The implied covenant of good faith and fair dealing, at least in the realm of shareholder and partnership disputes, may be one of the least understood and most misused legal doctrines.

I suspect the reason is, it’s not quite what it sounds like, and what it sounds like is an all-purpose, “lite” version of some quasi-fiduciary duty. I wish I had a dollar for every complaint I’ve seen in litigation between business co-owners in which, bringing up the rear in a parade of causes of action, the pleader alleges something like, “By reason of the foregoing, defendants breached their duty of good faith and fair dealing.” I wish I had another dollar for every court decision I’ve read dismissing such a claim on the ground it duplicates another cause of action for breach of contract.

Alright, you ask, so what is the implied covenant of good faith and fair dealing? Fundamentally it is a contract-centric doctrine whereby a court fills the “gaps” in the parties’ express agreement by discerning, under a reasonable expectations standard, what the parties would have agreed themselves had they considered the issue.  The doctrine is anchored in Judge Benjamin Cardozo’s 1917 opinion for the New York Court of Appeals in the Lady Duff-Gordon case (222 NY 88), where he famously wrote:

The law has outgrown its primitive stage of formalism when the precise word was the sovereign talisman, and every slip was fatal. It takes a broader view to-day. A promise may be lacking, and yet the whole writing may be “instinct with an obligation,” imperfectly expressed.

A more useful if less poetic description of the implied covenant is found in Dalton v. Education Testing Service, 87 NY 384 (1995), where, about 80 years after Judge Cardozo’s words, the New York Court of Appeals wrote:

Encompassed within the implied obligation of each promisor to exercise good faith are “`any promises which a reasonable person in the position of the promisee would be justified in understanding were included'” (Rowe v Great Atl. & Pac. Tea Co., 46 N.Y.2d 62, 69, quoting 5 Williston, Contracts § 1293, at 3682 [rev ed 1937]). This embraces a pledge that “neither party shall do anything which will have the effect of destroying or injuring the right of the other party to receive the fruits of the contract” (Kirke La Shelle Co. v Armstrong Co., 263 N.Y. 79, 87). Where the contract contemplates the exercise of discretion, this pledge includes a promise not to act arbitrarily or irrationally in exercising that discretion (see, Tedeschi v Wagner Coll., 49 N.Y.2d 652, 659). The duty of good faith and fair dealing, however, is not without limits, and no obligation can be implied that “would be inconsistent with other terms of the contractual relationship” (Murphy v American Home Prods. Corp., 58 N.Y.2d 293, 304).

The covenant of good faith and fair dealing is implied in all contracts, including shareholder, partnership, and LLC agreements. The covenant’s primacy is recognized to the extent that, even in states such as Delaware that generally authorize the restriction or elimination of fiduciary duties for certain types of business forms, by statute the agreement may not limit or eliminate the implied covenant of good faith and fair dealing.

There is an unmistakable trend in modern legal and business practice to include in the business entity’s organic documents broad exculpatory and safe-harbor provisions designed to insulate the firm’s managers against liability in suits brought by disgruntled non-controlling stakeholders. Can such provisions also neutralize claims based on violation of the implied covenant of good faith and fair dealing?

The Delaware Supreme Court’s Gerber Decision

A ruling earlier this month by the Delaware Supreme Court, in Gerber v. Enterprise Products Holdings, LLC, C.A. No. 5989 (Del Sup Ct June 10, 2013), was one of several decisions handed down by that court recently in which the court addressed the effectiveness of pro-management provisions in the organic documents of a business entity creating a conclusive presumption of good faith conduct. In Gerber, though, the question focused on whether provisions in a limited partnership agreement, ostensibly creating a conclusive presumption of good faith in connection with the fairness of certain sale and merger transactions, precluded a claim for breach of the implied covenant of good faith and fair dealing notwithstanding the express prohibition in § 17-1101(d) of the Delaware Revised Uniform Limited Partnership Act against elimination of the implied covenant.

The lower Chancery Court ruled in favor of the defendant general partner, holding that the general partner’s compliance with certain provisions in the limited partnership agreement (“LPA”), involving approval of a conflicted transaction by a special committee and reliance on the opinion of the partnership’s investment banker, insulated it from any liability for fiduciary or contract breach. The Delaware Supreme Court disagreed and reinstated the plaintiff limited partner’s claim for breach of the covenant of good faith and fair dealing.

The flaw in the lower court’s reasoning, according to the court’s decision written by Justice Jacobs, stemmed from

a decision by the LPA’s drafters to define a contractual fiduciary duty in terms of “good faith”–a term that is also and separately a component of the “implied covenant of good faith and fair dealing. Although that term is common, the LPA’s contractual fiduciary duty describes a concept of “good faith” very different from the good faith concept addressed by the implied covenant. [Italics in original.]

Justice Jacobs went on to delineate the difference between the two concepts of good faith by endorsing and quoting Vice Chancellor Laster’s explanation in ASB Allegiance Real Estate Fund v. Scion Breckenridge Managing Member, LLC, 50 A.3d 434, 440-42 (DelCh 2012), aff’d in part, rev’d in part on other grounds, 2013 WL 1914714 (Del May 9, 2013). The essence of the difference, according to VC Laster, is a temporal one. Whereas a court examines the status, relations and conduct of the parties “as situated at the time of the wrong” when analyzing a claim alleging fiduciary breach, a claim for breach of the implied covenant of good faith and fair dealing “looks to the past” and considers “what the parties would have agreed to themselves had they considered the issue in their original bargaining positions at the time of contracting.” As VC Laster further explained,

“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 whose contours are mapped out by Delaware precedents. 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.

Even the most carefully drafted agreement, Gerber‘s quotation of VC Laster goes on,

will harbor residual nooks and crannies for the implied covenant to fill. In those situations, what is “arbitrary” or “unreasonable”–or conversely “reasonable”–depends on the parties’ original contractual expectations, not a “free-floating” duty applied at the time of the wrong.

Is there a lesson for New York practitioners in Gerber? Absolutely.

• First, the court’s temporal distinction between the implied covenant and fiduciary claims provides a highly useful analytical framework.
• Second, understanding the different meanings of the terms “good faith” and “fair dealing” in the implied covenant context versus the fiduciary breach context will eliminate wasteful litigation of claims confusing one with the other.
• Third, New York transactional lawyers and litigators alike should study closely the court’s full opinion to understand better the extent to which parties to partnership-type agreements may limit the liability of business managers with a combination of exculpatory provisions and contractually defined standards of conduct designed to preempt judicial review.