In the annals of business divorce litigation and assorted other disputes between co-owners of closely held business entities, the cause of action for breach of the implied covenant of good faith and fair dealing likely wins the prize for the claim least understood by practitioners and most frequently dismissed by judges.
As I’ve written before, and as Professor Dan Kleinberger noted in his guest post on this blog, at least part of the confusion comes from its name. Start with the term “implied covenant.” To the average reader, it connotes a duty imposed by law without regard to the parties’ intentions and without mutual consent, like a fiduciary duty (the implied covenant often is referred to as the “implied duty”). Next comes “good faith,” connoting something done sincerely and honestly, without malice, disloyalty, or a desire to deceive or defraud. Finally comes “fair dealing.” Fair is fair is the opposite of unfair, right? Put them all together, and you’ve got what sounds like an all-purpose “lite” version of some quasi-fiduciary duty, enabling a court of equity to apply free-floating standards of honesty and fairness to adjust relations between business partners.
By and large, court decisions out of the Delaware Chancery Court have done a far better job than their New York counterparts in explaining the implied covenant’s strictly contractual roots and its parsimonious reach. A particularly good example is Vice Chancellor Sam Glasscock III’s recent Memorandum Opinion in Miller v HCP & Co., C.A. No. 2017-0291-SG [Del Ch Feb. 1, 2018], in which he dismissed a suit brought by a minority member of an LLC alleging that the controller breached the implied covenant by selling the company for $43 million to a third party via private sale rather than conducting an open-market sale or auction to ensure maximum value for all members under the operating agreement’s waterfall.
The waterfall guaranteed the controller the bulk of the first $30 million before any sales proceeds would be available to holders of other classes of membership units. The operating agreement also gave the majority-controlled Board sole discretion as to the manner of any sale to an unaffiliated third party, waived all fiduciary duties from the managers to the members, and obligated every member to consent to a Board-approved sale.
Under these provisions, the plaintiffs contended, the Board had a “perverse” disincentive to negotiate above the $30 million mark. Plaintiffs alleged that the defendants “pushed through a below-market sale” that “allowed them to achieve a quick exit and a 200% return on their capital investment” but left the plaintiffs and other investors “with little to nothing.”
VC Glasscock saw it otherwise:
The problem with the Plaintiffs’ assertion . . . is that the incentive complained of is obvious on the face of the OA [operating agreement]. The members, despite creating this incentive, eschewed fiduciary duties, and gave the Board sole discretion to approve the manner of the sale, subject to a single protection for the minority, that the sale be to an unaffiliated third party. It thus appears that the parties to the OA did consider the conditions under which a contractually permissible sale could take place. They avoided the possibility of a self-dealing transaction but otherwise left to the [defendant] HCP Entities the ability to structure a deal favorable to their interests. Viewed in this way, there is no gap in the parties’ agreement to which the implied covenant may apply. The implied covenant, like the rest of our contracts jurisprudence, is meant to enforce the intent of the parties, and not to modify that expressed intent where remorse has set in.
As so described, the plaintiffs’ claim based on the implied covenant of good faith and fair dealing was doomed from the start. Had the plaintiffs “wanted protection from self-interested conduct by the Defendants,” VC Glasscock pointedly observed, “they could easily have drafted language requiring the Board to implement a sales process designed to achieve the highest value reasonably available for all of [the LLC’s] members.”
The more lasting lesson for practitioners of VC Glasscock’s opinion lies in its thorough explanation of the covenant’s basic principles and the factors considered by courts when applying them. Here’s a partial summary of the opinion’s salient points:
- Delaware’s LLC Act permits parties to eliminate fiduciary duties in the LLC agreement, but, in Section 1101 (c), prohibits elimination of the implied contractual covenant of good faith and fair dealing which “inheres in every contract governed by Delaware law.”
- The elements of an implied covenant claim are those of a breach of contract claim: a specific implied contractual obligation, a breach of that obligation by the defendant, and resulting damage to the plaintiff.
- The implied covenant applies only when one party proves that the other party has acted arbitrarily or unreasonably, thereby frustrating the fruits of the bargain that the asserting party reasonably expected.
- A party’s reasonable expectations are measured as of the time of contracting, and any implied terms must address developments or contractual gaps that the asserting party pleads neither party anticipated.
- Courts will not rewrite a contract simply because a party subsequently wishes it had gotten a better deal.
- The implied covenant does not “establish a free-floating requirement that a party act in some morally commendable sense” and the court “does not derive implied obligations from its own notions of justice or fairness.”
- Fair dealing “does not imply equitable behavior.” The term “fair” is “something of a misnomer” and simply means actions consonant “with the terms of the parties’ agreement and its purpose.”
- “The first step in evaluating an implied covenant claim is to determine whether the contract in fact contains a gap that must be filled.” The covenant “cannot be used to circumvent the parties’ bargain.”
- If the contract does not directly address the matter, the court “must then consider whether implied contractual terms fill the gap” by asking “whether it is clear from what was expressly agreed upon that the parties who negotiated the express terms of the contract would have agreed to proscribe the act later complained of as a breach of the implied covenant of good faith — had they thought to negotiate with respect to that matter.”
- The implied covenant “operates only in the narrow band of cases where the contract as a whole speaks sufficiently to suggest an obligation and point to a result, but does not speak directly enough to provide an explicit answer.”
Now that we know what the implied covenant is and isn’t about, does anyone have a better name for it?