Monday, November 16, 2015
Daniel Kleinberger: Delineating Delaware’s Implied Covenant of Good Faith & Fair Dealing (Contract Is King Micro-sympsium)
Guest post by Daniel Kleinberger:
Part I - Introduction
My postings this week will seek to delineate Delaware’s implied contractual covenant of good faith and fair dealing and the covenant’s role in Delaware entity law
An obligation of good faith and fair dealing is implied in every common law contract and is codified in the Uniform Commercial Code (“U.C.C”). The terminology differs: Some jurisdictions refer to an “implied covenant;” others to an “implied contractual obligation;” still others to an “implied duty.” But whatever the label, the concept is understood by the vast majority of U.S. lawyers as a matter of commercial rather than entity law. And, to the vast majority of corporate lawyers, “good faith” does not mean contract law but rather conjures up an important aspect of a corporate director’s duty of loyalty.
Nonetheless, Delaware’s “implied contractual covenant of good faith and fair dealing” has an increasingly clear and important role in Delaware “entity law” – i.e., the law of unincorporated business organizations (primarily limited liability companies and limited partnerships) as well as the law of corporations.
Because to the uninitiated “good faith” can be frustratingly polysemous, this first blog “clears away the underbrush” by explaining what Delaware’s implied covenant’s “good faith” is not.
Part II – A Couple of Major “Nots”
- Not the Looser Approach of the Uniform Commercial Code
The Uniform Commercial Code codifies the common law obligation of good faith and fair dealing for matters governed by the Code: “Every contract or duty within [the Uniform Commercial Code] imposes an obligation of good faith in its performance and enforcement.” The Code defines “good faith” as “mean[ing] [except for letter of credit matters] honesty in fact and the observance of reasonable commercial standards of fair dealing.” An official comment elaborates: “Although ‘fair dealing’ is a broad term that must be defined in context, it is clear that it is concerned with the fairness of conduct rather than the care with which an act is performed.”
The UCC standard thus incorporates facts far beyond the words of the contract at issue and furthers a value (fairness) which in the entity context is usually the province of fiduciary duty. The UCC definition provides some constraint by referring to “reasonable commercial standards,” but “[d]etermining . . . unreasonableness inter se owners of an organization is a different task than doing so in a commercial context, where concepts like ‘usages of trade’ are available to inform the analysis.” ULLCA (2013) § 105(e), cmt.
The Delaware Supreme Court has flatly rejected the U.C.C. approach for Delaware unincorporated businesses.
- Not the Corporate Good Faith of Disney, Stone v. Ritter, and Caremark
An obligation to act in good faith has long been part of a corporate director’s duty under Delaware law, but the concept became ever more important following the landmark case of Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985). In Van Gorkom, the Delaware Supreme Court held directors liable for gross negligence in approving a merger transaction, a holding that “shocked the corporate world.”
Spurred by the Delaware corporate bar, the Delaware legislature promptly amended Delaware’s corporate statute. The amendment permits Delaware corporations to essentially opt out of the Van Gorkom rule. The now famous Section 102(b)(7) authorizes a Delaware certificate of incorporation to:
eliminat[e] or limit the personal liability of a director to the corporation or its stockholders for monetary damages for breach of fiduciary duty …, provided that such provision shall not eliminate or limit the liability of a director: (i) For any breach of the director's duty of loyalty to the corporation or its stockholders; [or] (ii) for acts or omissions not in good faith….
In effect, the provision authorizes exculpation from damages arising from claims of director negligence, but for some time the exception “for acts or omissions not in good faith” was controversial. Where plaintiffs could not allege breach of the duty of loyalty, they sought to equate “not in good faith” with extreme negligence.
Notably, the meaning of “not in good faith” was pivotal in the lengthy and costly litigation arising from the Disney corporation’s termination of Michael Ovitz. However, the Supreme Court’s decision in In re Walt Disney Co. Derivative Litig. left the issue murky. Eventually, in Stone v. Ritter, the court made clear that in this context “good faith” is an aspect of the duty of loyalty. The Court then equated a lack of this type of good faith with a director’s utter failure to attend to his or her oversight obligations (the so-called Caremark I duties).
Thus, a Delaware director’s fiduciary duty of good faith has nothing to do with the “good faith” of the Delaware implied covenant of good faith and fair dealing.
This posting is derived from Daniel S. Kleinberger, “Delaware’s Implied Contractual Covenant of Good Faith and “Sibling Rivalry” Among Equity Holders,” a paper presented at the 21st Century Commercial Law Forum: 15th International Symposium in Beijing, at Tsinghua University’s School of Law, November 1, 2015 (all footnotes and most citations omitted).