Good Faith and Fair Dealing in Fund Finance Transactions

Executive Summary

Every contract is subject to an implied duty of good faith and fair dealing pursuant to principles established under common law, state statutes, and, with respect to certain contracts, including fund finance credit documentation, the Uniform Commercial Code (“UCC”). While lenders and borrowers are permitted to pursue their respective interests, they are obligated to act in good faith. In practical terms, this duty becomes relevant when fund finance lenders exercise discretion over such matters as borrowing base calculations, investor exclusions, valuations, and default remedies.

Background: Sources and Scope of the Good Faith Obligation

All contracts carry an implied duty of good faith and fair dealing, with its source determined by the applicable law:

UCC: With respect to contracts governed by the Uniform Commercial Code (including fund finance credit documentation), UCC § 1-304 explicitly mandates good faith in both contract performance and enforcement. UCC § 1-201 defines good faith as requiring honesty in fact, as well as adherence to reasonable commercial standards of fair dealing.

State Law: Most states recognize this obligation as inherent to every contract. Spring Creek Expl. & Prod. Co., LLC v. Hess Bakken Inv., II, LLC, 887 F.3d 1003, 1019 (10th Cir. 2018), as revised (Apr. 13, 2018).

Common Law: The Restatement (Second) of Contracts § 205 articulates that “[e]very contract imposes upon each party a duty of good faith and fair dealing in its performance and its enforcement.” While the Restatement does not constitute binding authority, courts frequently reference it as persuasive precedent.

In fund finance transactions, which combine secured obligations governed by the UCC with extensive contractual provisions, the duty of good faith and fair dealing is a fundamental principle governing interactions between lenders and borrowers throughout the transaction.

The Limits of Contractual Discretion

The UCC does not allow parties to waive the duty of good faith and fair dealing. Parties can establish performance standards if they aren’t “manifestly unreasonable.” Critically, even where credit agreements grant a lender “sole and absolute discretion” over some matters, this language does not confer unlimited authority. While approaches vary by jurisdiction, courts increasingly interpret such discretionary provisions to include an implicit reasonableness requirement tied to the good faith obligation. As one court explained, “[w]hen a contract contemplates the exercise of discretion, the covenant of good faith and fair dealing includes a promise not to act arbitrarily or irrationally in exercising that discretion.” Mancini v. UBS AG, New York Branch, 757 F. Supp. 3d 571, 579 (S.D.N.Y. 2024).

This principle applies whether discretion is framed as “reasonable,” “sole,” or “absolute”:

• When discretion is granted under “reasonable” standards, courts employ an objective approach to determine whether the decision was commercially reasonable and consistent with established market practices. Martorella v. Deutsche Bank Nat. Tr. Co., 931 F. Supp. 2d 1218 (S.D. Fla. 2013).
• Even where discretion is described as “sole” or “absolute,” courts frequently interpret such terms to include a reasonableness condition. Kinzel v. Bank of Am., 850 F.3d 275 (6th Cir. 2017).

Borrowers often seek clear terms to prevent arbitrary or bad-faith decisions about loan access, while lenders want flexibility to protect their interests. The good faith requirement provides the legal framework that balances these competing concerns.

Understanding What Constitutes a Breach

Courts have traditionally resolved disputes over good faith by carefully examining the facts of each case. For a breach to occur, courts usually hold that a party must have deliberately acted contrary to the contract's intended purpose or prevented expected benefits; mere errors or poor decisions aren't enough. According to Shibata v. Lim, 133 F. Supp. 2d 1311 (M.D. Fla. 2000), a breach is present if conduct “unfairly frustrates the agreed common purpose and disappoints the reasonable expectations of the other party.”

Notably, the duty of good faith does not preclude a party from pursuing its own interests. Parties to fund finance transactions retain the ability to exercise discretion or negotiate terms that are beneficial to themselves, provided their conduct is not arbitrary, malicious, or unreasonable. Judicial precedent establishes that acting in self-interest under contractual rights is not, by itself, a breach of good faith; rather, a violation arises only when improper motives drive the conduct. Arch Ins. Co. v. Centerplan Constr. Co., 368 F. Supp. 3d 350, 372-73 (D. Conn. 2019), aff'd 855 F. App'x 11 (2d Cir. 2021).

