the last quarter century, courts in many states, especially California, have led a sustained assault on the doctrine of at-will employment. One weapon in that campaign has been to invoke (in our view, misconstrue) the traditional contract-law principle of the implied covenant of good faith and fair dealing to impose liability on employers for acting "arbitrarily" or in "bad faith" in discharging long-term employees. Under this theory, at-will employment was, in practice, transmogrified into just-cause employment just by the passage of time.

The Guz decision brings this trend to an abrupt end in California and restores the law of employment contracts to what it had previously been. Significantly, Guz is, in this regard, the culmination of legal developments that have been unfolding in other states for quite some time. It can now be said with some confidence that the implied covenant of good faith and fair dealing, which is implied by law in every contract, does not impose generalized obligations of fairness on employers. The prevailing law now is that, absent a statutorily proscribed purpose, private-sector employers have the right to fire their at-will employees for any or no reason unless doing so would violate public policy or some implied-in-fact restriction on the employer's prerogatives.

Employer's Presumed Duty of Good Faith and Fair Dealing

Twenty years ago, acknowledging academic criticism of the perceived excesses of at-will employment, two intermediate appellate California courts invoked the good faith and fair dealing covenant to rule that employers could not arbitrarily discharge their long-term employees even if they were employed at-will. See Pugh v. See's Candies, Inc., 116 Cal. App. 3d 311 (1981); Cleary v. American Airlines, Inc., 111 Cal. App. 3d 443 (1980) (further holding that breach of covenant provided for tort damages).

These decisions fueled a judicial reformation in the field of employment law. Over time, courts in California and many other states began operating on the assumption that "because the arbitrary termination of an employee is neither fair nor in good faith, such conduct violates the implied covenant contained in every employment contract, regardless of its terms." Guz, 8 P.3d at 1105 (discussing cases). This, among other doctrines, gave at-will employees in certain states job-security rights comparable to those enjoyed by individuals employed under fixed-term employment contracts.

These developments sparked a counter-reformation of sorts led by New York, a bastion of at-will employment. The highest court in that state was unmoved by arguments that "the freedom of contract underpinnings of the [at-will] rule have become outdated, that individual employees in the modern work force do not have the bargaining power to negotiate security for the jobs on which they have grown to rely, and that the rule yields harsh results for those employees who do not enjoy the benefits of express contractual limitations on the power of dismissal." See Murphy v. American Home Prods. Corp., 58 N.Y.2d 293, 301 (1983).

Any departure from the at-will rule was, the court said, "best left to the Legislature." Id. The court specifically addressed the implied covenant of good faith and fair dealing - which had been pioneered in New York by Judge Cardozo's decision in the law-school classic, Wood v. Lady Duff-Gordon, 222 N.Y. 88 (1917) - and explained that any implied-at- law covenant must be "in aid and furtherance of" the other terms of the parties' agreement and could not be found where it was "inconsistent with other terms of the contractual relationship." Murphy, 58N.Y.2d at 303. Accordingly, the Murphy Court ruled that the implied good-faith covenant could not restrict an employer's "unfettered" right to terminate an at-will employment contract, since that would be incongruous with the contract's express provision that it was terminable at will. Id. at 304. (This concept presumes that every worker has an employment contract, albeit typically oral and terminable at will. Unlike the old master-servant concept, the employment relationship is, under modern law, contractual, not status-based.)

The Current Meaning of the 'Good Faith' Covenant

In Guz, the California Supreme Court addressed, for the first time, the scope and limits of the covenant of good faith and fair dealing in the at-will employment context. There, Mr. Guz had worked for his employer for 22 years, working his way up from an administrative assistant position with a $750 per month salary to his final position as a financial reports supervisor earning more than $70,000 a year. Throughout his 22 years of service, Mr. Guz received "steady raises and promotions" and his performance reviews were "generally favorable." Nonetheless, when the company restructured and eliminated a division, the 50-year old Mr. Guz was one of the employees the company discharged.

In his suit, Mr. Guz claimed, among other things, that the covenant of good faith and fair dealing "precluded Bechtel [his employer] from terminating him arbitrarily . . . or in bad faith." Guz, 8 P.3d 1094. He further decried that the reasons for eliminating his division - an alleged need for cost reduction and a downturn in business - were arbitrary, false and pretextual, citing a company report announcing that Bechtel had enjoyed "an exceptional year."

In rejecting this claim, the California Supreme Court noted that the implied covenant of good faith and fair dealing "exists merely to prevent one contracting party from unfairly frustrating the other party's right to receive the benefits of the agreements actually made." Id, at 1110. Consequently, as the court explained, that covenant "cannot impose substantive duties or limits on the contracting parties beyond those incorporated in the specific terms of their agreement." Id.

