Monday, November 23, 2015

Daniel Kleinberger: Delineating Delaware’s Implied Covenant of Good Faith and Fair Dealing (Contract Is King Micro-Symposium)

Guest Post by Daniel Kleinberger

Part IV– Delaware’s Implied Contractual Covenant of Good Faith and Fair Dealing

Delaware case law applying the implied contractual covenant of good faith and fair dealing to a limited partnership dates back to at least 1993,[i] and Delaware’s limited partnership and limited liability company acts have expressly recognized the covenant since 2004.[ii] However, the contents of the implied covenant have not always been crystal clear.[iii]

     A passage from a 2000 Chancery Court decision is illustrative:

The implied covenant of good faith requires a party in a contractual relationship to refrain from arbitrary or unreasonable conduct which has the effect of preventing the other party to the contract from receiving the fruits of the contract.  This doctrine emphasizes faithfulness to an agreed common purpose and consistency with the justified expectations of the other party.  The parties' reasonable expectations at the time of contract formation determine the reasonableness of the challenged conduct.  [C]ases invoking the implied covenant of good faith and fair dealing should be rare and fact-intensive.  Only where issues of compelling fairness arise will this Court embrace good faith and fair dealing and imply terms in an agreement.[iv]

     This formulation was correct as far as it went, but it omitted the all-important frame of reference.  In the “fact-intensive” inquiry, what types of facts matter?  Where does the court look to determine “the agreed common purpose” and “the justified expectations of the [complaining] party”?  What evidence is admissible to prove the expected “fruits of the bargain”?

     The answers to these questions determine whether “implying obligations based on the covenant of good faith and fair dealing [remains] a cautious enterprise.”[v]  The broader the frame of reference, the more likely is the covenant to become “a judge's roving commission for determining fairness.”[vi] 

     Fortunately, over the past five years the Court of Chancery and the Delaware Supreme Court have provided both clarity and context.  The frame of reference is confined to the actual words of the agreement; the reasonable expectations must be gleaned from those words.[vii]

     Thus, the actual words of the agreement control the application of the implied covenant, both as to “fair dealing” and “good faith”:

“Fair dealing” is not akin to the fair process component of entire fairness, i.e., whether the fiduciary acted fairly when engaging in the challenged transaction as measured by duties of loyalty and care …. It is rather a commitment to deal “fairly” in the sense of consistently with the terms of the parties' agreement and its purpose.  Likewise, “good faith” does not envision loyalty to the contractual counterparty, but rather faithfulness to the scope, purpose, and terms of the parties' contract.  Both necessarily turn on the contract itself and what the parties would have agreed upon had the issue arisen when they were bargaining originally.[viii]

     When a court considers a fiduciary claim, the “court examines the parties as situated at the time of the [alleged] wrong….  [and] determines whether the defendant owed the plaintiff a duty, considers the defendant's obligations (if any) in light of that duty, and then evaluates whether the duty was breached.”[ix]  In contrast, because the actual words of the agreement control the application of the implied covenant:

An implied covenant claim ... looks to the past.  It is not a free-floating duty unattached to the underlying legal documents.  It does not ask what duty the law should impose on the parties given their relationship at the time of the wrong, but rather what the parties would have agreed to themselves had they considered the issue in their original bargaining positions at the time of contracting.[x]

     A successful implied covenant claim depends on finding a gap in the contractual language; therefore, an implied covenant claim cannot override an express contractual provision.[xi]  For example, if a limited partnership agreement creates options for limited partners under specified circumstances and not otherwise, the implied covenant will not extend the option right to circumstances not specified.[xii]  Expressio unius est exclusio alterius.[xiii]  There is no gap.

     But inevitably gaps will exist:[xiv]

No contract, regardless of how tightly or precisely drafted it may be, can wholly account for every possible contingency. Even the most skilled and sophisticated parties will necessarily fail to address a future state of the world ... because contracting is costly and human knowledge imperfect. In only a moderately complex or extend[ed] contractual relationship, the cost of attempting to catalog and negotiate with respect to all possible future states of the world would be prohibitive, if it were cognitively possible. And parties occasionally have understandings or expectations that were so fundamental that they did not need to negotiate about those expectations.[xv]