Best Practices for Fund Finance Transactions

Understanding how the duty of good faith applies in specific contexts is essential for both lenders and borrowers. The following scenarios illustrate common situations where good faith obligations come into focus:

Borrowing Base Decisions

In subscription credit facilities, lenders typically have discretion to determine which investor capital commitments are eligible for inclusion in the borrowing base. That discretion is generally expected to be exercised in good faith, meaning that any exclusion or limitation should be based on legitimate credit or legal concerns, such as a decline in an investor’s creditworthiness or enforceability risk, rather than solely to restrict the borrower’s liquidity.

In net asset value facilities, lenders may exercise discretion in valuing fund assets. Even when acting under “sole discretion,” good faith necessitates that asset valuations adhere to fair and commercially recognized standards. Arbitrarily reducing asset values to prompt a default or enhance negotiating leverage could constitute a breach of the duty of good faith.

Practical guidance: Ground borrowing base and valuation decisions on documented credit analyses, obtain third-party valuations where appropriate, and ensure that determinations align with industry standards.

Determining Material Adverse Effects

Credit agreements commonly include provisions stating that the occurrence of a “material adverse effect” (MAE) will permit the lenders to take certain protective actions, such as removing an investor and its capital commitment from the borrowing base, accelerating repayment, or suspending advances. The scope and application of MAE provisions are often subject to substantial negotiation, as borrowers are concerned about overly broad or vague language that could allow lenders excessive discretion.

Under UCC § 1-304, any determination or exercise of rights is governed by the duty of good faith and fair dealing. When invoking an MAE, lenders cannot act arbitrarily or dishonestly, regardless of contractual language granting “sole discretion.” Decisions must be grounded in legitimate commercial concerns, such as creditworthiness, enforceability, or significant changes in legal or financial circumstances.

Should a lender trigger MAE-based rights without a valid and objective reason, the borrower may have grounds to claim a breach of good faith and fair dealing.

Practical guidance: Base MAE determinations on thorough credit analysis or other objective criteria relevant to the situation, consult legal counsel and carefully document the reasoning underlying decisions, and communicate the rationale for invoking MAE provisions clearly and transparently to borrowers.

Exercising Default Remedies

Upon the occurrence of an event of default, the lender is entitled to exercise certain contractual rights, such as suspending further advances, demanding immediate repayment of all outstanding loans, or exercising other remedies available under the credit agreement. Subscription credit facilities frequently include a standstill period, which grants the borrower a short timeframe to repay the facility, typically through the general partner issuing a capital call to its limited partners, before a foreclosure.

Should the borrower fail to repay the facility as required during the standstill period, the lender may assume the right to issue capital calls. Such actions require both lender and borrower to cooperate in good faith, given their potentially intrusive nature. Borrowers are expected to assist by providing current contact information for limited partners, while lenders must ensure that any capital call aligns with the requirements specified in the limited partnership agreement and related fund documents.

Practical guidance: When exercising default remedies, particularly those involving direct interaction with limited partners, document all communications, follow fund governing documents precisely, and maintain professional cooperation with the borrower to the extent possible.

Key Takeaways

• Good faith is non-waivable: Even “sole discretion” language does not eliminate the duty to act reasonably and honestly.
• Document your rationale: Whether making borrowing base determinations, invoking MAE provisions, or exercising default remedies, maintain clear records of the business justification for discretionary decisions.
• Self-interest is permitted, but arbitrariness is not: Parties can pursue their contractual rights and protect their economic interests, but decisions must be grounded in legitimate commercial concerns, not ulterior motives.
• Prevention is better than litigation: Transparent communication, objective decision-making criteria, and adherence to industry standards are the most effective ways to demonstrate good faith and avoid disputes.

In fund finance transactions, the duty of good faith and fair dealing serves as a critical check on discretionary authority while preserving the legitimate interests of both lenders and borrowers. By grounding decisions in sound commercial judgment and maintaining transparent practices, parties can fulfill their contractual obligations while minimizing legal risk.