The defining feature of at-will employment is that the employee has no contractual right to continued employment. Thus, as Guz explains, "precisely because employment at will allows the employer freedom to terminate the relationship as it chooses, the employer does not frustrate the employee's contractual rights merely by doing so." Id. In other words, Bechtel's discharge of Mr. Guz, even if conducted in bad faith or in an arbitrary manner, did not and could not frustrate any contractual right Mr. Guz had because his at-will contract gave Bechtel the right to terminate him for any reason at all - good, bad or ugly. Because employers in the at-will employment context have no contractual limit on their discharge prerogatives, their "motive and lack of care in doing so are, in most cases at least, irrelevant." Id at 1111.

The only cases where the implied covenant has any force are those in which the employer acts in bad faith to frustrate an employee's receipt of a benefit expressly stated or implied-in-fact under the at-will employment contract. This could occur, for example, if an employee is fired solely for the purpose of cheating him out of compensation which had already been earned. See, e.g., Guz, 8 P.3d 1112; King v. Driscoll, 424 Mass. 1, 6 (1996). Even in such cases, the breach of the implied covenant is a fortiori a breach of the contract in which it is implied, rendering a separate claim for breach of the covenant superfluous. And, as the Guz Court and others have now made clear, any remedy for such a breach does not lie in tort, but "is solely contractual." 8 P.3d at 1112.

Policies Creating Implied-in-fact Restrictions

The other contract issue raised in Guz is whether circumstances emanating from the employment relationship, such as employee handbooks and other company policies, created an implied-in-fact agreement restricting the employer's otherwise unfettered right of termination. Styling this the implied contract claim (as opposed to the implied-covenant claim), the Guz court aptly stated that because the employment relationship is "fundamentally contractual," an employer and an at-will employee are free to reach another understanding that places limitations on one another's termination rights. Thus, for example, if an employer and at-will employee reach an understanding that the employee will be fired only under certain circumstances or after certain disciplinary procedures have been followed, there is no reason not to give that agreement legal effect. Guz ruled that this "other" understanding "need not be express, but, may be implied in fact, arising from the parties' conduct evidencing their actual mutual intent to create such enforceable limitations." Id. at 1101.

Mr. Guz argued that he had an implied-in-fact agreement with his employer that he would not be fired as long as he was performing satisfactorily. The court rejected Mr. Guz's contention that his longevity, regular raises, promotions, and good performance alone established enforceable limitations on his employer.

The court did, though, find that Bechtel had, in fact, "otherwise" limited its right to discharge by promulgating a company policy that employees would not be discharged until they were warned about their unsatisfactory job performance and given an opportunity to improve. Though the very policy relied on by Mr. Guz contained an at-will disclaimer - namely, that company employees "have no . . . agreements guaranteeing continuous services and may be terminated at [Bechtel's] option" - this, the court held, did not adequately foreclose the possibility that such a limitation existed. Even so, Mr. Guz failed on this ground because the implied limitation on performance-based discharge did not preclude the company from deciding to eliminate an entire division or restrict the manner by which it effected the reorganization. Mr. Guz did succeed, however, on his argument that Bechtel's own published layoff procedure created implied-in-fact obligations to him that Bechtel allegedly had breached. Mr. Guz, the court held, could properly recover for that.

Not surprisingly, the law in New York is otherwise. The New York Court of Appeals in De Petris v. Union Settlement Ass'n, 86 N.Y.2d 406 (1995), unequivocally stated that unless an employer makes the employee "aware of its express written policy limiting its right of discharge" and the employee "detrimentally relie[s] on that policy in accepting employment," the arbitrary or "bad faith" firing of that employee will not "give rise to a legally enforceable claim." Id., 86 N.Y.2d at 410. Thus, in New York, implied-in-fact restrictions on an employer's right to discharge requires an express written policy (not just a custom or practice) on which the employee relied when hired. In California and many other states, employees need not show nearly as much.

Avoiding Pitfalls that Dilute Termination Prerogatives

Perhaps the single most important lesson of Guz for employers is that all of their personnel policies must be drafted so as to avoid any possible inference of an "actual mutual intent" to limit their otherwise unfettered discretion to discharge at-will employees. Naturally, a plain-English at-will disclaimer that is contained in every offer letter, employee handbook and other policy statement, is signed by the employee and expressly states that the employee's at-will status cannot be changed except by an express writing signed by an authorized company representative, is indispensable. But it is not enough.

Rather, every policy must be drafted so as to imply discretion by, for example, speaking in terms of what the company may do or customarily or generally does, but not what it will do. In addition, policies and handbooks should not speak of "rights" to which employees are "entitled," but should rather inform employees of "benefits" for which they are "eligible" and will be "granted" in the employer's discretion. Similarly, employers should not "reserve" rights for themselves because that suggests that there are other rights that were given away to their employees.

Michael Starr is a partner in the Labor and Employment Group of Hogan & Hartson L.L.P.

A version of this article appeared in The National Law Journal. This article is reprinted with permission from the December 25, 2000 edition of The National Law Journal. �2000 NLP IP Company