     For example, suppose that: (i) a limited partnership agreement authorizes the general partner to restructure the organization as the general partner sees fit provided a competent expert provides a “fairness opinion” stating that the restructuring is fair to the limited partners; (ii) a competent expert furnishes the opinion; but (iii) the expert omits to consider the value of certain contingent assets of the limited partnership, namely the value of pending derivative litigation.[xvi]  Because the limited partnership agreement “[does] not specify whether the fairness opinion [has] to consider the value of derivative litigation,” the expert’s omission reveals “a gap for the implied covenant to fill.”[xvii]  The gap is filled with what the court concludes “the parties would have agreed to themselves had they considered the issue in their original bargaining positions at the time of contracting.”[xviii]

     In this respect, the implied covenant analysis resembles the analysis for determining whether a party’s contractual duties are discharged by supervening impracticably.  “In order for a supervening event to discharge a duty …, the non-occurrence of that event must have been a ‘basic assumption’ on which both parties made the contract.”[xix]  For impracticability or a breach of the implied covenant to exist, the situation at issue must have been fundamentally important to the deal and yet unaddressed by the deal documents.  Put another way:  the notion of a “cautious enterprise”[xx] means that only a condition that is egregious or at least extreme is capable of revealing a gap to be remedied by the implied covenant.[xxi]

Endnotes:

[i] Desert Equities, Inc. v. Morgan Stanley Leveraged Equity Fund, II, L.P., 624 A.2d 1199, 1207 (Del. 1993) (“Desert Equities alleges that the defendants breached their implied covenant of good faith and fair dealing when they, in bad faith, breached the Partnership Agreement.”).

[ii] 74 Del. Laws, c. 265, §15 (revising Del. Code tit. 6, § 17-1101(d) to provide inter alia that “the partnership agreement may not eliminate the implied contractual covenant of good faith and fair dealing”).  The same change was made to the limited liability company act by 74 Del. Laws, c. 275, § 13 (revising Del. Code tit. 6, § 18-1101(c) to provide inter alia that “the limited liability company agreement may not eliminate the implied contractual covenant of good faith and fair dealing”).

[iii] Cincinnati SMSA Ltd. P'ship v. Cincinnati Bell Cellular Sys. Co., 708 A.2d 989, 992 (Del. 1998) (stating that “[t]he articulation of the standard for implying terms through application of the covenant of good faith and fair dealing represents an evolution from previous Delaware case law” and that “Delaware Supreme Court jurisprudence is developing along the general approach that implying obligations based on the covenant of good faith and fair dealing is a cautious enterprise”).  See also, e.g., Desert Equities, Inc. v. Morgan Stanley Leveraged Equity Fund, II, L.P., 624 A.2d 1199, 1207 (Del. 1993) (reversing the Chancery Court’s dismissal on the pleadings of plaintiff’s implied covenant claim; accepting the seemingly redundant notion that bad faith breach of the partnership agreement could breach the implied covenant; and suggesting the general partner may have acted in bad faith by “act[ing] unreasonably”).  For a decision that addresses the redundancy issue, see Painewebber R & D Partners, L.P. v. Centocor, Inc., No. C.A. 96C-04-194, 1998 WL 109818, at *4 (Del. Super. Feb. 13, 1998) (“The Court is satisfied that the payment obligations of Centocor are encompassed by the express terms of the PPA and, as a matter of law, cannot be the subject of any implied covenant.”)

[iv] Cont'l Ins. Co. v. Rutledge & Co., 750 A.2d 1219, 1234 (Del. Ch. 2000) (internal quotations and footnotes omitted).

[v] Cincinnati SMSA Ltd. P'ship v. Cincinnati Bell Cellular Sys. Co., 708 A.2d 989, 992 (Del. 1998).

