KleinbergerIn a post two years ago I described the implied covenant of good faith and fair dealing as one of the least understood and most misused legal doctrines in the realm of shareholder and partnership disputes, inappropriately invoked by lawyers as often as not to allege breach of free-floating, fiduciary-like obligations untethered from the doctrine’s contractual foundation.

Here to explain what the implied covenant is — and, just as critically, what it’s not — is Daniel S. Kleinberger (pictured), Emeritus Professor of Law at William Mitchell College of Law. Professor Kleinberger is one of the country’s foremost scholars and leaders in legislative drafting projects concerning unincorporated business organizations. His lengthy bibliography includes widely-cited treatises on LLCs and partnership law along with innumerable articles and papers.

The Professor last graced this blog with a guest post in March 2015 on the subject of veiling piercing and LLCs. His current post on the implied covenant is an abridged version of a paper he presented this year at Tsinghua University’s School of Law in Beijing entitled “Delaware’s Implied Contractual Covenant of Good Faith and ‘Sibling Rivalry’ Among Equity Holders”. The post naturally focuses on the implied covenant’s articulation and application by the Delaware Supreme Court and Court of Chancery as the nation’s leading business court whose opinions often provide guidance to judges in New York and elsewhere grappling with their own, analogous common and statutory law.

I strongly encourage my readers who wish to learn more on the subject to read the unabridged version of Professor Kleinberger’s paper, including extensive footnotes which I found to be terrifically helpful. It’s available by clicking here



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

© Daniel S. Kleinberger – 2015


An obligation of good faith and fair dealing is implied in every common law contract and is codified in the Uniform Commercial Code (“UCC”). 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, the following Part II “clears away the underbrush” by explaining what Delaware’s implied covenant’s “good faith” is not.

A Couple of Major “Nots”

1.  Not the Looser Approach of the UCC

The UCC codifies the common law obligation of good faith and fair dealing for matters governed by the Code: “Every contract or duty within [the UCC] 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 UCC approach for Delaware unincorporated businesses.

2.  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.

The Delaware Supreme Court has flatly rejected the UCC approach for Delaware unincorporated businesses.

3.  Not Whatever is Meant by a Contractual Provision Invoking “Good Faith” 

Some limited partnership and operating agreements expressly refer to “good faith” and define the term. As the Delaware Supreme Court held in Gerber v. Enter. Products Holdings, LLC, such “express good faith provisions” do not affect the implied covenant. In Gerber, the Court rejected the notion that “if a partnership agreement eliminates the implied covenant de facto by creating a conclusive presumption that renders the covenant unenforceable, the presumption remains legally incontestable.”

The rejected notion arose from on an overbroad reading of Nemec v. Shrader – namely that “under Nemec, the implied covenant is merely a ‘gap filler’ that by its nature must always give way to, and be trumped by, an ‘express’ contractual right that covers the same subject matter.” Invoking Section 1101(d) of the Delaware Revised Uniform Limited Partnership Act, the Gerber opinion stated: “That reasoning does not parse. The statute explicitly prohibits any partnership agreement provision that eliminates the implied covenant. It creates no exceptions for contractual eliminations that are ‘express.’”

Some agreements contain express good faith provisions but omit to define the concept. Such omissions render the agreement ambiguous and impose on the courts an interpretative task that involves looking not only to other, related provisions in the agreement but also to the negotiations, if any, and other circumstances that led up to the agreement being made. A few Delaware cases have even resorted to the corporate fiduciary duty concept of good faith. In any event, if, as held in Gerber, an agreement that expressly defines “good faith” cannot affect the implied covenant, a fortiori neither can an agreement that uses the term but omits to define it.

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, and Delaware’s limited partnership and limited liability company acts have expressly recognized the covenant since 2004. However, the contents of the implied covenant have not always been crystal clear.

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

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.” The broader the frame of reference, the more likely is the covenant to become “a judge’s roving commission for determining fairness.”

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.

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. [Gerber, 67 A.3d at 418-19]

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.” (Id.) 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. [Id.]

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. 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. Expressio unius est exclusio alterius. There is no gap.

But inevitably gaps will exist:

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. [Allen v. El Paso Pipeline GP Co., LLC, 2014 WL 2819005, at *11 (Del. Ch. June 20, 2014) (internal quotations and citations omitted)]

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. 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.” 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.”

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.” 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” 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.