[vi] Daniel S. Kleinberger, Two Decades of "Alternative Entities": From Tax Rationalization Through Alphabet Soup to Contract as Deity, 14 Fordham J. Corp. & Fin. L. 445, 469 (2009) (first presented as the keynote address at the 2lst Century Commercial Law Forum – Seventh International Symposium 2007 – sponsored by School of Law, Tsinghua University, Beijing, People’s Republic of China).  See also Nemec v. Shrader, 991 A.2d 1120, 1128 (Del. 2010) (“Crafting, what is, in effect, a post contracting equitable amendment that shifts economic benefits from [one set of shareholders to another] would vitiate the limited reach of the concept of the implied duty of good faith and fair dealing…. The policy underpinning the implied duty of good faith and fair dealing does not extend to post contractual rebalancing of the economic benefits flowing to the contracting parties.”); Lonergan v. EPE Holdings, LLC, 5 A.3d 1008, 1019 (Del. Ch. 2010) (criticizing and rejecting attempts to “re-introduce fiduciary review through the backdoor of the implied covenant” of good faith and fair dealing).  This point is precisely what divided the majority and dissent in Nemec. The core of the dissent is this statement: “[U]nder Delaware case law, a contracting party, even where expressly empowered to act, can breach the implied covenant if it exercises that contractual power arbitrarily or unreasonably.”  Nemec, at 1131 (Jacobs, J. dissenting).  The statement does not recognize that the frame of reference must be the words of the contract.  Cf. ULLCA (2013) § 409(d), cmt. (stating that “the purpose of the contractual obligation of good faith and fair dealing is to protect the arrangement the members have chosen for themselves, not to restructure that arrangement under the guise of safeguarding it”).  But cf. HB Korenvaes Inv., L.P. v. Marriot Corp., Del. Ch., C.A. No. 12922, Mem. Op. at 11, Allen, C., (June 9, 1993) (“Indeed the contract doctrine of an implied covenant of good faith and fair dealing may be thought in some ways to function analogously to the fiduciary concept.”) (quoted in Gale v. Bershad, No. CIV. A. 15714, 1998 WL 118022, at *5 n. 24(Del. Ch. Mar. 4, 1998); Gale v. Bershad, No. CIV. A. 15714, 1998 WL 118022, at *5 (“The function of the implied covenant of good faith and fair dealing in defining the duties of parties to a contract, is analogous to the role of fiduciary law in defining the duties owed by fiduciaries.”); Blue Chip Capital Fund II Ltd. P'ship v. Tubergen, 906 A.2d 827, 832 (Del. Ch. 2006) (stating that “[t]he court [in Gale v. Bershad] explained that the implied covenant of good faith and fair dealing defines the duties of parties to a contract and is analogous to the role of fiduciary law in defining the duties owed by fiduciaries”) (citing Gale v. Bershad, No. CIV. A. 15714,.1998 WL 118022 at *5, (Del.Ch. Mar. 3, 1998)).

[vii] These points are analogous to Professor Williston’s four corners approach to determining ambiguity for the purposes of the parol evidence rule.  See, e.g., Wallace v. 600 Partners Co., 86 N.Y.2d 543, 548, 658 N.E.2d 715, 717 (1995) (stating that “[t]he question whether a writing is ambiguous is one of law to be resolved by the courts” and that “excursion beyond the four corners of the document” is warranted only when the wording is not “clear and complete”) (citing Williston, 4 Williston, Contracts, § 610A, at 513 [3d ed.]).  The “roving commission” notion resembles Professor Corbin’s approach to the ambiguity question.  “According to Corbin, the court cannot apply the parol evidence rule without first understanding the meaning the parties intended to give the agreement. To understand the agreement, the judge cannot be restricted to the four corners of the document.”  Taylor v. State Farm Mut. Auto. Ins. Co., 175 Ariz. 148, 153, 854 P.2d 1134, 1139 (1993) (citation omitted).  Delaware takes the Williston approach.  GMG Capital Investments, LLC v. Athenian Venture Partners I, L.P., 36 A.3d 776, 781-84 (Del. 2012) Schwartz v. Centennial Ins. Co., No. CIV. A. 5350 (1977), 1980 WL 77940, at *5 (Del. Ch. Jan. 16, 1980) (stating that “parol evidence may not be used to show an ambiguity in the first place”).

[viii] Gerber v. Enter. Products Holdings, LLC, 67 A.3d 400, 418-19 (Del. 2013) (quoting ASB Allegiance Real Estate Fund v. Scion Breckenridge Managing Member, LLC, 50 A.3d 434, 440–42 (Del. Ch. 2012), aff'd in part, rev'd in part on other grounds, 68 A.3d 665 (Del. 2013)) (footnotes omitted) (citations omitted) (internal quotations omitted without ellipsis by Gerber). 

[ix] Gerber v. Enter. Products Holdings, LLC, 67 A.3d 400, 418 (quoting ASB Allegiance Real Estate Fund v. Scion Breckenridge Managing Member, LLC, 50 A.3d 434, 440–42 (Del. Ch. 2012), aff'd in part, rev'd in part on other grounds, 68 A.3d 665 (Del. 2013)) Del. 2013).  Gerber was overruled on other grounds by Winshall v. Viacom Int'l, Inc., 76 A.3d 808 (Del. 2013).  See also Gilbert v. El Paso Co., 575 A.2d 1131, 1142-43 (Del. 1990) (enforcing express conditions pertaining to a tender offer; stating that “[a]lthough an implied covenant of good faith and honest conduct exists in every contract … such subjective standards cannot override the literal terms of an agreement”).

[x] Gerber v. Enter. Prods. Holdings, LLC, 67 A.3d 400, 418 (Del. 2013) (quoting ASB Allegiance Real Estate Fund v. Scion Breckenridge Managing Member, LLC, 50 A.3d 434, 440–42 (Del. Ch. 2012), aff'd in part, rev'd in part on other grounds, 68 A.3d 665 (Del. 2013)) (emphasis added) (footnotes omitted) (citations omitted) (internal quotations omitted without ellipsis by Gerber).  In this respect, the implied covenant parallels the contract law doctrine of unconscionability.  See Restatement (Second) of Contracts § 208 (1981) (stating that the unconscionability analysis addresses whether “a contract or term thereof is unconscionable at the time the contract is made”) (emphasis added); UCC § 2-302 (stating that the doctrine applies only if “the court finds the contract or any clause of the contract to have been unconscionable at the time it was made”) (emphasis added).

[xi] Nemec v. Shrader, 991 A.2d 1120, 1127 (Del.2010) (“The implied covenant will not infer language that contradicts a clear exercise of an express contractual right.”).

[xii] See Aspen Advisors LLC v. United Artists Theatre Co., 843 A.2d 697, 707 (Del. Ch.) aff'd, 861 A.2d 1251 (Del. 2004) (“By specific words, the parties to the Stockholders Agreement and the Warrants identified particular transactions that would provide the Warrantholders with the right to receive the same consideration paid to common stockholders (e.g., in mergers involving United Artists) and the right (if they had exercised their Warrants) to tag along (i.e., in certain change of control transactions). Similarly, the parties also (by omission) defined the freedom of action other parties to those contracts (such as United Artists, the UA Holders, and Anschutz) had to engage in transactions without triggering rights of that nature.”).

[xiii] “[T]o express or include one thing implies the exclusion of the other.” EXPRESSIO UNIUS EST EXCLUSIO ALTERIUS, Black's Law Dictionary (10th ed. 2014).

[xiv] However, whether a gap matters depends on whether a party’s conduct makes the gap apparent – i.e., whether one party’s conduct exposes an issue on which the parties would have agreed had the issue arisen when the deal was being made.

[xv] Allen v. El Paso Pipeline GP Co., L.L.C., No. CIV.A. 7520-VCL, 2014 WL 2819005, at *11 (Del. Ch. June 20, 2014) (internal quotations and citations omitted).

[xvi] In simplified form, this example reflects one of the transactions – the 2010 merger – addressed in Gerber v. Enter. Products Holdings, LLC, 67 A.3d 400 (Del. 2013), overruled on other grounds by Winshall v. Viacom Int'l, Inc., 76 A.3d 808 (Del. 2013).

[xvii] Allen v. El Paso Pipeline GP Co., L.L.C., No. CIV.A. 7520-VCL, 2014 WL 2819005, at *14 (Del. Ch. June 20, 2014).  The opinion refers to the omission “creating a gap,” id. but the author respectfully disagrees.  The gap existed ab initio.  It remained hidden until revealed by the expert’s omission.

[xviii] Gerber v. Enter. Prods. Holdings, LLC, 67 A.3d 400, 418 (Del. 2013) (quoting ASB Allegiance Real Estate Fund v. Scion Breckenridge Managing Member, LLC, 50 A.3d 434, 440–42 (Del. Ch. 2012), aff'd in part, rev'd in part on other grounds, 68 A.3d 665 (Del. 2013)) (emphasis added) (footnotes omitted) (citations omitted) (internal quotations omitted without ellipsis by Gerber).  It might be more consistent with actual practice to revise the quoted language so that the sentence read: “The gap is filled with what the court concludes the now complaining party would have insisted on as a condition to going forward with the deal, if the party had then considered the issue in the party’s original bargaining position at the time of contracting.”

[xix] Restatement (Second) of Contracts § 261, cmt. b (1981)

[xx] See n. 66.

[xxi] In this respect, the implied covenant is similar to the unconscionability doctrine of contract law.  See Restatement (Second) of Contracts § 208. cmt. b (1981) (“Traditionally, a bargain was said to be unconscionable in an action at law if it was ‘such as no man in his senses and not under delusion would make on the one hand, and as no honest and fair man would accept on the other….”) (quoting Hume v. United States, 132 U.S. 406 (1889), which in turn was quoting Earl of Chesterfield v. Janssen, 2 Ves.Sen. 125, 155, 28 Eng.Rep. 82, 100 (Ch.1750)).

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